It was another eventful weekend as the U.S. Federal Reserve, in an unscheduled meeting on Sunday, slashed interest rates by 100 basis points to bring rates close to zero and launched a fresh $700 billion quantitative easing (QE) program in its latest effort to support the U.S. economy from being crippled by the COVID-19 pandemic.
Despite these aggressive measures, global equity markets continued to sell off significantly on Monday and we are continuing to see dislocations in many other asset classes. As of this writing, the S&P 500 Index is now down -30% from the February 19th high and the S&P/TSX Composite Index is down -31%. To update you on what I’m seeing across the different assets and delve into what might happen next, I’ve compiled an FAQ below:
What happens next and when will equity markets bottom?
I believe three things need to happen before we can talk about a bottoming for equity markets:
1) Material fiscal stimulus to support the recent easing monetary policies from central banks. There is already talk of fiscal measures moving to payroll tax cuts and $1,000 rebate checks to every adult in America in the coming weeks.
2) A peak of the COVID-19 spread. In China, new COVID-19 cases are down 84% this week, new deaths are down 54%, and the 113 new cases last week represent 0.4% of the peak levels from just four weeks ago. With policy makers and everyone else now at heightened alert to “flatten the curve,” I am optimistic that COVID-19 will be contained in the coming months in the rest of the world. In the coming weeks, however, the news will likely get worse.
3) Excessive discounting of a recession scenario. I see some similarities to 2008 in the price action of many of the assets that I track. I am also seeing moves in some assets, like bonds, that are breathtaking and unprecedented. In the short term, the market will tend to overreact to an extreme and become overly pessimistic. Clearly, we are not there yet notwithstanding the -30% decline in Canadian and U.S. equity markets from their peaks. However, at some point, the market will digest all the bad news and become comfortable with a recession scenario.
The historical evidence suggests that stocks will fluctuate and struggle for some time to fully discount the many unknowns caused by this exogenous shock before finding a floor. When the market finds this level, equity markets will be poised for a strong rally long before economic data or investor sentiment inflect up.
In the meantime, the volatility that we’re seeing in the markets is the new normal, which is why it would be detrimental to compounding long-term wealth to be selling on the -5% down days and chasing to buy on the +5% up days. Just as investors shouldn’t be despondent when markets are off -5% one day, investors shouldn’t be ebullient when markets are rallying +5% the next day. Remember that these +/- 5% days are within the range of expected volatility in this environment where the VIX Index is over 80.
Lastly, stock market bottoms are a process, not a point in time that anyone can point to – it takes time for the process to play out.
How bad is market sentiment?
The “fear gauge” or the VIX Index is a good measure of investor sentiment. More formally, the VIX Index is a market index reflecting the market’s expectation of the S&P 500 Index forward volatility over the next 30 days. On Monday, it closed at 82.69, which reflects enormously high levels of investor anxiety that we haven’t seen since the 2008 financial crisis. A high VIX reading of 82 cannot be sustained as it implies an annual percentage move in the S&P 500 index of +/- 82% over the next 12 months, 68% of the time. Put another way, this implies that investors are expecting a daily move of +/- 5.1% for the S&P 500 index, 68% of the time. While we have easily been seeing daily moves of this magnitude going back several weeks now, these large swings in volatility will not sustain.
Are we headed to a global recession?
This is already the baseline scenario for 2020. Markets have already priced in some probability of this scenario, which explains the magnitude and pace of the equity market sell-off. When markets have excessively priced in this scenario, that is when we will have a starting point for a bottoming process in equities. Depending on how quickly the COVID-19 spread is contained, the global economy may also experience a sharp recovery in the second half of this year, but real GDP in Q2 will post negative growth.
The collapse in oil prices by almost 50% in the past month also contributes to a recession scenario this year. Many of the shale oil companies have over-leveraged balance sheets and will not survive through this downturn with the WTI crude at US$30. This potential wave of bankruptcies will mean losses for their creditors, which will roil the entire credit market and cause an increase in loan losses for the banks. It should be no surprise that energy and bank stocks, which are mostly categorized as value stocks continue to significantly underperform the quality and growth stocks that typically have strong balance sheets.
How are the iAIC portfolios faring in this environment?
On a relative basis, the Leon Frazer Canadian and U.S. Dividend portfolios have outperformed significantly throughout this bear market over the past three weeks. In particular, the U.S. Dividend fund is outperforming the S&P 500 Index by over 200 basis points YTD as of March 16. None of the stocks in the portfolios have cut their dividends and there is no expectation that any of our holdings will be forced to cut their dividends. Both portfolios hold higher quality companies with stronger balance sheets than in the past.
In the T.E. Wealth Prosperity equity portfolios, I do not have real-time performance metrics of the external managers. I do have real-time performance data on the Prosperity Canadian Equity sleeve managed by Gil Lamothe and that portfolio is outperforming the S&P/TSX Index by over 200 basis points YTD as of March 16. I am confident that the significant changes we made to the Prosperity managers in recent months have helped these funds outperform during this difficult stretch. The managers we kept and the new ones we hired all employ an investment style that emphasizes quality, strong management and sustainable business models. These types of companies will not only survive a bear market, they will provide better downside protection in this environment and perform well when the economy recovers.
Why did equity markets decline further on the U.S. Federal Reserve announcements of interest rate cuts and QE purchase of $700 billion?
This likely reflects some combination of “buy the rumour, sell the news” from late Friday afternoon when equity markets spiked up in the last half hour of trading. There is also concern that the Fed, by cutting rates to zero, has fired its “bazooka” and has run out of ammunition in dealing with the economic fallout from COVID-19. Furthermore, it’s unclear whether the Federal Reserve is permitted under legislation to cut rates into negative territory. With this second emergency rate cut in the past two weeks, investors may also be spooked that the Fed has visibility into upcoming economic data that is very weak which the rest of us haven’t seen yet.
Will the extraordinary measures by the U.S. Federal Reserve be effective?
Parts of the Treasury bond market became very illiquid and volatile last week, and these actions by the Federal Reserve were undertaken to ensure a functional market for bonds. Last week, it was unusual for bond prices to decline and yields to rise when equities were so weak. In a significant risk-off environment, safe haven assets like Treasury bonds, gold and gold stocks should be rallying, which is what we saw in the early parts of this equity sell-off.
In a bear market such as what we find ourselves in now, leveraged investors face margin calls and are forced to sell what they can. In this scenario where Treasury bonds are being liquidated with few buyers willing to step up to buy, the Federal Reserve coming in as a buyer of last resort will help shore up liquidity and balance the overt selling pressure with buying demand. To that end, this is an effective means to stabilize the bond market and we saw Treasury bonds rally on Monday.
It’s debatable how effective these monetary policies, no matter how significant and unconventional, will be in offsetting the economic fallout from COVID-19. The market wants to see a massive fiscal stimulus package as part of the government response to this public health crisis. That fiscal stimulus is coming in the U.S. and in Canada, and we’ve already seen announcements of large fiscal packages in Japan and Germany.
Why are some bond ETF’s trading at a discount to their Net Asset Value (NAV)?
ETF investors are able to access immediate liquidity when they sell ETF’s, just as when they sell stocks. In times of distress, the underlying assets held by the ETF can become very illiquid and cannot be sold at a reasonable price or quickly enough to meet ETF redemptions.
One of the largest and most liquid bond ETF’s, the iShares 20+ Year Treasury Bond ETF (ticker: TLT), was trading at a 5% discount to its NAV at one point last week. On Monday, it was still trading at just under a 1% discount to NAV. In theory, this should never happen because it would result in a riskless arbitrage. However, when investors become forced sellers because of margin calls or panic selling, the underlying assets – in the case of TLT, long duration Treasury bonds – cannot be sold at a reasonable price or quickly enough. So the ETF price will converge down to a level where the bond dealers believe they can transact on these bonds. In this instance, the ETF will trade at a discount to its NAV and the ETF price also becomes the best determination of the fair value of the underlying assets.
Lieh Wang, Chief Investment Officer
iA Investment Counsel Inc.
1 Health research by Bernstein China COVID-19 tracker: Is China getting back to work? March 16, 2020
2 Market data by Bloomberg
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