Second Half 2020 Outlook
Knowledge is power. But just like anything else, too much knowledge can be debilitating, if not harmful.
After an absolute deluge of information about the financial markets today, statistics, market movements and subsequent emotions investors are left in a difficult position. What information matters most going forward, and what action items, if any, should I take to reposition my assets?
Financial Markets Today: Reviewing First Half 2020
Below is a quick snapshot of where the markets stand after the first half of 2020.
The S&P 500 dropped 32% between February 19th and March 23rd. This pullback was so violent that it marked the quickest bear market on record for US stocks. Losses that typically take a year to unfold were felt in the matter of weeks.
Diversification was difficult to come by as cheaper international stocks followed US stocks down. Alternatively, emerging market stocks did hold up relatively better than US stocks. We surmise this is because Chinese markets sold off in December as COVID-19 first affected this market.
High-quality US corporate bonds lost more than 20%, marking a faster and deeper pullback than seen during the Global Financial Crisis. Facing a liquidity crunch with Wall Street banks not trading, even the highest of quality Treasury bonds began to fall in value.
The Wall Street Journal has an excellent recap of the market’s nadir.
In The Day Coronavirus Nearly Broke the Financial Markets, the Wall Street Journal quoted Adam Lollos, head of short-term credit at Citigroup as saying “The 2008 financial crisis was a car crash in slow motion. This was like, ‘Boom!’”
Michael Collins of Prudential Investment Management says, “The broker-dealer community was frozen. It was as bad as at any point during the great financial crisis.” (Broker-dealer refers to large Wall Street banks who provide liquidity to the markets.)
Echoing the health effects, the impact of coronavirus on the markets was incredibly challenging. Through central bank and government coordination of $14 trillion in stimulus efforts, the markets began to rally.
By the end of June, the S&P has rallied 36% and is currently down 4% for the year. Interestingly, the S&P 500 was down 20% in the first quarter and up 20% in the second quarter.The strong performance of large tech companies has buoyed the index’s return. This fact partially explains why the stock market’s return has differed from the realities of the economy.
Global stocks outside of the US are down 11%, which is in line with US stock returns. Although we’d typically expect less expensive stock markets, like international stocks, to fall less, headline risk around COVID-19 and the lockdowns of European cities contributed to this market decline.
High quality US corporate bonds now stand at 6% gains for the year, even after their 20% drop in 2020. The Fed’s announcement to purchase corporate bonds has buoyed their returns.
The real pain continues to be felt in other areas of the market. Small US companies (between $200 million and $2 billion) are down over 20% for the year as investors are worried about the economic contraction. Small cap US companies derive more of their revenue from US operations, which explains why they are still in a bear market as the US is in a recession.
Looking Forward: Capital Markets Outlook
In any financial market analysis, the area in particular worth noting are the credit markets. Because the best outcome for bond investors is the return of their capital plus interest, bond investors are naturally more pessimistic. This pessimism is reflected in the bond credit markets where investors continue to demand higher income for risk.
Below is a graph highlighting the perceived riskiness of high-yield bonds. A spiking chart indicates that investors are requiring higher interest rates for the same amount of risk.
During the height of the Coronavirus Crash, bond investors were requiring nearly 3x more income than they were receiving months earlier. Any level above 6.5% is typically referred to as “Crisis Levels”.
After touching levels last seen in the oil crisis of 2015, the high-yield bond market is beginning to rebound. High-yield spreads have retraced 72% of their prior widenings, as of June 16th. Nonetheless, the current levels remain heightened and indicate that these investors remain concerned about the financial health of US companies.
Another area we are looking at going forward is the elevated VIX. This index is commonly referred to as “Fear Gauge” and typically trades around 17.
The chart below illustrates the VIX over the past year. There is a notable spike in March that reached an all-time high for the VIX.
Seeing a chart dip from a high of 82 to today’s value of 32 can feel like we’ve returned to normal. That couldn’t be further from the truth.
Normally trading at 17, the VIX remains in the 90th percentile of historical VIX valuations.
The current VIX value indicates that traders expect daily average moves of 2% for each of the next 30 trading days. For comparison, the S&P 500 has averaged 0.76% moves since 1990. The possibility of 2% daily moves is extraordinary.
For discerning investors, a VIX above 30 is a flashing yellow sign.
Looking at both the credit and stock markets, we see mixed signals. The initial rebound is completed and looking forward the market is offering both caution and opportunity.
US stocks show caution with the VIX. There is also caution with smaller US stocks that remain in a bear market. On the other hand, international stocks that were once cheap have gotten even cheaper.
Bond investors, grappling with 0% interest rates, have opportunities in the credit markets. Understanding the possibility of company defaults, these investors must weigh this risk with the opportunity to make considerably more than the yield on US Treasuries.
Regardless of the state of financial markets today, we are approaching the markets with cautious optimism. We expect to see significant market pullbacks in the 3rd quarter, followed by a rebound in the fourth quarter. Greater opportunity exists for stock markets to rebound in Asia and Europe where their economies begin to return to normal. Moreover, before the Corona Crash stock market valuations in these countries were relatively cheaper than US stocks.At the moment, we see greater opportunities in the bond markets, where investors can be attractively compensated for taking credit risk. We look to the high yield bond markets for opportunities and income. As opportunities arise, we will look to put cash to work, understanding that attractive opportunities will disappear by the time the economy has fully recovered.
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