Virus starts with v but ends with u-shaped

We have seen second-quarter annualized GDP estimates ranging from -5% to -30%, but the unprecedented combination of a pandemic and the modern global economy makes this very difficult to call.
April 2020

2020 began largely as we expected from an economic perspective, but as the first quarter ended it was difficult even to remember what “normal” economic times looked like, that is, before COVID-19 mushroomed and became a global health crisis.

Before the situation deteriorated in late February, many economists expected the economic effects of the virus to be primarily felt in the first and second quarters with a “v-shaped” recovery to follow. Now many expect a “u-shaped” recovery occurring perhaps by year-end. Economic indicators can lag the headlines, but U.S. unemployment had already begun to spike as the first quarter ended with more to come, likely climbing to double digits as large segments of the economy remain shut down in an effort to contain the virus. We have seen second-quarter annualized GDP estimates ranging from -5% to -30%, but the unprecedented combination of a pandemic and the modern global economy makes this very difficult to call. The numbers will be painful, regardless of the precise magnitude. In terms of the human cost, the pain is already acute.

A large dose of reality

Worldwide cases of the virus are more than 1.5 million at this writing, with 89,000 deaths. The U.S. became the global leader in cases toward the end of the first quarter and now has nearly a half-million cases with more than 14,000 deaths. U.S. political and business leaders struggled to come to terms with the risks associated with the virus for much of the quarter. As late as March 24, President Trump was still publicly suggesting that he wanted the country “opened up” by Easter. A week later, the administration finally appeared more unified under a new course, acknowledging that deaths could reach between 100,000 and 240,000 even if social distancing and shelter-in-place requirements remain in place through April and beyond. The administration’s health officials remain optimistic that those numbers will not be reached if the U.S. population follows the distancing guidelines.

The Fed as first responder

While the administration’s response was inconsistent during the first quarter, the Federal Reserve (Fed) responded immediately and decisively once the writing was on the wall for the economy. In addition to cutting interest rates to zero, the Fed enacted financial-crisis-era measures such as the term asset-backed securities loan facility along with new programs, including a commitment to buying corporate bonds in the primary and secondary markets. Liquidity evaporated in fixed income markets as the crisis accelerated in March, and the Fed’s actions should help to keep capital markets functioning and thus help businesses acquire funding in the coming quarters, when some of the sharpest economic pain is likely to be felt.

The Fed is also looking after “Main Street” through a program to support loans to small- and medium-sized businesses. Combined with its commitment to quantitative easing without limits (known by some as “QE Infinity”), the Fed has gone from the lender of last resort to big banks to lender of last resort for the entire economy. While this expanded role concerns some market observers, as investors we support the Fed’s bold and decisive actions to support the economy during this crisis. At this point we believe it prudent to err on the side of overreaction, especially considering the lack of inflationary pressures in the economy.

Fed balance sheet

Virus starts with v but ends with u-shaped - Fed balance sheet chart

Sources: U.S. Federal Reserve, BMO Global Asset Management

Pandemics aren’t red or blue

Once it became clear that the monetary policy response in the U.S. would be aggressive, expectations for fiscal stimulus took center stage. Congress and the Trump administration responded relatively quickly given the deeply entrenched partisan divide in Washington. At roughly $2 trillion, the package dwarfs the government’s 2009 stimulus ($831 billion) and includes direct payments to families and support for businesses of all sizes. The direct payments are to be delivered within weeks of the bill’s passage, but some questions remain regarding the timing of other elements of the plan, such as support for stretched health-care resources in hard-hit states like New York and loans to municipalities and businesses. With the effects of the crisis already starting to show in unemployment claims, which spiked during the last week in March, Congress may need to provide further support as the U.S. economy struggles to recover its health.

Equity markets struggle to price in the effects

The forward-looking nature of asset prices was in sharp focus as the crisis escalated in March, with wild swings in the equity markets as investors weighed the inevitable pain of an economic full-stop against the potential relief provided by monetary policy and fiscal stimulus. The S&P 500 moved more than 1% on 21 of the 22 trading days in March while also recording its largest single-day rally since 2008 (rising more than 9% on March 24).

The volatility has already elicited speculation regarding the bottom for equity markets. While no one is likely to predict this with any certainty, what is certain is that we are facing a sharp contraction, bleak economic data and many negative headlines in the near term. Unemployment will climb, particularly in hospitality, tourism and other customer-facing sectors. Manufacturing, which was primed for a strong bounce back this year, now faces twin supply and demand shocks.

Corporate earnings expectations fell dramatically during the quarter with analysts racing to mark down expectations that looked elevated to us heading into 2020. While 10% earnings growth was expected coming into the year, consensus expectations have now moved into sharply negative territory. Additionally, share buybacks and dividend increases, a key tailwind for equities in recent years, are likely to come off meaningfully, not least because of political pressure on corporations who have accessed various government loan programs.

As a result of these factors, it is probably too early to call market lows and we are expecting more volatility. However, the tone of our discussions has shifted — in early March we were focused on what we wanted to sell and are now considering what we may want to buy.

Fixed income: From liquidity everywhere to not a drop to drink

At this point it may be difficult to recall that we began the year with the Fed on hold and some signs of an economic rebound around the world. For example, global manufacturing PMIs turned higher as 2019 ended and we expected further improvement in the sector this year. However, once policymakers grasped the global economic implications of the crisis and cut rates aggressively, the debate shifted quickly from whether or not there would be a recession to how deep and protracted the recession would be. Investors became aggressively bearish and things got quite hairy in the fixed income markets as yields cratered, liquidity vanished and spreads ballooned. Corporate bonds were especially hard hit — during the weeks of March 13 and March 20 corporate spreads doubled the widening that occurred during the worst weeks of 2008 at the height of the financial crisis, while high-yield spreads blew past 1,000 basis points, the threshold that would typically place an individual bond into the “distressed” category in an index.

Bloomberg Barclays U.S. Aggregate Corporate OAS

Virus starts with v but ends with u-shaped - Bloomberg Barclays US Agg Corporate OAS chart

Sources: Bloomberg Barclays, BMO Global Asset Management

The Fed did not hesitate and quickly announced the aforementioned programs to buy corporate bonds in both the primary and secondary markets. The Fed also moved to support money markets, allowing banks and broker-dealers to purchase commercial paper from money market funds at attractive funding rates. Many similar actions occurred around the globe as central banks sought to maximize the monetary policy response to the crisis. However, though we saw some improvement in fixed income markets as a result of these quick actions, the road back to “normal” conditions remains a long one. High yield and investment grade corporate spreads tightened but remained historically wide as the quarter came to a close.

Weren’t we just talking about an election?

Remember when the Democratic primaries and the 2020 presidential election seemed to lead the news every day? Though most of the remaining primaries have been postponed, Joe Biden had wrestled control of the Democratic nomination away from Bernie Sanders just prior to the eclipse of electoral politics by the COVID-19 crisis. While the entire context has shifted due to the virus, tail risk to market sentiment has still been reduced by a moderate candidate becoming the Democratic front-runner. Meanwhile, President Trump’s reelection campaign has started to position him as a “wartime” leader fighting the virus. His approval rating has moved roughly in line with the equity markets, however, so the economic news over the next six months may be a determining factor for undecided voters, thought to be a rare species in these times of unprecedented partisanship but nonetheless crucial in swing states such as Michigan and Pennsylvania.


Needless to say, during a quarter such as this we felt it prudent to reduce risk in portfolios. In mid-March, we trimmed equity exposure, selling international developed equities into cash. We will look to redeploy and expect to do so soon, as opportunities tend to develop quickly in volatile market environments.

We have been either negative or neutral on credit broadly for the last two years. We have seen better opportunities in equities and even wondered when or how a better environment for buying credit would materialize. Well, one dramatic month has significantly altered the picture, and credit is finally starting to look more attractive on a cross-market basis, particularly U.S. investment grade. This will be an area of focus as we assess our portfolio positioning in the difficult months ahead.

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This is not intended to serve as a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. Information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. This presentation may contain forward-looking statements. “Forward-looking statements,” can be identified by the use of forward-looking terminology such as “may”, “should”, “expect”, “anticipate”, “outlook”, “project”, “estimate”, “intend”, “continue” or “believe” or the negatives thereof, or variations thereon, or other comparable terminology. Investors are cautioned not to place undue reliance on such statements, as actual results could differ materially due to various risks and uncertainties.

This publication is prepared for general information only. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investment involves risk. Market conditions and trends will fluctuate. The value of an investment as well as income associated with investments may rise or fall. Accordingly, investors may receive back less than originally invested.

The Bloomberg Barclays U.S. Aggregate Bond Index is an index that covers the U.S. investment-grade fixed-rate bond market, including government and credit securities, agency mortgage pass through securities, asset-backed securities and commercial mortgage-based securities. To qualify for inclusion, a bond or security must have at least one year to final maturity and be rated Baa3 or better, dollar denominated, non-convertible, fixed rate and publicly issued.

Purchasing managers’ indexes (PMIs) are based on monthly surveys sent to senior executives at companies in key industries. The surveys include questions regarding business conditions and whether conditions are improving, deteriorating or holding steady.

The S&P 500® Index is an unmanaged index of large-cap common stocks.

Investment cannot be made in an index.

The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Basis points (bps) represent 1/100th of a percent (for example: 50 bps equals 0.50%).

Foreign investing involves special risks due to factors such as increased volatility, currency fluctuation and political uncertainties.

Past performance is not necessarily a guide to future performance.

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