The spread of the novel coronavirus (COVID-19) has progressed to a level that few, if any, predicted just two weeks ago. While the impact on communities here and around the globe continues to grow, the impact on the markets has been swift and intense, with the S&P 500 giving up its 30% gain from 2019 in a matter of weeks. In mid-January, we wrote in our Q1 2020 Economic Outlook that the US economy was in relatively good shape, and a recession (if it happened) was likely to be caused by some sort of shock. That shock could be COVID-19.
Today, we find ourselves asking not about the probability of recession but about the depth and duration. Equity markets, which have fallen below January 2019 levels, are clearly pricing in a recessionary environment.
There are two main ways that the coronavirus is impacting global economic activity: 1) Supply chain disruptions; 2) social distancing, which is starting to derail the activities of daily life, like dining out, travel, and sporting events. Either one of these shocks would be enough to cause dramatic market reaction; together, they are an unprecedented challenge. Investors are finding it extremely difficult to price in the overall impact of such a slowdown and have so far been selling somewhat indiscriminately.
Response to COVID-19
Can the Fed come to the rescue as it has in the past? Not entirely. Given the demand shock that comes with social distancing and already low US interest rates, the Fed’s toolset is limited. Like losing sleep, the loss of economic activity cannot be undone, although you can recover from it.
Coming out of a COVID-19 supply-demand shock will require action by both the Federal Reserve (monetary) and the US government (fiscal). On the monetary front, the Fed is providing full support to the economy and the markets. On Sunday, the Fed cut its target interest rate again, to nearly zero (0% to 0.25%), and will be buying up to $750 billion in Treasury bonds and mortgage-backed securities, in addition to the more than $1 trillion it plans to inject into the overnight lending (repo) market, to maintain liquidity.
Just as important are fiscal actions, via government spending and tax policy. This week, Congress is likely to pass basic financial support for Americans affected by coronavirus (both directly and indirectly), such as paid sick leave, unemployment insurance, and coverage for coronavirus testing. And we are also likely to see significant government spending to support smaller businesses, such as a tax holiday and fast loans, as part of a package being proposed by the US Treasury, which as of today is estimated at $850 billion.
At some point, the combination of low oil prices, low interest rates, and targeted fiscal support should prop up the US consumer, providing a floor for the ensuing economic downturn. As we’ve emphasized in the past, the US consumer is key to our economy. The drastic measures that may be necessary to combat COVID-19 (China, South Korea and Italy are examples) will impact US consumer spending. At LNWM, as we begin to think about recovery and assess when to add risk to our portfolios, consumer behavior will be a key consideration.
As past crises have demonstrated, we can and will recover, although predicting timing and duration is impossible. China has already begun to show signs of returning to normal, as the rate of new cases there has fallen dramatically. China took drastic measures similar to what is being implemented in Italy, and now parts of the US, including Seattle. Ultimately, markets will recover as the spread of the virus slows, due to the discovery of a vaccine and/or aggressive, ongoing steps to limit contagion. In the near term, we think the latter is more likely, resulting in an economic recovery that is drawn out, and not V shaped.
LNWM Portfolio Positioning
While capital markets have sold off globally, there is a silver lining. We’ve long touted the benefits of portfolio diversification, which were increasingly difficult to defend during the longest bull market in history. Now strategic diversification is a plus, as is our allocation to actively managed funds whose managers have room to maneuver. While our portfolios are down year-to-date, performance so far has been in line with our expectations given the bear market environment. Our allocation to hedge funds and other alternative assets have generally outperformed the equity market. That said, we have not stood still and will continue to make changes as opportunities present themselves. In fact, we are already strategizing about the most effective ways to capitalize on the inevitable rebound.