Recent Developments: Before recent market volatility surged, the U.S. economy had been on a solid footing. A buoyant job market had fueled rising household income and strong consumer spending; that spending cushioned the economy through choppy waters created by the trade war with China, a manufacturing sector contraction and weakening momentum abroad.
Then came the coronavirus. A public health emergency transformed into an economic emergency.
At that point, both the magnitude and duration of the economic effects of the virus became highly uncertain. And, its future impact will depend on how the disease progresses, the efficacy of the action countries take, public health officials’ contingency plans and implementations, and policymakers’ actions to mitigate the effects on sentiment and economic activity.
Preliminary data has suggested that the U.S. economy is already shrinking, as businesses close and unemployment soars. This would suggest that the U.S. economy has fallen into a recession in the first quarter of 2020. At this point, GDP growth in Q1 is expected to exceed -2% and is expected to continue to fall in Q2-2020. Q3 GDP is also likely to contract.
The extent of the coming downturn has remained unclear, given uncertainties stemming from an unknown trajectory of the pandemic, extreme volatility in the financial markets, restrictions on daily economic activity of unknown duration and government responses adjusting daily, and while we have seen glimmers of hope, the situation is likely to continue changing in the weeks and months ahead.
Outlook: The events of the past few weeks have been unprecedented, and there is no useful roadmap to follow for giving clear insights into how the economy may evolve in the coming quarters. In general, however, the fallout from the coronavirus outbreak will have a significant and negative impact on U.S. economic prospects at least in the short term. There is now a higher risk of recession.
A record-setting rate of economic contraction in the second quarter is essentially a foregone conclusion, and growth-depressing after-effects of the shock are expected to linger through the third quarter.
Non-farm payrolls may decline by roughly eight million jobs (or more) over the next two quarters and the unemployment rate will shoot up from its current 50-year low of 3.5% to 9% by the third quarter of this year. The slump in economic activity and the sharp rise in the unemployment rate should push consumer price inflation down to less than 1% by this summer.
But the U.S. economy may start bouncing back later this year. The economy built up few major imbalances during the recently ended 11-year long expansion, so it should return to a positive trajectory once the coronavirus pandemic is brought under control and further outbreaks do not reappear.
Recent Developments: As the year began, the consensus opinion was that the U.S. and much of the world were in the later stages of the economic cycle. Nobody foresaw, however, that economic activity would largely grind to a halt as a result of the coronavirus pandemic. Largely forgotten in the ensuing volatility, U.S. equity markets actually recorded all-time highs as recently as February 19th. While conversations early in the year were centered on whether there would be a recession in 2020, the debate has now shifted to how deep and long the recession will be.
Developed international equity returns for the quarter were sharply negative. European equities, as measured by the MSCI Europe index, fell more than 24% during the period due to the spread of the coronavirus. Italy and Spain were amongst the world’s most severely affected countries. In Japan, stocks outperformed broader international indexes, generating a quarterly loss of about 17%. As of quarter end, Japan had experienced a slower spread of the coronavirus and a lower mortality rate. The MSCI Emerging Markets index declined more than 23% during the quarter. Amongst the BRICs, China was the clear winner, falling about 10% as the number of new Covid-19 cases declined and economic activity began to resume.
Fixed income markets were mixed for the quarter. Government bond yields declined as investors sought safety amid rising fears driven by the coronavirus pandemic. The move downward in yields and heightened volatility largely occurred in late February and March as much of the world locked down in response to the pandemic. The U.S. 10-year treasury yield dropped 129 bps during the quarter and established new all-time lows. Overseas, the 10-year German bund fell 30 bps, and the UK gilt yield declined 50 bps. Government bonds outperformed corporate issues, and high yield credit suffered, given the risk adverse environment. Emerging market bonds generated significant losses as the value of local currencies fell, relative to the dollar.
Outlook: While the coronavirus pandemic will probably weigh on the world’s economy beyond 2020, a recovery of equity indexes during the second half of the year is a possibility. Historically, the stock market typically troughs before the recession is over. Although markets have recovered a bit the past couple of weeks, there is no guarantee that they have troughed. Any optimism must be tempered by the unknowns surrounding the current health crisis. Nonetheless, assuming the virus is contained soon, a short recession is possible as is a recovery of risk assets in the second half of the year.
In the U.S., the first quarter saw the nearly eleven year bull market come to an end. Despite an upward move during the quarter’s final days, the index remains decidedly negative for the year. On a positive note, long term investors may enjoy tailwinds in the form of aggressive monetary and fiscal policies that may eventually promote stronger economic conditions when the virus disruption has cleared. Additionally, the recent fall in both short term and long term interest rates strengthens the case for U.S. equities, for both current income and future capital gains. The U.S. remains a high quality equity market supported by ample liquidity.
Internationally, the current health crisis has had a negative impact on the entire globe and has touched each of the world’s economies. Outside of China, Europe has been the worst affected region. The Eurozone is likely to experience a deeper recession than the U.S., but may also experience a bigger economic bounce when the coronavirus subsides as it will benefit from a rebound in global trade. For long term investors, the arguments in favor of international stocks haven’t changed since the start of the year. In general, we continue to believe that the inclusion of a material allocation to foreign stocks in a diversified portfolio remains appropriate.
As the year began, expectations surrounding emerging markets assumed improving trade relations and economic growth, supported by the lagged impact of global monetary policy easing and the partial de-escalation of the U.S.-China trade dispute. The coronavirus pandemic changes this thesis for the time being. Global growth will be delayed, and near term Chinese economic growth will be materially impacted. The extent to which the crisis sustains remains unclear, but successful containment would support a meaningful rebound in economic activity. Valuations in emerging markets are attractive and some exposure to emerging markets may be appropriate, but coronavirus related risks certainly suggest that caution is prudent.
For fixed income investors, the environment remains challenging with yields on 10-year Treasuries ending the quarter at 0.70%. Developed market government bonds continue to serve a useful role as a ballast against risk-off episodes. Credit markets face downside risks and increased uncertainty given the current economic outlook and reduced appetite for risk assets. While there may be select opportunities within the high yield asset class, and issues are attractively priced, caution is appropriate as widespread defaults are likely in the months ahead. High quality fixed income should continue to play a key role in managing portfolio risk. However, the prospect of an economic recovery, especially if accompanied by high government debt loads, tempers overall enthusiasm for fixed income investments.
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This economic and market commentary was prepared by Capital Market Consultants, Inc. (CMC), an independent investment management consulting firm, and has been approved for distribution by GW & Wade, LLC. Data used to prepare this report by CMC are derived from a variety of sources believed to be reliable including well established information and data software providers and governmental sources. CMC is not affiliated with any of these sources.
The information provided above is general in nature and is not intended to represent specific investment or professional advice. No client or prospective client should assume that the above information serves as the receipt of, or a substitute for, personalized individual advice from GW & Wade, LLC, which can only be provided through a formal advisory relationship.
About the indices presented above:
- Standard & Poor's 500 (S&P 500®) Index is a market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
- The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the Nasdaq.
- The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
- The MSCI ACWI (All Country World Index) is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world.
- The MSCI EAFE Index is an equity index which captures large and mid cap representation across Developed Markets countries around the world, excluding the US and Canada.
- The MSCI Emerging Markets Index (EM) captures large and mid cap representation across 24 Emerging Markets (EM) countries.
- The Bloomberg Barclays Global Aggregate Bond Index measures global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
- The Bloomberg Barclays US Aggregate Bond Index measures the performance of the U.S. investment grade bond market. The index invests in a wide spectrum of public, investment-grade, taxable, fixed income securities in the United States – including government, corporate, and international dollar-denominated bonds, as well as mortgage-backed and asset-backed securities, all with maturities of more than 1 year.
- The Bloomberg Barclays US Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets. It is composed of the US Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities.
- The Bloomberg Barclays US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
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