Across every single industry, the pandemic has caused a significant shift in how people work and interact every day with others. Teams find themselves working remotely and collaborating virtually, with teleconferencing, video chats and electronic meeting materials becoming our new operating standards.
Against the backdrop of this new reality, and as most people are doing these days, I found myself browsing through Netflix. That’s when I noticed that the classic Robert Zemeckis movie, Back to the Future, was one of the trending titles. This made me think: what if we could travel back in time, not even as far back as 1955, but rather to January 1 of this year?
The world seemed entirely different back then.
2019 had just closed with a 31 percent return on U.S. equities, marking a decade that saw 13.5 percent returns per year. The economy had grown steadily at 2.3 percent, and the unemployment rate was at a historic low of 3.6 percent. Escalating tensions between the U.S. and Iran, and the beginnings of the Senate impeachment trial dominated headlines, so it may have been easy to miss the first stories of a novel coronavirus spreading in the Hubei province of China. Perhaps you thought COVID-19 would be like other outbreaks, like SARS or H1N1, which were concerning, but ultimately contained.
If you were able to go back to January 1, 2020, and find your slightly-younger self, you may have shared one key piece of information: the world will not be prepared for what is to come. Over 448,000 lives will be lost globally to the coronavirus. Businesses, schools, government agencies, and religious and cultural centers will be closed, with individuals told to stay at home to reduce the risk of infection. The unemployment rate in the U.S. will skyrocket to 14.7 percent in April, and the Fed will cut interest rates to nearly zero. Congress will pass rescue funding and stimulus measures totaling over $5 trillion, and the real GDP will fall -4.8 percent annualized in the first quarter.
And what about the stock market? Your future self will share that the S&P 500 index will be down -5 percent through May 31, 2020. But how is that possible? During the 2008 financial crisis, the GDP contracted -8.4 percent annualized in the fourth quarter of 2008, which represented the largest drop since World War II. Unemployment was at 10 percent in October of 2009, and the S&P 500 fell by over -50 percent. During the Great Depression, the GDP contracted by -26 percent, the unemployment rate was nearly 25 percent, and the S&P 500 declined over -80 percent.
So, given the state of the world during the 2020 pandemic, you would think that the market would be down far more than just -5 percent. In fact, the market was down -35 percent from its intraday peak on February 19 to its intraday low on March 23. The market does historically bottom well before the economy reaches its lowest point. When the market low came in March of 2009, the economy grew again in the third quarter of that year. But the swiftness of this current rebound defies expectations.
Could the market have gotten ahead of itself? Or maybe it knows something we do not and has priced-in a quick reopening of the economy and recovery in earnings. The Fed did intervene to help stabilize markets, with actions that included a landmark program that had the central bank buying U.S.-listed ETFs that invest in corporate bonds for the first time ever. In June, the Fed also announced that it would buy corporate bonds as well, which immediately boosted the Dow Jones Industrial Average to a nearly 800-point gain at the open of the day after the announcement. However, these interventions by the Fed still do not fully explain how the equity markets rebounded so quickly. Whatever the reason, the upside and downside prospects in equity beta are not as compelling as some of the other alternatives. Thankfully, portfolios with a significant equity exposure have returned to relatively healthy shape.
The equity markets have guided the recovery in risk assets. While other asset classes have rebounded off their lows, there are still opportunities in other areas. As a rule of thumb, the more illiquid the opportunity, the more attractive it is, because that removes the opportunity from the liquidity poured into the system by the Fed and by fiscal policy.
You can see this with high yield spreads, which reached 1,100 basis points (bps) in late March and fell to 585 bps. This is still nearly 230 bps wider than at the beginning of the year. These elevated spreads have often foreshadowed attractive returns in the future. At the same time, there is a belief that a full credit cycle with accompanying defaults and distressed opportunities is on its way. Managers who have the chance to move through the cycle should find opportunities in stressed and distressed bonds and loans, structured credit, non-performing loans, and restructurings.
There are many other opportunities. These include:
- Small caps were down significantly more than large caps in the first quarter
- International equities, which have lower valuations than domestic equities
- Value equities, whose spread versus growth is historically high
- Emerging markets value are the cheapest asset class right now
- Direct lending and real estate, should benefit from a general re-pricing of risk and reduction in credit availability
It may be challenging to think about “leaning in” at a time when the state of the economy still feels uncertain, but it may be advantageous right now to move portions of a portfolio out of domestic long-only equities, which have rebounded strongly, and into other areas where there is more room to grow.
Andy Conner is a Principal and Chief Investment Officer at Asset Strategy Consultants.
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