Key Points:

• Economic data has begun to show the extensive impact of the pandemic and sweeping lockdown measures that have curtailed business activity in the U.S. and abroad. At this point, it is widely expected that there will be a sharp contraction in the global economy over the next coming months.

• Despite what many news story headlines may say, there are no signs thus far that this crisis will cause an economic depression (a sustained downturn in economic activity).

• Although we are at the doorstep of a sharp economic downturn, the stock markets are way ahead of it. While no one knows for sure what will happen, what we do know is that markets (investors) have factored in a very sharp decline in economic activity and corporate earnings.

• We continue to believe that there will be a quick and robust recovery once signs appear that infections are peaking and that policy actions have had a chance to infuse through the economy and markets. Until that time, however, we expect uncertainty and fear about the trajectory of COVID-19 to continue driving high market volatility.

• The stock market declines since their February 19th highs have been unsettling but have created an opportunity for diversified investors to take advantage of market dislocations that may improve their investment outcomes for the years to come.

At the moment, we are operating in what is probably the noisiest market that many investors have ever seen. Market moves and government actions that seemed unthinkable a few weeks ago are now daily occurrences. Currently, there is not a lot of visibility on the trajectory of COVID-19 and the breadth and depth of its impact.

Volatile market conditions will likely persist until we see signs of improvements with containing the virus. Although necessary, stringent containment and social distancing policies are causing economic activity to come to a near standstill. However, unprecedented and coordinated government and central bank action should help businesses and households through the shock.

What is the current outlook for the economy?

Economic data has begun to show the extensive impact of the pandemic and sweeping lockdown measures that have curtailed business activity in the U.S. and abroad. At this point, it is widely expected (known, really) that there will be a sharp contraction in the global economy over the next coming months. Many expect that the magnitude of the contraction (which is clearly visible in the profound falloff in economic activity and stock markets), might reach levels last seen during the 2008 Great Recession and, in some regards, during the Great Depression of the 1930s. (See Figure 1.)

As sharp and painful as the economic downturn may be, it is also expected to be a relatively short downturn. A recession will likely be brief because the need to restrain activity will dissipate once the global measures to stem the contagion work to slow the spread of the virus and eventually contain it. Given the early signs that we already see and most current projections, that should occur by late in the second quarter. In the meantime, aggressive fiscal and monetary efforts around the world should not only provide enough support to markets and economies to get through this crisis, but also help the global economy to rebound later in the year.

Is this likely to result in an economic depression?

Despite what many news story headlines may say, there are no signs thus far that this crisis will cause an economic depression (a sustained downturn in economic activity). The current situation has a few superficial similarities to the Great Depression, such as major declines in consumption and output; a sharp sell-off in stock markets; and soon, a steep fall in employment. But this crisis is entirely different from the Great Depression (as well as the Great Recession).

In an interview this week conducted by Marketplace, economist Ben Bernanke, former Chair of the Federal Reserve (from 2006 to 2014) and scholar of the Great Depression, was asked whether this crisis could cause another economic depression. His answer was a definitive, “No.” He explained that the causes of the Great Depression were both financial banking-related (i.e., bank insolvency and failures) and monetary policy-related (i.e., Federal Reserve made big mistakes, such as raising interest rates and reducing the money supply). The Great Depression lasted for 12 years.

In contrast, the cause of the current crisis is a pandemic, a force of nature, that will likely clear in a matter of months once the spread is contained. Additionally, this time around, the banking system is healthy, as banks are well-capitalized and are nowhere close to facing insolvency. Furthermore, central banks around the world are quickly taking the necessary actions to ensure that the financial system holds together and that local governments, businesses, and households in need have access to credit.

Why should I stay invested if the situation is likely to get worse before it gets better?

Although we are at the doorstep of a sharp economic downturn, the stock markets are way ahead of it. As usual, one of the main drivers of future market direction is the differences in what is already expected (and hence factored into market prices) versus what ultimately happens. While no one knows for sure what will happen, what we do know is that markets (investors) have factored in a very sharp decline in economic activity (noted in Figure 1.) and corporate earnings. (See Figure 2.)

As of now, we have three major pieces in place to get us through the crisis, and eventually out of it quickly, so that the damage to the economy and earnings doesn’t get materially worse than what is already expected.

The first piece is significant and coordinated monetary policy stimulus around the world to help support the credit markets and the financial system now, and to position economies for recovery quickly after the crisis passes. The second piece is an unprecedented amount of fiscal policy stimulus, led by with the U.S. government passing the $2 trillion Coronavirus Aid, Relief, and Economic Security (“CARES”) Act, which will provide immediate relief with direct aid to small, medium, and large businesses; lower-income households; people that become unemployed; state and local governments; and the healthcare system. The third piece is the enforcement of measures (around movement and social distancing) by authorities around the world designed to help slow the spread of the virus and prevent further overwhelming healthcare systems.

What has Capstone been doing for my portfolio?

In our previous communication, we highlighted some of our portfolio management processes that we’ve been patiently implementing over the last couple of weeks. One area of focus has been on rebalancing, by trimming from significantly overweight bond positions and incrementally adding to stocks that are significantly discounted. The goal has been to gradually bring portfolios back to their target (neutral) mix based on client-specific objectives.

Another area of focus has been on taking advantage of opportunities to harvest losses in stock positions 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 (like we’ve had recently surrounding the passage of the CARES act), and certainly so portfolios don’t miss out on what will eventually be a sustained recovery.

Our team will continue to monitor portfolios closely, and systematically tax-loss-harvest and rebalance portfolios when it makes sense to do so. As always, we will be deliberate when implementing these processes.

What is Capstone doing to better position my portfolio for what may happen next?

In our March 10th communication, we highlighted some other action plans that we could put in place to better position portfolios should market conditions get worse.

We continue to believe that there will be a quick and robust recovery once signs appear that infections are peaking and that policy actions have had a chance to infuse through the economy and markets. Until that time, however, we expect uncertainty and fear about the trajectory of COVID-19 to continue driving high market volatility. The stock market declines since their February 19th highs have been unsettling but have created an opportunity for diversified investors to take advantage of market dislocations that may improve their investment outcomes for the years to come.

As such, Capstone’s Investment Committee decided to move forward with the following set of action plans:

1. Increase U.S. Stock Allocations

We will be increasing U.S. stock allocations. The increase will be accomplished by shifting a portion of international stock allocations toward the U.S. We believe that now is a good opportunity to do this because U.S. stocks are on sale, and given the relative strength of U.S. corporations, they could be more insulated should global stock markets continue to fall amid this ongoing crisis.

We also believe that the U.S. economy will be much better positioned for recovery compared to many other major economies abroad. This is due to what was a relatively stronger U.S. economy going into the crisis, and the unprecedented amount of economic stimulus that is being injected into it.

Despite this shift, we still believe in the merits of global diversification; portfolios should continue to maintain international allocations. Many of the largest industry-leading companies in the world are based abroad, and for that matter, so are some of the fastest-growing economies. Additionally, international markets are attractive from both a valuation and dividend yield perspective. As such, the reduction in international allocations is not meant to be permanent, but rather a move that we think is prudent while we get through this crisis. Over time, we will evaluate when it may make sense to bring international allocations back up again.

2. Increase Large-Cap Stock Allocations

We will be increasing large-cap stock allocations within the U.S. This will be accomplished by shifting a portion of small-cap stock allocations toward large-cap company stocks. We believe that now is a good opportunity to do this for similar reasons to those mentioned above. We're seeing significant discounts in many of the largest companies in the world that suffered losses in line with the rest of the market, amid the indiscriminate selling we’ve seen this year. Additionally, sturdier large companies will likely be better able to withstand the imminent economic slowdown, particularly if it lasts longer than expected.

We also believe that the large-cap companies like the ones listed in Figure 3. below will certainly be around long after this crisis passes. But more importantly, these large companies will likely be better positioned for a recovery not only as the U.S. economy recovers in the shorter-term, but also as international economies recover in the longer-term. With that said, we still believe it makes sense to invest in small-cap company stocks given the diversification benefits and the potentially higher returns over long periods. As such, similar to the reduction in international stocks, the reduction in small-cap stocks is not meant to be permanent but rather, a positioning that we think is prudent at this time.

3. Maintain High Credit Quality within Bonds

Well before the onset of the pandemic, we positioned our portfolio bond allocations to be more defensive against stock market declines such as these. We made bond allocations more defensive by allocating to funds that focus on buying high-quality, low-default risk types of bonds such as: U.S. government and agency bonds, international sovereign bonds, investment-grade corporate bonds, AAA-rated mortgage-backed bonds, and investment-grade municipal bonds.

Outside of a few trading days when temporary liquidity issues surfaced across the entire marketplace, these types of bonds provided much-needed stability to portfolios. We expect this protection to continue, especially with Federal Reserve buying these types of bonds to ensure the markets function the way they should.

There is an opportunity today that exists in corporate bonds, particularly in lower-quality corporate bonds that have declined in value and are currently offering higher yields to investors. We do not believe that now is the right time to go down in quality because of the still elevated potential risk of further stock market declines. We also do not believe now is the right time to shift out of government bonds, despite record-low interest rates. Interest rates will likely stay low for the foreseeable future, so we are not concerned at the moment about bond prices going down. We are as comfortable as ever with bonds we have in portfolios. These types of bonds should remain good preservers of capital if the downturn continues.

As we mentioned in our previous communication, we don’t know for sure how the virus and its market and economic impacts will ultimately pan out. However, we believe in the resiliency of the U.S. economy and its people, particularly when everyone bands together to face a common challenge. We are still 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

¹https://advisors.vanguard.com/insights/article/asharpcontractionthenanupswing

²https://insight.factset.com/sp-500-projected-to-report-first-double-digit-decline-in-earnings-10-in-10-years-in-q2

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