Our discussion of the capital markets for the first quarter could be quite brief: it was bad. However, there are some interesting sound bites worth noting:
• The S&P 500 fell more than 30% in four weeks, the fastest decline ever.
• The S&P 500 recovered more than 20% from the low, marking the quickest ever bear market and then bull market (though we don’t believe the bear is completely over).
• The ten-year Treasury yield fell from 1.55% to a record low of 0.54%.
• 6.6 million people filed for unemployment benefits in a single week.
It has been a period of new records, which is probably appropriate since the global response to the pandemic is unprecedented. Never before have diverse nations enacted a coordinated shut down of the global economy. If we weren’t living through it, no one would believe it was possible.
Because there isn’t much precedent for such an occurrence, we don’t have a lot of guidance on how long it will last. China has been an interesting model since the virus ran its course there first. However, while the Chinese economy has reopened, there are disturbing signs the virus may be coming back in a second wave. It would be concerning if the current social distancing and economic shut down were expected to last more than a couple months.
Yet, beyond the shutdown there are still things to worry about. The U.S. government alone has enacted significant economic stimulus to get us through the crisis. A $2 trillion stimulus package is just the tip of the iceberg. The Fed’s balance sheet jumped to $5.8 trillion from $3.7 trillion in just a few weeks. This was a greater expansion than during the 2008 financial crisis, and it happened in just a blink of an eye. Additional fiscal policy measures are already being talked about.
Regardless of the final size of all these stimulus initiatives, it is clear there will be a lot more money coursing through the economy. The economy was already strong prior to the shutdown, so the prospect of inflation in the wake of the recovery is certainly a consideration.
However, there was significant government stimulus during the Great Depression and again in the 2008 financial crisis. In both cases there was discussion of inflation, but in neither case did a lasting, damaging inflation take place. So, it is anyone’s guess what will happen this time. Inflation has not been a factor in our markets or economy for many years, so it would certainly be a game changer. In terms of investment portfolios, inflationary periods have generally been good for stocks. Rising prices drive up asset values as well as prices in the overall economy.
Inflation is bad for bonds, but candidly, we’re not sure what will be good for bonds in the future. Imagine you had money to invest and someone offered you an opportunity to commit capital for ten years with an annualized return of less than 1%. Would you do it? There are certainly other reasons to invest in bonds, such as stability, but the return prospects look pretty dismal.
We have responded by reducing the duration of the bonds that we manage. Shorter-duration bonds are more defensive, and can help hedge against rising interest rates. After roughly forty years of declining interest rates, it is quite possible rates will reverse course and start to move higher. This, combined with inflation, would be a bad scenario for bonds.
This is one reason we have shifted money in recent years away from bonds toward alternative investments. While they haven’t been anyone’s favorite investment, we’re happy to report that they held up quite well in the first quarter. An average of the funds we use would have been down around 3%, which is better than corporate bonds. Looking forward, these investments have much higher expected returns than the bond market, and they have just shown us that their risk profile is not significantly higher than bonds.
The first quarter was an aberration for stocks and bonds. Stocks are already starting to firm early in the second quarter, but the economy and stock market are not yet out of the woods. There may be more pain to endure, but eventually stocks will recover and we’ll be on to better times.
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