“A black swan is an unpredictable event that is beyond what is normally expected of a situation and has potentially severe consequences. Black swan events are characterized by their extreme rarity, their severe impact, and the widespread insistence they were obvious in hindsight.” – Investopedia

“You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in the markets. When hit with recessions or declines, you must stay the course. Economies are cyclical, and the markets have shown that they will recover. Make sure you are a part of those recoveries!” – Peter Lynch, Manager of the Fidelity Magellan Fund between 1977 and 1990, when the fund averaged more than 29% per annum.

LAST QUARTER REVIEW

The longest Wall Street bull market in history ended on its 11th anniversary on Monday the 9th March, when the coronavirus black swan that had until then seemed a largely Chinese and Asian problem, announced its true threat to the global economy! Less than three weeks earlier, the S&P 500 had closed at a record of 3386.15 representing a gain of more than 400% since the post Lehman closing low of 676.53 on the 9th March 2009.

The almost surreal events of the last three weeks can truly be described as a black swan event simply because if any of us had been told just a couple of weeks ago that the whole of the UK (as well as much of the rest of the world) would be on lockdown with huge swathes of economic activity mothballed for the foreseeable future, we would not have believed it. Yet this is the scenario we are in following the unprecedented spread of the coronavirus dubbed COVID-19 that originated in Wuhan in Hubei province, China in mid-November 2019.

While investors had been watching the worrying scenes of what had been happening in Italy throughout February, which outside of Asia had been the only country severely impacted with COVID-19, markets had remained relatively calm on the expectation that the virus could be contained and was unlikely to become a pandemic. The catalyst for Black Monday’s collapse was the events of Sunday the 8th March when talks between Saudi Arabia and Russia on controlling oil supply in response to slowing demand from the countries impacted by COVID-19 and in particular China, broke down.

The oil price immediately collapsed by 20% and at one point was down 31%, the biggest drop since the Gulf war in 1991 before beginning to impact equity markets in Asian time zones. By the time Wall Street began trading on Monday the 9th, the die was cast and panic ensued, which would have undoubtedly been exacerbated by the algorithmic sell signals from passive funds which these days make up such a large segment of overall markets.

In the bond market, the yield on the benchmark 10 year US Treasury (UST) fell below 0.5%, and the yield on the US Long Bond (30 year UST) closed below 1% on Monday the 9th, both historical firsts. A rollercoaster week in equity markets, that likely signals the type of volatility investors may have to endure until the COVID-19 infected numbers have peaked in the West, ended on Friday the 13th March with the S&P surging on the back of policymaker response, albeit still down 8.79% for the week.

Looking at the S&P 500 index, investors had seen the US market fall 7.6% on Monday 9th, rise 4.94% Tuesday, fall another 4.89% Wednesday, fall again 9.54% Thursday before bouncing again 9.29% on Friday. No wonder traders and investment managers’ nerves on both sides of the Atlantic were frayed by the weekend.

On Sunday March 15th, the Federal Reserve whom had already reduced interest rates by 0.5% (at a Federal Market Open Committee meeting) in early March to 1.25% took the unprecedented action of reducing rates by another 1% effectively re-introducing a zero interest are policy (ZIRP), while also announcing a massive $700 billion quantitative easing (QE) program. Some might have expected the market to respond well to this news, but instead the reverse happened as traders maybe sensing worse was to come with the economic impact caused by COVID-19, sold heavily when markets opened on Monday the 16th March.

On that day, the S&P 500 fell 11.98%, and the equity market continued its volatility during that second week of the bear market, although interestingly as so often happens in a time of crisis, the perceived safe havens of US Treasuries and gold also fell heavily, as leveraged investors with margin calls sold whatever liquid assets they could get their hands on. On Monday, the 23rd March, the Fed announced additional monetary measures to counter the emergency including the provision of up to $300 billion in new financing for employers, consumers, and businesses; and a program to continue purchasing Treasury securities and agency mortgage-backed securities in the amounts needed to support smooth market functioning.

Amid the continuing uncertainty as investors waited to see what fiscal package Congress would add to what was effectively unlimited QE pledged by the Fed, Wall Street indices fell on Monday the 23rd March, with the S&P 500 closing at 2237.4%, down 34% from the all-time record high of 3386.15, established on the 19th February this year. Since then markets have not only stabilised but officially entered a new (cyclical) bull market at the end of trading on Thursday 26th March, as the S&P closing price of 2630.07 was up just over 20% since the Monday (23^rd) low, and incredibly down only around 11% since the 6th March, albeit 22% since the record high of the 19^th February.

This shows investors the incredible volatility that can occur in a schizophrenic market alternating between fear and greed, and often displaying whichever emotion at counterintuitive moments. This was never more apparent than with the Thursday (26th) rise of more than 6% in the S&P 500 on the day the Department of Labor announced that the number of Americans filing for unemployment benefits jumped to an all-time high of 3.28 million in the week ended March 21st, the highest level since the series began in 1967 and well above market expectations of just one million, as efforts to contain the rapid spread of COVID-19 hit businesses and activity across the country.

Part of the reason for equity markets remaining becalmed and recovering some of the losses into the quarter end was due to the decision by Congress on Wednesday the 25th March to approve a $2 trillion fiscal rescue package to help alleviate the economic stress during the next several weeks. Similar fiscal and monetary stimulus measures have been taken in the UK, the European Union and elsewhere in the world to try and help ease the economic pain while markets wait for the coronavirus peak infection point to pass.

GDP Data shown are to the 31st December 2019; Interest Rate, Equity & Bond Index Data are to the 31st March 2020; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices used: S&P US T-Bond, S&P UK Gilt Bond, S&P Eurozone Sovereign Bond (Eur), S&P China Bond, S&P Japan Government Bond, S&P Germany Sovereign Bond.

CURRENT CONSIDERATIONS

Our optimistic expectations that we wrote about in our last Market View just three months ago have been cruelly shattered by the COVID-19 black swan that virtually no market commentator or investor could have foreseen. Instead we are now looking at what can be salvaged economically from the inevitable US and global recession that has commenced, and whether we are likely to see a quick recovery (V shaped), a more gradual recovery (U) or indeed a prolonged recession / depression (L).

The impact of COVID-19 crept up stealthily on markets as people in different parts of the world first stopped travelling, and then stopped eating out. Now, all over the world, governments are telling its citizens to stay at home, and worst of all nobody knows how long for, meaning uncertainty which markets hate with a vengeance!

The monthly purchasing managers’ indices (PMIs) published by IHS Markit, on the 24th March should offer an indication of how deep the recession might be in the US and other western economies. The data are worse than anyone could have expected and suggest a recession comparable to that of the financial crisis of 2007-09, and maybe even more severe.

The PMIs are compiled from surveys of purchasing managers at 400 companies in each of several countries, and cover manufacturing, services, construction and the whole economy. Managers are asked about a host of questions including current and future activity, new orders, employment, suppliers’ delivery times and more.

The magic number for each index and sub-index is 50, with any number above suggesting economic expansion and below contraction, thereby providing a good leading indicator for GDP.  To begin with the Eurozone, where the index fell from 51.6 to 31.4, its lowest number since the series commenced in 1998, with service sector jobs cut at the fastest rate since May 2009.

Although the United Kingdom data were not as bad in the survey which was conducted on the 12th March, it must be remembered that the UK did not go into lockdown until the 23rd, as we are a few weeks behind Europe on the COVID-19 isolation action, so the likelihood is we shall follow the trend lower. Similarly the US data for now are nowhere near as bad as in Europe, although the survey did provide signs that COVID-19 had stopped the US’s consistent record for job creation, which of course has since been confirmed by the Department for Labor unemployment claims.

While it is impossible to predict the exact impact this data will have on GDP, Chris Williamson, chief economist at IHS Markit, was quoted in The Economist newspaper as suggesting “the March numbers are roughly consistent with a fall in American GDP of 5%, at an annualised rate, and around 2% quarter-on-quarter (i.e., faster still) in the euro area. But with such a sharp fall, extrapolating from past relationships is hard. And March is only the beginning. Economists are already predicting far, far steeper falls in second-quarter GDP.”

Interestingly when leveraged investors began selling liquid safe assets such as US Treasuries and gold in order to satisfy margin calls during the second phase of the March market sell off, one asset class benefitted as it has always done historically, namely the US dollar. This was largely due to the shortage of offshore dollars (or eurodollars) which the Fed has little or no control over.

This is the reason that whenever a crisis such as the COVID-19 or the Lehman subprime mortgage debacle of a decade ago impacts global markets, the Fed has to quickly open up SWAP lines with other major central banks to try and accommodate the increased demand for the greenback. Since the beginning of the equity market collapse on the 9th March, the dollar as measured on the DXY index (which represents a basket of other major fiat or paper currencies including the euro, yen and sterling) rose from a low of less than 95 at the beginning of Black Monday to almost 103 on the 20th March, albeit profit taking and concerns at the extent of the fiscal and monetary stimulus from the US has since resulted in the level dropping to nearer 100.

The likelihood is that the dollar bull market will continue as long as there is a shortage of these eurodollars, which realistically is probably as long as the coronavirus lockdown and collapse of global trade continues, Few countries have insular economies that are self-sufficient, and therefore need to trade and deal with other economies and the usual means of doing so is through the global reserve currency of the US Dollar.

Effectively there are just two ways economies and non US businesses can obtain these eurodollars, with the primary one being through mercantilism, whereby you sell your goods to the US or other countries and get dollars in return. A great example of this of course is the petrodollar which simply means oil producing countries selling their oil in return for dollars, but whenever the price of your commodity is dropping and, or the demand is drying up it creates a dollar shortage.  The second way of obtaining the shortfall in dollars is usually through the other dollar redistribution channel – the financial channel, usually the eurodollar market, or sometimes eurobonds as happened in 2016-17, and any surplus acquired often results in hot money inflows.

However the strains are currently showing on both of these methods of finding adequate dollar supplies, hence the dollar shortage, and the surge in the value of the greenback against other currencies. If the crisis were to persist for an indefinite period of time, the eurodollar shortage will put vulnerable emerging market economies at risk as the adverse exchange rate piles pressure on their budget deficits, balance of payments, etc.

For investors in developed Western economies, the big question is will all the fiscal and monetary stimulus being poured into the economy to tide it over until the COVID-19 pandemic threat has been seen off, be enough to ensure the West does not go into a deep recession / depression? The $2 trillion fiscal stimulus approved by Congress sounds a lot but in the context of $14 trillion of dollar-denominated debts outside of the US, or potentially $25 trillion if off- balance sheet numbers are included, it is unlikely to suffice.

Of course that’s before we even begin to consider the nigh on $100 trillion of unfunded liabilities in the US alone. Maybe that is why we saw the emergence of the new cyclical bull market on Wall Street on the 26th March as the market surmised that much more fiscal stimulus is on its way, in addition to potentially an unlimited extension of the Fed’s balance sheet as it begins buying non US Treasury bonds in earnest to help stave off a credit collapse.

Of course it is highly unlikely that this tentative new cyclical bull will be allowed to grow into another secular version (thereby making the bear market that commenced on the 9th March the shortest in history) just yet. It is also possible that the market senses that a byproduct of all this stimulus might at last be serious inflation which historically has been good for equity markets, at least in the initial years after its arrival.

FORWARD OUTLOOK

As we suggested in last quarter’s forward outlook, our shadowy offshore eurodollar market concerns have been crystallized, albeit by an unlikely black swan in the form of COVID-19. The immediate predicament the world finds itself in currently with total or partial shutdown across great swathes of the global economy is the reality that energy is and always will be the currency of life, while historically GDP has been proportional to oil consumption.

So as both oil consumption and price temporarily collapses, the outlook economically is pretty grim. Fortunately policymakers have recognised the chasm created by the pandemic’s freezing of global economic activity and have enacted persuasive fiscal and monetary stimulus to shore up the shortfall.

Will it be enough longer term only time and of course markets will tell! Realistically it is unlikely a definitive bottom will be found in stock valuations until the shape of the COVID-19 pandemic curve becomes clear, and the numbers infected have peaked.

At this point, the market cannot determine whether we are going to get a V-shaped recovery, a U-shaped recovery, or an L-shaped one. It is perfectly feasible that if the lockdown period in the US and elsewhere is short as has been suggested by President Trump (who hopes to have the US open for business as usual by Easter Sunday), that the recession will be short-lived and the American and other major global economies race back to expansion again.

The downside to such optimism of course is that should the economic isolation and lockdown be ended prematurely, and the COVID-19 pandemic reignite, the subsequent fall-out from a re-run of similar actions could result in a prolonged slump. Getting the balance right in this context will prove crucial to the outcome of the shape of the recession recovery curve, and accordingly whether a new genuine bull market in global stocks can materialise.

On both a short term and longer term scenario, we continue to view equity markets as the asset class of choice for investment portfolios. However any new money waiting to be invested, we shall recommend holding in cash for now.

Additionally, for the foreseeable future and until the COVID-19 pandemic peak in infections is behind us, markets are likely to remain volatile and provide a rollercoaster ride (much as we saw in March). It makes sense therefore for anyone in drawdown to reduce the amount taken until markets settle down again.

As we close, it is worth remembering the timeless quote from the father of value investing, Benjamin Graham, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” Accordingly we remain convinced that client portfolios continue to offer excellent value from a risk adjusted long term perspective.

As always, investment risk is at the forefront of our advice and, whilst it is often necessary to undertake adjustments in portfolio allocation in order to maintain individual preferences, we are confident that our advised portfolios remain well placed in meeting our clients’ needs. On behalf of all of us here at Ash-Ridge Asset Management, we hope that you and your loved ones will remain healthy and upbeat until we have seen the last of the dreadful COVID-19 pandemic!

Copyright © Ash-Ridge Asset Management 1st April 2020.

Data Sources: Bloomberg; Brookings Institute; Economic Cycle Research Institute: Financial Sense; Financial Times; German Federal Statistical Office; Hoisington Investment Management; National Bureau of Statistics China; Office for National Statistics; Real Vision; S&P Indices; The Cabinet Office Japan; The Economist; The Federal Reserve; The National Bureau of Economic Research; Trading Economics; UK Debt Management Office; US Debt Clock.org; Wall Street Journal; Zero Hedge.

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