Special Report: Now What?

June 30, 2020
By Patrick V. Masso, CFA

As we near the end of 2020, we ask ourselves this classic question.

I often ask my two-and-a-half-year-old son this simple question as he insists on being picked up by dad…for the umpteenth time before noon. We can ask the identical question at this juncture in financial markets: Now What?

Let’s first recap the path taken so far in 2020. After disregarding slowing growth throughout 2019, on the back of a fresh bout of optimism following the agreement between the United States and China on a “phase one trade deal”, domestic equity markets were making fresh all-time highs in January and February.

Just a few short weeks later, we were unknowingly at the top of the equity market roller coaster, and it has been a wild ride ever since! The range of outcomes generated by the uncertainty regarding COVID-19 expanded dramatically and financial asset volatility exploded. After peaking on February 19th, the S&P 500 Index experienced a decline greater than 35% in just 23 trading days – the steepest decline of such magnitude ever. March produced a handful of dark days.

Then, compared to other crises, monetary and fiscal policymakers responded relatively quickly and with much greater force. The measures enacted, combined with a greater understanding of the virus’s lethality, and the plans to reopen the economy caused the barreling rollercoaster to slam into a trampoline and catapult higher.

In fact, the S&P 500 Index retraced more than 85% of the lost ground from March 23rd to June 8th, producing one of the best stretches of positive returns over other similar length periods.

Now what?

The last five trading days have seen market participants ask this very question. As of this writing, the S&P 500 had declined 8.25% between June 8th and June 15th.

While I grin as my son giggles uncontrollably upon being asked the question, your money is no joke and the answer matters.

The resumption of economic activity has coincided with increases in case counts across several counties and states. Market participants are closely monitoring the probability of a “second wave”.

Thankfully, the fatality rate appears much lower than initially feared. The data show the bulk of fatalities concentrated in elderly populations, particularly in communal living arrangements, with increased risks for those already battling other illnesses.

Should a second wave take hold, we do not anticipate policymakers will institute another full stoppage of economic activity. Our guess is that the cost-benefit analyses combined with political considerations will prevent an additional broad shutdown.

In the meantime, small businesses across the country are clearly hurting. Entrepreneurs have seen cash flows dry up. Businesses without adequate liquidity buffers are facing real solvency issues. It is nearly impossible to profitably run a hotel or restaurant at 50% capacity. With similar dynamics across other industries, default rates on riskier bond market investments will probably continue to rise.

In the face of a double-digit unemployment rate alongside a looming US election, expect the chatter about a second aid package from Congress to heat up over the next several weeks. Undoubtedly, neither side of our two-party system will want to disappoint unemployed voters, so the federal deficit and debt will assuredly continue skyrocketing.

Remember, financial markets and economies are not identical. The former are leading indicators that continuously try to account for the future state of the latter. In this case, markets have latched onto “less bad” being good enough. While risks remain and volatility will almost certainly stay elevated for quite some time, we suspect any sort of incremental improvements to be met positively with investors willing to place additional bets.

A recovery in GDP and corporate profitability to 2019 levels will likely take at least a couple years. Unfortunately, many businesses, numerous small and some large, will succumb to liquidity and solvency pressures or the potential longer-term impacts of how the “new economy” will function going forward. Hopefully, the resources of these failed businesses will be reallocated across new ventures as the complex, dynamic, and adaptive American capitalist system was designed to function.

Over time, we will heal from this recession and capital markets will award medals, like they always do, to those companies most able to persevere and adapt to an ever-changing system subject to outside shocks.

Our investment process is intentionally built with multiple layers of flexibility and diversification to take advantage of constantly changing environments. As the investment landscape shifts and the push-pull between risk and opportunity changes, we will continue to actively manage your portfolio to capitalize on these opportunities.

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