Key Points:

• Stock markets have been pricing in the increasing probability that the U.S. and several other international economies may slip into a recession due to the necessary containment measures that are affecting almost every area of commerce and the broader economy.

• The good news is that governments and central banks have started to respond more forcefully this past week. While the various stimulus measures that have been put in place so far have yet to stem the stock-market selloff (or improve sentiment), they will ultimately prove successful.

• The reality is that the strong actions required to thwart the virus’s spread are going to hurt short-term economic growth. The result may be a U.S. recession. Recession risk has also heightened in other developed market countries. However, if the U.S. or global economy were to slip into a recession, there are reasons to believe that a recovery would be relatively quick.

• Global stocks in aggregate have fallen over around 30% from their February high through March 16th. It is important to keep in perspective that significant market pullbacks are an inevitable part of investing in stocks, but so are the full recoveries (and new highs) that have followed afterward.

• Along with other central banks around the world, the Federal Reserve (the Fed) has taken significant and preemptive measures to ease financial conditions. The Fed has made it clear that they have many other tools to support the financial system, and they will not hesitate to use these tools if needed. Markets are now looking for a comprehensive global fiscal response from governments to support households and businesses.

• We continue to regularly monitor client portfolios to ensure that they stay close to their target mix based on client-specific objectives. Together with rebalancing, we have been taking advantage of opportunities to harvest losses in stocks to offset future portfolio gains and lower client tax bills.

• We’ve been tested with some of the most volatile markets that we have seen since 2008, and in the long run, our disciplined investment management process will have helped our clients weather the storm and achieve their long-term goals.

What is the current situation?

A lot has happened since our last commentary several days ago. The coronavirus has been declared a pandemic by the World Health Organization. The speed at which the Covid-19 disease is spreading has led authorities (on national and community levels) to take strong measures including closing borders, schools, and businesses, as the center of the pandemic shifts to Europe and the U.S.

Stock markets have been pricing in the increasing probability that the U.S. and several other international economies may slip into a recession due to the necessary containment measures that are affecting almost every area of commerce and the broader economy. Many stock-markets around the world, now including the U.S., are well into a bear market, defined as a 20% drop from a recent high. Investors have continued to move into safe-haven assets, mainly U.S. treasuries and other government bond securities.

The good news is that governments and central banks have started to respond more forcefully this past week. The task at hand for governments and central banks continues to be to ensure that an economic downturn is short-lived and that financial markets and the banking system are functioning properly.

While the various stimulus measures that have been put in place so far have yet to stem the stock-market selloff (or improve sentiment), they will ultimately prove successful. All of these monetary and fiscal steps will matter in the intermediate and long term. In the short-term, however, we are at the doorstep of a likely economic downturn, caused by a virus that’s surrounded by a lot of uncertainty and fear; the stock markets are way ahead of it. Although things are disrupted right now, the foundation for repairs has been put in place—with more to come—all of which will likely result in a relatively fast recovery.

Are we heading into a recession?

It is still too early to tell if the U.S. will go into recession, which is a period of declining economic activity that lasts for several consecutive months. The reality is that the strong actions required to thwart the virus’s spread are going to hurt short-term economic growth. The result may be a U.S. recession. Recession risk has also heightened in other developed market countries.

Ultimately, the exact depth and duration of the economic impact are uncertain but should be temporary as the outbreak itself will eventually dissipate. According to estimates by Vanguard economists, their base case is that if the U.S. follows the same path as other countries (China and South Korea) that have managed to contain the virus, cases will crest before May, in which case, the U.S. would likely avoid a recession. If the cases crest after May, then the U.S. would likely go into a mild recession. ¹

However, if the U.S. or global economy were to slip into a recession there are reasons to believe that a recovery would be relatively quick. First, this would be considered an “event-driven” recession. In the past, the recoveries that occur after event-driven recessions have been relatively short and fast. This stands in contrast to much longer (multi-year) recoveries for other types of recessions that are either cyclically-driven (i.e., the economy gets too hot) or structurally-driven (i.e., a financial system collapse).

Second, if the U.S. were to slip into a recession, consumers in aggregate would be in relatively good shape to get through it. The job market has been very strong with an unemployment rate at or near half-century lows for almost two years. Consumers' balance sheets are in good shape and are not over leveraged. Consumer discretionary income will get a boost from lower oil prices and lower mortgage payments from refinancing. Additionally, housing market values should be stable with limited supply on the market.

With the recent temporary closing of many businesses including retail stores, restaurants, theaters, resorts, and theaters, many expect the implementation of various fiscal measures to help support emergency unemployment benefits to hourly and salaried workers who are furloughed during the crisis.

There will be a recovery, and it will likely be sharp and fast.

How much further could stock markets fall from here?

Global stocks in aggregate have fallen over around 30% from their February high through March 16th. According to Goldman Sachs research, the average decline of the U.S. stock market around U.S. recessions has amounted to roughly 30% since the early 1950s. While we have reached the 30% average (as of this writing), it is possible we could go down lower if we don’t continue to see a pre-emptive and coordinated policy response.

It is important to keep in perspective that global equity markets have experienced eight bear markets over the last 40 years, or roughly one every five years.² Significant market pullbacks are an inevitable part of investing in stocks, but so are the full recoveries (and new highs) that have followed afterward.

It is this type of volatility, albeit unsettling, that helps investors who stick to their investment plans achieve higher rates of return in the long run. Now is not the time to be selling, particularly because bear markets can have some of the sharpest rallies (many times in a single day) that, if missed, can be very costly. (See Figure 1.) We continue to advocate that investors stick to their investment plans, rebalance their portfolio, and incrementally increase their positions in high-quality companies that have fallen due to fear-driven indiscriminate selling.

What else can be done to help the economy?

Along with other central banks around the world, the Federal Reserve (the Fed) has taken significant and preemptive measures to ease financial conditions, including lowering its short-term target policy rate to nearly zero and providing liquidity to the banking system and lending markets. The Fed also eliminated reserve requirements on banks to encourage banks to support lending to households and businesses.

The Fed has made it clear that they have many other tools to support the financial system and they will not hesitate to use these tools if needed. These tools include establishing lending facilities to better enable banks to extend credit to households and businesses; and additional and expanded bond buying programs, which are effective in lowering (and anchoring) long-term interest rates even with the Fed’s short-term target policy rate at zero. The bigger question, right now is what can governments do to support households and businesses.

According to the BlackRock Investment Institute, a comprehensive global fiscal response could have the following elements:³

• To help support households: Fiscal measures could include generous sick-pay support and short-time work schemes to stabilize incomes and to limit job losses – especially where such arrangements were not available before. Several countries are already preparing such measures. Income support can come via adjustments to welfare and labor market programs, such as unemployment insurance. Welfare programs could also be tweaked by temporarily enhancing benefits and reducing waiting times until citizens become eligible. Direct payments to affected households are an option.

• To help support companies: Fiscal authorities could suspend collection of tax revenues and social security contributions to provide temporary cash flow relief to firms and the self-employed while at the same time accelerating outgoing public payments and reducing unpaid bills to the private sector. In some instances, cash grants via local governments and natural disaster relief agencies might be required beyond loans. These are ways to directly provide some relief to company balance sheets that can be quickly implemented within current government programs. Automatic fiscal stabilizers should be allowed to work fully and, if needed, existing fiscal rules could be temporarily suspended.

This does not mention appropriations for healthcare funding to target immediate virus containment and treatment efforts. It also doesn’t mention disaster assistance loans for small businesses that are impacted by the coronavirus to help overcome the temporary loss of revenue they are experiencing.

So far in the U.S. there hasn’t been anything significant on the fiscal policy front. However, we expect to see more fiscal stimulus responses from federal and local governments. Swift, decisive action will be required to mitigate the virus itself and its economic effects. Bold and appropriately targeted fiscal stimulus can help individuals and economies get beyond what should be a temporary setback.

What is Capstone doing with portfolios now?

We continue to regularly monitor client portfolios to ensure that they stay close to their target mix based on client-specific objectives.

The downside volatility we’ve experienced in stock markets has coincided with gains in high-quality bonds. Our portfolio trading team has been actively looking at portfolios to identify opportunities to rebalance by trimming from bonds that have appreciated and incrementally adding in high-quality stocks that are now at significantly discounted valuations. We are being very patient with this process.

Coinciding with these rebalance trades, the team has been taking advantage of opportunities to harvest losses in stocks to offset future portfolio gains and lower client tax bills. We have been doing this while keeping portfolios invested so that they don’t miss out on days with sharp rallies, and certainly so they don’t miss out on what will eventually be a sustained recovery.

Our team will continue to closely monitor portfolios. We’ve been tested with some of the most volatile markets that we have seen since 2008, and in the long run, our disciplined investment management process will have helped our clients achieve their long-term goals.

These have been very difficult conditions and we’re likely not out of the woods yet. But please know that Capstone is working tirelessly to execute our portfolio management process with discipline to help you weather the storm.

What is the plan going forward?

In our previous communication, we highlighted some other action plans that we could put in place to further alleviate portfolios from a worst-case, extreme, scenario.

At this time, we still do not believe that these action plans are necessary. However, if needed, we will not hesitate to execute these plans. Our clients should rest assured that any decisions we make when it comes to portfolio management are deliberate and executed with discipline. We urge clients not to panic and to stick to their long-term investment plans.

Although we don’t know for sure how the virus and its market and economic impacts will ultimately pan out, we believe in the resiliency of the U.S. economy and its people, particularly when everyone bands together to fight a common challenge. We are confident that we will get through this, and will come out stronger because of it. The country and the rest of the world will recover.

We will continue to keep you updated on the evolving situation. Please do not hesitate to reach out to us should you have any questions or concerns. As always, we are here for you.

Sources

¹Vanguard: https://advisors.vanguard.com/insights/article/coronaviruswhatweknowandwhatwedont

²Vanguard analysis based on the MSCI World Index from January 1, 1980, through December 31, 1987, and the MSCI AC World Index thereafter, indexed to 100 as of December 31, 1979. Both indexes are denominated in U.S. dollars.

³BlackRock Investment Institute: https://www.blackrock.com/americas-offshore/insights/blackrock-investment-institute/coronavirus-policy-response

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