This quarter is one we will likely never forget.  The coronavirus’ impact on our healthcare system, our financial health and our way of life has been severe.  The speed and magnitude of this fallout has left everyone in a state of shock.  Never in history has the U.S. stock markets fallen so far, so fast.  This includes the Great Depression, the 1987 crash, 9/11 and the financial crisis of 2008.  This bull market ended in violent fashion nearly eleven years to the date after it began.

Historically, stock market collapses are usually caused by economic factors such as rising unemployment or inflation, a slowdown in economic growth, consumer spending or consumer confidence.  This quarter began with our economy in great shape on multiple fronts.  The virus and the extensive effort to limit its spread instantaneously turned off almost all economic activity across the country.  The financial impact to the stay at home policies implemented to flatten the virus curve has caused a rush to an event-driven economic recession.  The short-term economic impact will be devastating as business and personal revenues have been seriously downsized.    

The stock market is a discounting mechanism as it constantly processes the likelihood of future economic outcomes to arrive at today’s current price.   Currently, the market has an expected time frame for a return to economic normalcy.  We know if the economy rebounds quicker than the collective expectations, the markets will bounce back rapidly.  If the virus keeps the economy shut down longer than expected, the markets will endure more pain.  The government has initiated massive fiscal and monetary measures to cushion the damage to workers and companies both large and small. 

The quarter began like many of the previous 43 quarters with stock markets moving higher and the economy strengthening.  February 12, 2020 seems like a lifetime ago when the major U.S. stock indices (Dow Jones Industrial Average, S&P 500 and the NASDAQ) closed at 29,551, 3,379 and 9,726, respectively.  By quarter-end these indices fell 26%, 24% and 20% from the mid-February peak levels.  The market volatility in stocks, bonds and oil in the second half of this quarter has been unprecedented.  Daily asset price swings greater than five percent have become commonplace.  This virus knows no borders and international markets have experienced similar pain.  For the quarter, international developed stock markets were down 22.8% and emerging markets fell 23.6%.                                            

The bond market reaction to this economic shock was quite predicable.  The flight to quality trade was in full force.  In these situations, investors sell risk assets like stocks, preferred stocks, high yield bonds and corporate bonds to buy U.S. Treasury notes.  This causes treasury interest rates to drop, causing their prices to rise.  Interest rates differentials for riskier bonds like corporate bonds and junk bonds rise, driving their prices lower.  This phenomena was evident in the first quarter returns as Barclays Long Term U.S. Treasury Index was up 20.9%, while the Barclays High Yield Bond Index was down 12.7%.   

The Federal Reserve board took immediate action, prior to their scheduled March meeting, to return the fed funds rates to zero as they did in the ’08-’09 recession.  In addition to these fed rate cuts, the Federal Reverse said they will do whatever it takes to provide massive amounts of liquidity to the financial system.  At quarter end, the treasury yield curve settled in at these yields:  2-year 0.23%, 5-year 0.37%, 10-year 0.70% and 30-year maturities at 1.35%.  We even saw negative yields momentarily for the first time at the very front end of the yield curve.

Investors, advisers and money managers alike are put to the test during times of market crisis.  This is certainly one of those times.  It’s imperative not to panic during times of market stress.  The anxiety and pain are real, but it is essential to look beyond today’s turmoil and focus on tomorrow’s opportunities.   

The virus will end, the markets will rebound and life will return to normal.  Hang in there, be patient and together we will get through this crisis.  Lean on your carefully constructed financial plan for support and as the basis for any subsequent actions.  Focus on all the positives in your plan including income generation sources through social security, pensions, fixed indexed annuities, and bonds.  Remind yourself of the long-term benefits of stock ownership and view your allocation to stocks with the long-term time frame that it deserves.  Take a deep breath, stay calm and remain confident in your financial plan.       

To expand on these Market Commentaries or to discuss any of our investment portfolios, please do not hesitate to reach out to us at 775-674-2222

The last two weeks of January hinted that the coronavirus might negatively impact the financial markets.  The late January sell off was mild and U.S. stocks quickly reversed course and rose to new all-time highs by mid-February as employment and manufacturing numbers showed strength.  Shortly thereafter, some companies began to publicly quantify the negative financial impact from the coronavirus and the markets retreated from their all-time highs. When the virus began to spread aggressively outside of China’s border through Europe, Korea and the Middle East, the bottom quickly fell out of the global stock markets.  

The speed and magnitude of this correction shocked all investors as $5 trillion in market value vanished in one week.  The roughly 12% stock decline was painful, but not without precedent.  Stocks and viruses have a history and this time around is not that different, so far.  Back in 2003, the SARS virus was the top story leading a 12.8% decline over a 38-day period.  In late 2015, the Zika virus caused a 12.9% decline.  After these viruses ran their course, the markets eventually recovered to hit new highs.

After the dramatic week that we all endured, it’s important to put things into perspective.

• S&P 500 was up over 30% in 2019
• Year-to-date the S&P 500 is down 8.3%
• The bull market in stocks is eleven years strong
• Corrections are a fact of life in all bull markets
• The last meaningful correction was in the fourth quarter of 2018 and a correction was overdue
• Interest rates are low and the economy is still positive

The catalyst for this correction has been biological.  It is fear based, not fact based.  If all of these fears come to fruition, the economic facts will eventually change and the correction will be justified.  If the coronavirus is adequately contained or a vaccine is developed, this market will rebound as quickly as it sold off. 

The U.S. began the year on solid economic ground and so far nothing has changed.  Companies with significant exposure to China are going to be affected as China has basically been shut down for a month.  Supply disruptions are real and can have a temporary negative impact on those companies.  If a pullback in earnings or economic activity does transpire, it will likely be short lived and offset in the year ahead.  The U.S. consumer holds the key to future economic prosperity.  The depth and duration of the coronavirus scare will influence consumer confidence and ultimately the magnitude of any further correction.               

Obviously, this was a tough period for stocks as every major market looked to discover a bottom to rebound from.  Global equities endured their worst declines since the 2008 financial crisis in the last week of February.  Commodities also plunged as concerns about the coronavirus sending the global economy into a recession.  Gold was a bright spot as fear drove investors to the buy the safe haven asset.  In February, U.S. stocks were down 8.2% as measured by the S&P 500.  International developed countries and emerging markets were also hit hard falling by 9.0% and 5.3% respectively.  Oil fell 13.6% for the month coming off its worst week since 2008.  Most of the price declines so far were panic driven.  There may be more panic to come if the virus worsens.  If the coronavirus lingers, weak consumer demand could induce an economic slowdown.  At some point a great buying opportunity will emerge.    

Despite all the fear based stock market turmoil, the bond market was a major beneficiary as interest rates moved even lower.  This flight to quality trade sent interest rates to all-time lows.  U.S. Treasury yields on 2-5 year maturities traded below one percent for the first time ever and the 10-year Treasury note was not far behind, closing the month yielding 1.13%.  The yield curve has maintained its positive upward slope with 2, 5, 10 and 30-year maturities yielding 0.86, 0.89, 1.13 and 1.65 percent respectively at month end.  The already hot housing market will now have even lower mortgage rates available for new buyers and those homeowners looking to refinance their existing mortgages.

After the disastrous week that was, the Federal Reserve weighed in with some comments to help calm market fears.  The comments assured investors they are closely monitoring the effect of the coronavirus on the economy and stand ready to cut short-term interest rates if necessary.  Fed watchers are now projecting there is a 100% chance of a 50 basis point rate cut by or at the next Fed meeting on March 18, 2020.  While a Fed rate cut may provide a psychological benefit to the market, it will do little to change the trajectory of this virus lead market correction.  When the biological threat is deemed under control, the market will heal.            

For those investors who have implemented a systematic plan of portfolio rebalancing, please be reminded this strategy works well in both directions.  In recent monthly commentaries, we addressed the power of using market strength to rebalance your portfolio back to its targeted risk tolerance by selling stocks (the outperforming asset) and buying bonds (the underperforming asset).  For those investors who took this step – congratulations.  You now have the opportunity to rebalance in the other direction.  Stock market weakness, like we just experienced, opens the door to raise the risk of your portfolio back to target by selling bonds at higher prices and buying stocks at lower prices.  For those investors with a solid asset allocation and proper diversification, just keep on plugging.  Don’t panic in the face of fear, do not let fear dictate your next investment move and most of all stay invested for the long haul.

MARKETS BY THE NUMBERS:

To expand on these Market Commentaries or to discuss any of our investment portfolios, please do not hesitate to reach out to us at 775-674-2222

At Gradient, we examine trends in both the stock and bond markets to get a better sense of investor sentiment regarding the future of the US economy.  Three fixed income (bond) indicators that we watch closely are changes in the yield curve, potential inversions of the yield curve, and the level of credit spreads for investment grade and high yield bonds.  Below we will provide a brief explanation of these indicators, why we feel they are important to examine, and what recent trends have occurred in each.

Yield Curve

The yield curve is a line that reflects interest rates at various maturities, and the most widely watched curve for US investors is the US Treasury yield curve.  The chart below shows the treasury yield curve as it stands today versus 2 years ago.  The blue line represents the current yield curve while the green line reflects the yield curve as of 2/20/2018.  The current yields under all categories are lower than they were 2 years ago but have decreased more aggressively at longer maturities.  As interest rates decline, existing bonds become more valuable, and this has been the primary cause of the bond market rally seen since 2019. 

10-year versus 2-year spread

Another well-watched indicator is the spread between 2-year and 10-year treasuries, especially as we near an “inversion” (where 2-yr rates are higher than 10-yr rates).  The reason investors have interest in this indicator is that an inversion has preceded every recession since 1950.   The below chart shows the spread of the 10-year versus the 2-year since 1977 and the gray bars represent recessionary periods.  We did experience an inversion briefly in 2019 and this has created some consternation regarding a potential upcoming recession.  However, the magnitude and length of the inversion was relatively shallow compared to prior inversions that preceded a recession.  Also, while an inversion has preceded prior recessions, it does not indicate that recessions are imminent in the near future.  

Corporate Bond Spreads

Corporate bond spreads represent the premium amount that investors receive for taking on the risk of a company potentially defaulting on their debt.  Higher risk bonds from lower quality companies typically carry a higher premium to take on default risk.  Below is a chart that shows the spread for both investment grade corporate bonds (blue line) as well as riskier high yield bonds (red line) since 1998.  When investors are confident in economic conditions, spreads are relatively low.  When we see economic recessions, where companies are facing a higher degree of uncertainty in their businesses, investors require a higher premium to take on the risk of default.  Currently, we are near all-time lows in spreads for both investment grade and high yield bonds, suggesting that investors are less concerned about defaults in the near term. 

While no single indicator can provide a crystal-clear picture of investor sentiment on economic conditions and outlook for the future, using these indicators together can provide some greater clarity on how bond market investors are positioning for the future.  It is our opinion that investors do expect short term interest rates to stay stable or slightly decline, and that investors are not positioned for recessionary conditions.  Our expectations are for lower returns in bonds compared to 2019 but also a “lower for longer” scenario where interest rates stay relatively range bound at current levels.    

To expand on these Market Reflections or to discuss any of our investment portfolios, please do not hesitate to reach out to us at 775-674-2222.