Road to Recovery: First Edition

This new series is designed to help investors look beyond today’s unprecedented noise, put events in context as they unfold, and understand important investment themes amidst incredible emotional and financial volatility.

The title of this series is admittedly premature. We are in the throes of the worst health crisis in modern times, which has sparked one of the fastest market corrections in history. We are in the early stages of understanding the impact of the virus on our health systems, economic activity, and financial markets. The news is certainly going to get worse before it gets better.

Still, there are key steps unfolding that are gradually helping our communities, our nation, and our markets get back in order. It will take time, with inevitable successes and missteps. Solutions will emerge unpredictably, with inconvenient timing. But they will emerge.

Importantly, from an investment perspective, we suspect the path to solution will introduce a new underlying investment regime—one no longer governed by historically low interest rates, negligible inflation, and meager growth. It will likely produce a different set of investment winners and losers than we’ve seen over the prior decade. We will be discussing what this regime might look like in the coming weeks and as the path to solution emerges.

In this first edition, we lay out the Pathway to the End Game and recognize A Bit of Good News from Monday’s markets.

First Things First: Pathway to the End Game

Until a vaccine is developed (perhaps 12 months away) or the virus runs its course (which can happen, but no guarantees), the path to stability will not come from better demand or improved supply chains.

It will come instead from government intervention, prudent pacing within the health care system, and concerted behavioral change by large populations.

The major challenge is that efforts to contain the virus—and there are several, very different strategies being used—have brought major parts of national economies to a complete halt. The urgency is that the longer it takes to get economies running again, the worse the level of lay-offs, bankruptcies, and investment in the future becomes. Time is of the essence to avoid long-term damage.

Our framework for the “pathway to the end game” includes three elements, in our view:

1. A bridge or safety-net to help affected businesses and families make it through this period of forced economic dislocation. That bridge will be in the form of NEW monetary policies from central banks and AGGRESSIVE fiscal policies from national governments. These will eventually need to be unwound, but that will be a different, future problem.
2. Finding the formula that contains the virus—a solution that is unique to a particular country’s values, traditions, and social norms. The US, France, Spain, and UK, for example, can learn from China, South Korea, Singapore, and Italy, but the solutions won’t be uniform or easily replicable across the countries.
3. Sustained commitment to new behaviors that are not likely to stop in the next few months. Analogous pandemics sometimes took several rounds of resurgence before ultimate containment.

These three elements are interrelated and dependent on each other to a large extent. Absent a vaccine, there’s no simple solution. We expect markets to remain volatile as they measure progress along this path.

A Bit of Good News on Monday: Credit Markets Returned to Rational Trading

In terms of building a bridge or safety-net, we believe the Fed’s announcement over the weekend to use unprecedented tools to address liquidity concerns in credit markets was a very positive, early step.

By way of background and for context, recall two things:

• The Fed’s initial actions—to lower rates to near-zero earlier in March and to push yields down in longer-term bonds and mortgage-backed securities—did nothing to calm equity markets. Stocks continued to go down, sending a message that traditional monetary policy had likely run its course and was not the solution to the current problem.
• Then, about two weeks ago, credit markets started to show signs of deep stress. These were bad signs that lenders would rather hold cash than provide liquidity to banks or credit to investors:
  • Yields on 10-year Treasury securities began to rise (prices falling) even as stocks were falling.
  • Buyers of mortgage-backed securities—important to support consumer housing trends—essentially disappeared, driving mortgage rates higher.
  • Yields on overnight loans between banks and other short-term facilities started rising, compared to longer-term rates.

In response, the Fed signaled yesterday that it would bring bigger, more substantial resources to the problem, including:

• Providing $1-$2 trillion of support to short-term credit markets (such as overnight bank loans and commercial paper markets), helping to stabilize money market funds, overnight funding facilities, and even state and local government municipal funding.
• Increasing its long-term bond buying from $700 million to essentially “what it takes” to keep credit markets functioning.
• Offering an initial $300 billion to three areas:
  • Lending facilities to support large corporations issue new bonds and investors trade existing bonds (a new program)
  • Lending facilities to small businesses, backed by collateralized assets like credit card loans, auto loans, and student loans (actually used during 2008-9, too)
  • Lending programs to “eligible small businesses” (still to be defined, presumably through Congress)

In short, the Fed, building momentum over the past three or four weeks, has moved quickly to strive to reduce borrowing costs; keep credit flowing to businesses, state and local governments, and small enterprises; and introduce mechanisms that support expected fiscal policy from Congress.

Trading in bond markets confirmed the intended impact: on Monday, the 10-year Treasury yield dropped (prices rose) as stocks fell, mortgage rates fell incrementally, and yields on muni bonds dropped. One day does not make a trend, however, and we point out that riskier areas of fixed income like junk bonds continue to trade down, with widening spreads.

Strengthening the Bridge: Fiscal Policy from Congress
Alas, maintaining liquidity in credit markets is only part of the solution. The Fed’s actions may help improve borrowing activity and an orderly distribution of funding, but it alone does not speak to the major downdraft hitting the economy now: the fact that business activity and consumer spending have significantly slowed down.

Congress has already begun debating legislation to set fiscal policy, expected to be $1 trillion to $2 trillion initially. We don’t have a lot of details on what’s in the package, but we expect it to provide: direct financial assistance to households ($300 billion?); expanded unemployment benefits ($200 billion?); loans to small businesses with additional incentives to retain workers; support for hospitals and health workers ($250 billion?); and perhaps some support to state and local governments.

Currently, Republicans and Democrats have not reached agreement on the final package. We anticipate they will arrive at agreement, which should help strengthen the safety net in what is proving to be a difficult and looming economic crisis.

Final Thought
At this point, it is clear to us that the US, China, and other major global economies have already entered a period of negative growth. Estimates are for the US to experience -2% to -5% for the first quarter, and a historic decline in second quarter (perhaps an annualized -10% to -20% or more). The markets are already anticipating something like this.

How economies rebound in the second half of the year, in our view, will depend primarily on the three elements we’ve outlined above. A sound fiscal plan from Congress, working in conjunction with the dramatic intervention by the Federal Reserve, will go a long way in putting the support in place to navigate the challenges of containing COVID-19.