It May Look Like A Depression, But It's Not

Former Fed Chair Ben Bernanke said it best: "This is more like a major snowstorm than the Great Depression."

Imagine if a lethal snowstorm dropped ten feet of snow on all of the inland areas of the U.S., or if a deadly set of hurricanes damaged the major coastal population centers. There would be some parts of the country that would cope reasonably well, but in most places economic activity would grind to a halt and take months to get back to normal. Activities would be canceled. Employees would be furloughed. Store shelves would be depleted and restocking limited.

But unlike the present situation, few would fear losing their permanent job. Those who could keep working would do so, and those who couldn’t would wait until their employer had a new plan (or location) and called them back in.

What would also be different is that even with a large number of fatalities and mass furloughs, there would be less tendency to panic and sell stocks. Most investors would recognize the situation as a more intense version of other natural disasters experienced in the past, remaining more focused on the long-term value of corporations as opposed to jumping to the conclusion that it’s the end of capitalism as we know it.

Of course, the coronavirus epidemic is not familiar to anyone, so it’s hard to visualize any return to a normal economy. But if you extend the horizon some three years into the future, it’s difficult to see a scenario where things don’t improve. At that point, most of the population will either be vaccinated or have natural immunity to Covid-19, and will have returned to their normal pattern of spending. For those who still get infected, a variety of anti-viral drugs could keep them out of the hospital. And the effects of many other diseases may be dwindling too, because vaccine technology (which failed to generate much interest over the last two decades) should finally have the respect it deserves. And with that it should attract large amounts of investment capital, resulting in new breakthrough products and possibly better replacements for existing vaccines.

As to how the path toward an economic recovery will play out, it’s not an easy thing to predict. The 2008 Financial Crisis caused roughly 1 in 6 businesses to fail, with most being liquidated or sold to stronger competitors. Today the high-yield bond markets are suggesting it may not be that bad this time around. Unlike the Financial Crisis, Congress appears more willing to backstop the economy until everything gets back on track, setting the stage for the stock market to recover faster than it did back then (from its March 2009 lows, the S&P 500 took 3.5 years to recover its losses). Of course, no one knows for sure. With much of the global economy in the same situation, we might see synchronized stagnation instead of synchronized growth. But given that most of the world’s central banks are boldly stepping up, the odds favor a recovery that’s faster than what we saw a little over a decade ago. Today’s response has been very different compared with the events that played out in 2009, when the ECB wasn’t even sure if it had the authority to act like a central bank!

Given that efforts to contain and/or eradicate Covid-19 may have costs (relative to GDP) that are on par with major wars fought in the past, some will question whether the U.S. can take on such a large amount of additional Federal debt without "bankrupting" the country in the process. Fortunately, the U.S. has less than half as much debt as Japan and has never needed a goods and services tax. Because there is broad agreement that saving people’s lives and restoring personal freedom is worth whatever it costs, Congress will likely be willing to swallow some tough medicine when we emerge from this successfully. So if the answer is a national goods and services tax (perhaps similar to the 5% GST that Canada implemented in 1991), rest assured that we’ll be able to service whatever debt we end up with. Estimates for that kind of tax put the additional revenue generated at roughly $3 trillion over a decade.

So while we are clearly in uncharted territory, it’s unlikely we’re heading for a depression. Much like the 2008 Financial Crisis, we will probably see a period where financially strong companies buy out their weaker competitors, with overall earnings returning to near-normal levels in a period of less than three years.

First Quarter Review
The stock market’s reaction to the only pandemic that’s ever shut down the U.S. economy was intense, with stock and bond losses that rivaled the 2008 Financial Crisis at one point in late March. Recovery began as The Fed cut interest rates and injected liquidity into the bond markets, and continued as Congress was negotiating the final sticking points on the bipartisan CARES act (which was completed and signed by Trump in just weeks, compared with months for the Financial Crisis bailout package). For the quarter the S&P 500 posted a loss of 19.6%, while the Barclays Aggregate Bond Index finished with an increase of 3.1%.

Selling activity was unusually strong due to the Black Swan nature of the pandemic, in part because there is mortality risk along with the usual financial fears. As a result, a large volume of securities moved from weak hands to strong hands in a very short period of time. The strong hands are in many cases corporate insiders who have a better idea than analysts or the general public regarding how easy it will be to survive a 3-6 month shut-down of the economy.

Our portfolios performed in line with their risk targets during the selloff, except for a brief period when liquidity in corporate bonds temporarily magnified losses. Amid high volatility levels we opted to stand pat. In fast-moving markets it is often too risky to make defensive moves; that was especially true this time, given the potentially oversold nature of the plunge (the last thing we wanted to do was lock in losses right near the bottom).

The stock side of our portfolios maintained a heavy tilt toward growth stocks, which helped to limit losses (in this situation, technology and health care firms are among the least threatened by the economic shutdown). On the bond side, our heavy emphasis on corporates - both investment-grade and high-yield - caused us to lag the Barclays index by a significant amount. Still, given the unusually large yield premium on corporate bonds (especially high-yield issues), we expect it will be relatively easy to outperform the bond benchmark over the next 12 months.

Outlook
Assuming daily new cases of Covid-19 peak in most regions during the month of April, the stage should be set to begin re-starting the idled portion of the economy. Given the large number of on-site coronavirus testing systems being rolled out (including some that provide results in just minutes), factories that employ thousands of workers may have an option that lets them resume operations relatively quickly by testing everyone who returns. Smaller businesses may have to adopt new procedures, but odds are most will be up and running within a month or two, though it’s an open question as to when business levels will return to normal. The leisure sector may take the longest, because consumers will remain cautious, except perhaps for a small percentage of the population who might learn they have natural immunity through an antibody test. The rest of us may need to remain cautious until an effective vaccine is rolled out, and for that reason destinations, restaurants and events may not fully recover until 2021.

Compared with the aftermath of the Financial Crisis, the current situation does not seem to be having as much impact on construction activity (back in 2008-2011, a large share of it ground to a halt and spending didn’t fully recover until 2016). That’s good news, because construction activity has both a long lead time and a big multiplier effect on economic activity. So if it holds up reasonably well, the rest of the economy can get back on track faster and easier.

There will be bankruptcies. Many of them might have occurred normally over a five-year period (especially in the retail sector), but the shut-down could greatly speed up the process. This is not necessarily a bad thing. To the extent that these firms re-emerge with healthier balance sheets, or get liquidated with valuable assets being sold to stronger competitors, it sets the stage for the economy to rebound faster when it can. In the current situation, there are many technology disruptor firms in a relatively strong position and many retail and leisure firms with very weak balance sheets. One likely scenario is that much like the period from 2009-2012, the strong will buy out the weak and in three years earnings largely recover to previous levels.

So, at this point the stock market recovery is largely a waiting game. Low interest rates combined with GDP weakness prompts investors to favor growth stocks. Given that our stock holdings are already tilted in favor of growth-oriented firms, we’re comfortable with our current positioning, though we may adjust some positions to keep volatility scores on the low end of their targeted range. While there are interesting opportunities among heavily indebted firms, it probably doesn’t make sense to consider this segment until the market has fully discounted the bleak employment figures that may be yet to come. On the bond side, we remain bullish on the high-yield sector. Some of our blended portfolios already have positions in this segment, and for those that don’t, we’ll be looking to move in that direction as the risk scores allow.

Sincerely,

Jack Bowers
President & Chief Investment Officer