Market & Economic Outlook
Market Commentary Q2 2020 - Economic Outlook
Second Quarter 2020
Global Pandemic Shakes Markets and Economies
By all accounts, the global economy was hitting its stride entering 2020. In the U.S., dovish monetary policy led to three rate cuts providing the economy room to extend its historically long run. German manufacturing data, a proxy for global trade, was inflecting upward and U.S. employment was as strong as it had been in decades with no signs of slowing down. Investors viewed a trade conflict ceasefire as the last remaining obstacle to be cleared before continuing to add risk. Equity markets had anticipated much of this good news as evidenced by strong 2019 returns that continued into the first seven weeks of 2020.
At the same time, little attention was paid to a growing concern in China about a mysterious and rapidly spreading illness. Even when China placed large portions of its population under quarantine orders in late January, investors dismissed the action as a blip on the radar screen. However, by the end of February, “coronavirus” was becoming a household term. The disease it causes, COVID-19, was formally declared a global pandemic by the World Health Organization on March 13.
The Black Swan Arrives
The economic and market ramifications of widespread government-mandated social distancing policies intended to prevent contagion were wide and deep. As soon as it became apparent that the problem would not be isolated to China, investors recalibrated to a new paradigm that included a temporary shutdown of major segments of the global economy. Investors raced to exit any asset deemed “risky” in a search for safety. The demand for “risk haven” U.S. Treasury bonds drove the 10-year Note’s yield down to 0.33% from a yield of 1.91% at the beginning of the year.
This extraordinary exogenous shock was like a record scratch of epic proportions for financial markets that were dancing to a very upbeat song. After hitting an all-time high on February 19, the S&P 500 Index sold off into bear market territory at the fastest speed on record, and market volatility as measured by the CBOE Volatility Index (VIX) soared to levels that exceeded prior highs set during the Great Financial Crisis in 2008.
As the quarter ended, a relief rally on news that monetary and fiscal responses were being readied pared losses, but not enough to save the S&P 500’s quarterly return from being the worst since the 4th quarter of 2008 when the index declined by 22%.
Market Returns Summary
The impact of the dramatic decline in business activity across the country was quickly apparent: several large companies announced they planned to save cash by suspending, delaying, or reducing corporate contributions to employee 401(k) plans
and the University of Michigan Consumer Sentiment Survey fell to 89 from 96 in February. According to Bloomberg, it was “the fourth largest one-month drop in nearly half a century” for the survey.
As companies shuttered their doors to prevent contagion, mass layoffs began. Unemployment claims soared to 3.3 million for the week ending March 21, a level four times higher than the prior record set in 1982.
For the last two weeks of the quarter, initial unemployment claims totaled nearly 10 million—far surpassing anything witnessed over a two-week period during the Great Financial Crisis and the highest level of seasonally adjusted claims in the history of the series.
The Department of Labor’s non-farm payroll report dropped by 701,000 in March, driving the unemployment rate up to 4.4% from 3.5% in February. It was the first decline in payrolls since September 2010. The survey, which is conducted midmonth, reported that two-thirds of the drop came from the hospitality industry. Final unemployment numbers for the quarter are expected to be even higher.
As markets tumbled while state governments put social distancing measures in place, the Federal Reserve (Fed) and Congress responded by implementing a variety of market and economic relief measures intended to contain the economic fallout. It would be difficult to understate the size, speed and scope of the aid packages.
The Fed’s decision to cut short-term rates and restart quantitative easing
was just the beginning. The Fed stated it is “committed to using its full range of tools to support households, businesses, and the U.S. economy overall in this challenging time.”
New emergency stabilization monetary and fiscal measures included:
As the quarter ended, there were indications that vigorous Fed interventions were restoring the flow of credit to large corporations as U.S. companies raised a record $109 billion in public bond offerings.
This is a vital function as companies look to shore up their cash positions to weather the storm and fund operations amid falling revenue.
Pouring Oil On the Fire
In early March, on the heels of significantly dwindling demand for oil due to the COVID-19 pandemic, Saudi Arabia and Russia locked horns in a price war, flooding the market with cheap crude. As of quarter end, the combined effect of slumping demand and oversupply pushed crude oil prices to their lowest point in nearly two decades.
The negative ramifications of oil priced at $20 a barrel or below can be expected to extend far beyond stock prices for oil majors like Exxon or Chevron. The oil sector employs some 615,000 people in the U.S. with 600,000 of these jobs concentrated in Texas, Louisiana and the Midwest.
Many of these workers are employed by the several hundred privately-owned companies, often in rural areas, that manage from a few wells to a hundred or so.
The impact of these companies possibly failing will be particularly painful for local businesses and banks as oil field pay is generally higher than alternative jobs. Shutting down wells is also problematic—the process is expensive and can result in damage to the well, making resuming production problematic should prices return to long-term averages.
Bond markets are particularly vulnerable to the oil shock. Rock-bottom rates over the last few years encouraged oil and gas producers to leverage operations. It will be difficult to service and refinance this debt in the current environment.
Moody’s, the bond rating organization, calculates oil exploration and production companies have $86 billion in debt that will mature in the next four years and pipeline companies hold another $123 billion due over the same time period. The U.S. shale industry is in similar trouble: as shown in the chart below, a sample of 29 companies hold $133 billion of debt and interest to be paid over the next six years.
It would not be surprising if domestic oil producers face a Darwinian struggle over the next few years as stronger companies with cleaner balance sheets and access to credit snap up oil production sites and firms mired in bankruptcy proceedings. Predictably, law firms specializing in bankruptcy protection are already seeing a flood of new business.
No Room at the Inn
As Saudi Arabia doubled down on its confrontation and increased production by three million barrels a day, loaded tankers left port in late March headed for Europe and the U.S. According to Bloomberg, another 16 very large crude carriers are waiting to load at Saudi oil terminals.
Their journey may be one that ends in anchorages off the coast because the world is running out of places to store oil. Already, more than 80 tankers are anchored off the coasts of Scotland and Texas among other ports.
In Western Canada, storage levels have hit 75% with more oil on the way.
“For the first time in history we are seeing the likelihood that the market will test storage capacity limits within the near future,” according to Antoine Haiff of the research firm Kayrros.
If tank farms approach capacity, and demand continues to decline due to COVID-19, oil prices may see continued downward pressure.
Cutting off a Nose to Spite a Face
Bowing to pressure from the U.S. government to shake hands and make a deal, the early second quarter meeting of OPEC plus Russia saw an agreement to reduce oil production. Russia’s earlier gambit of refusing to go along with OPEC’s request to cut production could well be part of a larger plan to both cripple the U.S. shale industry—which recently helped the U.S. become the world’s largest producer— and to drive a wedge between the U.S. and the Saudi regime.
The U.S./Saudi relationship, reliant on both oil supply and security agreements, dates back to the 1930s but has been under increasing strain since the Twin Towers attack of September 2001. As Russia seeks to expand its sphere of influence in the Middle East, creating tensions between the two countries may be part of a longer-term strategy.
Russia might choose to extend its approach for some time. Saudi Arabia’s fiscal break-even cost, or the oil price at which a country’s fiscal balance is $0, is around $84
a barrel. While the Saudis have begun modernizing their country’s economy away from oil, they have a long way to go. Russia’s command and control economy may be able to weather the storm, however, having lowered the country’s fiscal break-even cost from around $100 a barrel in 2014 to $40 a barrel today.
Without a doubt, the coronavirus health crisis has pushed the global economy into a deep downturn and markets are reacting unfavorably. The path forward is highly uncertain and will likely be beset by negative economic data flow for the foreseeable future. Virus fears and quarantine measures are creating a massive global demand shock and there will be corresponding second-order effects amplified by global trade and the global nature of the financial system. Discretionary spending, tourism, exports, and manufacturing will all come under severe pressure.
Given the unprecedented collapse in demand associated with shutting down large parts of the economy, a key question is how deep the recession will get and how long it will last. These are difficult questions to answer without data indicating the full scope of the economic fallout of social distancing. A sudden onset of extreme economic constraints makes traditional analysis of data trends virtually useless. With this in mind, we expect overall financial market volatility to persist as investors search for a vector on the trajectory of the economy.
However, pent-up demand and forceful policy stimulus measures could yield a decent rebound in global growth later in the year. The recovery will likely be mild and uneven, and the economy will take time to heal back to its prior potential. Markets tend to rebound months in advance of an actual recovery in the economy, anticipating better times ahead, before showing up in economic data.
No accurate line of sight on the economy will be possible without a foreseeable end to the heath crisis. To this end, investors should accept this reality as a “known unknown” while also remaining confident in the resilience, ingenuity and innovation of humankind. Our job is to evaluate near-term risks while assessing long-term opportunities presenting themselves in the face of events currently exacting a tragic human and economic cost on society.
Seeing an Endgame in View
Unlike the deep and rapid downturns in the past, such as the 1930’s Great Depression and 2008’s Great Financial Crisis, this crisis has an endgame in the not-too-distant future—hiding in plain sight—which provides some much-needed optimism. Social distancing measures combined with warmer spring temperatures could cause the virus to have a harder time spreading. The unprecedented collaboration from the healthcare industry, governments, universities, and nonprofits all banding together to deliver effective solutions in the areas of containment, treatment and ultimately vaccines to stem the pandemic is a heartening development. It’s human nature to focus on the recent cascade of bad developments, but we need to have faith in a brighter future. We are only limited by the size of our collective imagination.
Our investment process focuses on asset classes through the lenses of valuations, economic fundamentals and technical indicators, but also includes the identification of specific catalysts related to the underlying factors driving markets that would suggest the worst is behind us. For example, a peak in infection growth rates or a medical breakthrough leading to an effective therapy or vaccine could turn the tide of sentiment. Unprecedented globally-coordinated policy responses have already put a significant stake in the ground to soothe concerns about dire economic scenarios becoming reality.
Often the best returns come in the darkest hour when anxiety and uncertainty are high and volatility is at an extreme. Markets are ultimately able to see through the bad times today to better times ahead, especially during a transitory risk like a virus outbreak. Eventually investors will overlook the 2020 economic and corporate profits recession and price the market on the future recovery in 2021 and beyond.
Today we are in unchartered territory, and violent market swings are emblematic of this uncertainty. However, we remain optimistic on the long-term outlook for the economy and markets and believe the world will be in a better place a year or two from now. We should never underestimate the resiliency of human nature, the ability to adapt and to ultimately overcome difficult times. Like other sudden and unexpected events of the past, this too shall pass—we will prevail.
Economic and Market Perspectives is a publication of HighMark Capital Management, Inc. (HighMark). This publication is for general information only and is not intended to provide specific advice to any individual or institution. Some information provided herein was obtained from third-party sources deemed to be reliable. HighMark and its affiliates make no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication and bear no liability for any loss arising from its use. All forward-looking information and forecasts contained in this publication, unless otherwise noted, are the opinion of HighMark, and future market movements may differ significantly from our expectations.
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Economic and Market Perspectives is a publication of HighMark Capital Management, Inc. (HighMark). This publication is for general information only and is not intended to provide specific advice to any individual or institution. Some information provided herein was obtained from third-party sources deemed to be reliable. HighMark and its affiliates make no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication and bear no liability for any loss arising from its use. All forward-looking information and forecasts contained in this publication, unless otherwise noted, are the opinion of HighMark, and future market movements may differ significantly from our expectations. HighMark, an SEC-registered investment adviser, is a wholly owned subsidiary of MUFG Union Bank, N.A. (MUFG Union Bank). HighMark manages institutional separate account portfolios for a wide variety of for-profit and nonprofit organizations, public agencies, and public and private retirement plans. MUFG Union Bank, a subsidiary of MUFG Americas Holdings Corporation, provides certain services to HighMark and is compensated for these services. Past performance does not guarantee future results. Individual account management and construction will vary depending on each client’s investment needs and objectives. The benchmarks referenced in this piece are used for comparative purposes only and are provided to represent the market conditions during the period(s) shown. Benchmark returns do not reflect the deduction of advisory fees, custody fees, transaction costs, or other investment expenses, but the returns assume the reinvestment of dividends and other earnings. An investor cannot invest directly in unmanaged indices. Investments employing HighMark strategies: • Are NOT deposits or other obligations of, or guaranteed by, the Bank or any Bank affiliate • Are NOT insured by the FDIC or any other federal government agency • Are subject to investment risks, including the possible loss of principal invested.
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