2020 Q1 Summary: Our Brief Thoughts on the YearSubmitted by Jodi Vleck , Beta Wealth Group on April 15th, 2020
2020 First Quarter Summary
Our Brief Thoughts on the Year
We write a different quarterly outlook this time because the circumstances are vastly different. It is more personal because it was written from our homes, surrounded by our families, and may stray further outside of strict economic-market analysis since it is impossible to look at anything in a silo.
The current market-healthcare challenges are unprecedented, and recovery will benefit from solutions beyond the swift and supportive action of policymakers. Partnership and collaboration, in business and within our communities, will be critical. We must not lose sight of the fact that what we face, at its core, is a health crisis that will require humanity as well as perseverance.
Our economy is facing unprecedented challenges as we navigate the COVID-19 pandemic. The economy most likely entered a recession in March 2020 with potentially the largest economic decline in modern history. Policymakers acted fast, delivering sizable fiscal and monetary stimulus that will help mitigate some of the economic decline. Financial markets also experienced exceptional volatility and dislocation, and as the scope of the economic slowdown becomes clearer over the next quarter, valuations could see further volatility and downside, which is typical during the early stage of recessions.
In what has been a tale of two halves within the quarter, the S&P 500 had a strong start to the year and hit multi-year highs, with Emerging Markets such as China being negatively impacted more by the virus early on. Since the health crisis hit developed markets in late Feb/early March, US/European markets suffered a 25-30%+ peak-to-trough decline and credit markets in the US suffered dislocations, while Chinese markets outperformed the US even as the crisis looked to be contained in most Asian geographies where the virus was contained by “social distancing” guidelines and widespread testing.
Into the Great Unknown
Writing an outlook at a time of so much uncertainty due to the COVID-19 pandemic is difficult, to say the least. For many economists working with a traditional GDP model, the assumptions going in are as much of a guess – educated though it may be – as the final numbers of the forecast. The economy most likely shrank in Q1, with prospects for Q2 shaping up to be a devastating dislocation in economic activity, employment and output. March 2020 will likely mark the end of our record-long expansion.
Having experienced many economic and credit cycles, we have learned three critical lessons.
- First, each cycle is unique – in terms of catalysts, vulnerabilities and challenges. After each cycle, we work to remedy vulnerabilities and put a framework in place to address their reoccurrence. History can be immensely helpful but is not a blueprint for the future.
- The second lesson is that over the long run, the $20 trillion US economy remains vast, dynamic and broadly resilient. The benefit of a wider vision shows us that we do recover, and we find normal again, but it will likely be a different normal. Events like 9/11 or the OPEC oil embargo of the 1970s have a lasting imprint on our culture, but our economy does heal from downturns and eventually comes out strong on the other side.
- The third lesson is that while the downturn – both financial and economic – is happening, it can be very scary indeed. Now even more so because the real problem is a health crisis, not a downturn born of economic excesses or financial sector folly. It is hard to wrap our minds around the fact that the dislocation – economic and social – could last for longer than we initially anticipated. Our next normal may well look different from the last decade.
For these reasons, our Q2 outlook will focus less on trying to estimate dollars and cents of lost economic activity or the percentage impact on GDP. Current estimates of Q2 GDP range from a 15% contraction to a 40% contraction. Either way, it will likely be devastating to the economy and investors. At the March 15 FOMC meeting, the Federal Reserve did not release economic projections, and Fed Chair Powell noted that given how rapidly events were unfolding, that a forecast is “just not something that’s knowable” and that “writing down a forecast … did not seem to be useful.”
Portfolio Positioning – Asset Allocation Discipline & Mean Reversion
As always, during these volatile times, we highlight the importance of asset allocation through a recent chart from JP Morgan below, which shows best-to-worst performing asset classes over a 15-year period from 2004-2020. This chart also illustrates a central concept of investing i.e. mean reversion, wherein the best and worst performing asset classes annually keep changing, and highlights the importance of rebalancing portfolios periodically to ensure that the overall portfolio mix is consistent with the broader objectives of building a globally diversified portfolio.
The Road Ahead: The Most Pressing Investor Questions
Given recent market events, here are a few of the biggest questions on investor minds, and our corresponding thoughts.
- What are broader expectations for global growth now that economic activity has come to a standstill? Is the global economy headed into a recession, and how might this recession be different from prior recessions?
Global growth forecasts have been marked down noticeably over the past month. Currently, the consensus opinion amongst most institutional investors and economists is that the recession has already started and we will likely experience steep GDP growth declines and an earnings recession in Q2 2020 that will likely result in negative mid-teens US GDP growth (annualized) in countries like the US, negative GDP growth in Q3 and possibly for 2020; however, as a chart from PIMCO illustrates, expectations also call for a growth rebound starting in Q4 (see chart below) should the pandemic be controlled by then.
- How long will it take for global economies to rebound back to normalized growth? How much of a slowdown/recession has already been priced into the markets?
Given that there are few precedents to this type of market action other than possibly 1987 and 1929 and that the source for this crisis is a previously unknown virus and business shutdowns are government-mandated, there are no hard and fast rules for how long it could take for the economy/markets to recover. However, we know that “social distancing”, travel bans and “work from home” orders have worked to slow the spread of the virus both in Asia and in states like Washington/California thus far and that vaccines/cures are inevitable just as there were for SARS and Ebola pandemics; also, current projections call for infections to peak in the US sometime in April.
Our best guess is that markets will hit lows right around when news regarding global fatalities/infections is most dire and the economic news (e.g. jobless claims/industrial production/consumer sentiment/unemployment rates) and company-specific earnings/guidance are most negative. The degree/shape of a global rebound i.e. whether it is a V-Shaped (quick) recovery or a U-Shaped (slower) recovery will depend eventually on the trajectory/containment of the virus, short-term measures taken by Global Central Banks and Global Governments to stabilize the economy/markets and our collective societal willingness to return to normalcy.
- What are key measures taken by the US Government and the Federal Reserve that might help stabilize markets/overcome this economic slowdown?
Thus far, we have had two different types of market and economic stabilization actions:
Monetary and Fiscal, from the Federal Reserve and the White House respectively.
As the Coronavirus-driven slowdown took shape, the Federal Reserve has moved decisively thus far by cutting rates 150 basis points in March, the fastest-ever series of cuts in the Central Bank’s history. In addition, during the March lows, the Federal Reserve took steps to provide much-needed liquidity to the bond market including buying mortgage-backed securities and corporate bonds which helped stabilize the credit market. Further, we believe most global central ranks are poised to do multiple rounds of Quantitative Easing to ensure free/smooth flow of credit through the economy
On the Fiscal Side, the President signed into law a $2.2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Stimulus Act, the largest of its kind ever, to help address the economic fallout from the pandemic. Below is a brief summary of some of the provisions included in the $2.2 trillion stimulus package:
Benefits for Individuals:
- Immediate Payments. Some taxpayers will receive a one-time payment in the amount of $1,200/taxpayer or $2,400/married couple filing jointly (plus $500/qualifying child). The amount of the payment is based on 2018 (or 2019, if filed) tax return numbers and may be reduced for higher-income taxpayers.
- Student Loan Relief. Federal student loan payments are suspended through September 30, 2020, and shall not accrue interest.
- Unemployment Claim Expansion. Benefits have been expanded to include self-employed workers, independent contractors, and freelancers (the “gig economy”) with an additional $600/week for four months on top of state benefits. Benefits are extended to 39 weeks. (Many states, including California, normally limit benefits to 26 weeks.)
Benefits for Small Businesses and Nonprofits:
- Forgivable Loans. Small business loans for up to 2.5 months of payroll (small businesses and nonprofits with fewer than 500 employees) will become available. Loans are to be streamlined and not based on some of the previously stringent guidelines. If certain criteria are met, the loans may be partly or fully forgiven.
- 2020 Payroll Tax Deferral. This is available for those small businesses that do not take advantage of the forgivable loan mentioned above.
Benefits for Taxes and Retirement Planning:
- Delayed Tax Filing/Payments. For individuals and some small businesses, the new deadline is July 15, 2020, to file and pay 2019 federal taxes. Please check your state’s tax board for their filing deadline. Many states, including California, are now aligned with the federal July 15th deadline. Please consult your tax professional to determine the optimal filing strategy for you.
- 2020 Required Minimum Distributions (RMDs). These are waived, giving individuals who were previously required to take distributions more flexibility in taking withdrawals from their IRAs and retirement plan accounts, potentially lowering their overall tax bill.
- New Charitable Deduction. For those who do not itemize deductions, there will be an allowable “above the line” deduction for cash charitable contributions not to exceed $300.
- No Cash Charitable Contribution Limits. The 2020 charitable contribution limitation for individuals will now be
- 100% of your adjusted-gross-income, or “AGI,” if you donate cash directly to a charity. (Note: Donor-advised funds and Section 509(a)(3) supporting organizations are not eligible.)
The above list is not exhaustive. We encourage you to reach out to your financial advisor or tax professional to discuss any potential planning opportunities for your specific situation. Please navigate here for our recent take on this topic: https://www.betawealthgroup.com/blog/cares-act-largest-stimulus-package-us-history
- With respect to the Coronavirus, what is the anticipated trajectory for the pandemic in the US/globally and when might we see this impact taper?
The COVID-19 pandemic originated in Wuhan (Hubei Province) in China around early December and quickly spread to much of the developed world, including Europe and the United States. Based on official estimates which one should view with a big caveat, the weekly percentage change both in cumulative cases and mortality rates have declined in China as well as in other Asian countries like South Korea. Over the past few days in early April, we have also seen fatalities slow in Italy and Spain, two of the hardest countries with the highest mortality rates, and in New York (which has become the epicenter of the crisis in the US). Based on infection prediction models from the Institute for Health Metrics and Valuation (IMHE) at the University of Washington, the US (assuming adoption of social distancing practices) should hit peaks both in new cases/daily mortality, by late April.
On a related note, we have several different approaches being followed by healthcare companies like Gilead Sciences, Moderna, Genentech and Regeneron Pharmaceuticals to containing this pandemic. First approach involves developing vaccines that will help prevent onset of COVID-19, and the second approach involves developing anti-viral cures which might be aided by the fast-tracking of FDA approvals; however, both approaches will likely not lead to solutions until later in the year or early 2020. Until then, containment will be key.
- Are markets around the world cheap or fairly-valued now that markets have corrected?
With the recent global market selloff, most global equity markets have corrected anywhere from 20-30%, and most bond categories (e.g. Munis, Investment Grade and High Yield Bonds) sold off as well. As the chart below from JP Morgan illustrates, most asset classes trade well off highs, with International Equity Markets trading significantly below historical averages and Global High Yield/Investment Grade bonds trading at rock-bottom valuations. Within the US, it is worth nothing that the average S&P 500 stock trades at close to a 2.5% dividend yield and even after dividend cuts across multiple industries, this to us looks more attractive to the 10-year Treasury which has an ~0.7% yield. This is just our roundabout way of saying that when the dust settles (whether in 3-6 months or later), that investors in search of yield in a low interest-rate environment might have few alternatives to owning high-quality dividend-paying equities.
- What broad investment changes has Beta Wealth Group been making to Portfolios in recognition of recent market volatility? How do you balance short-term market moves with long-term investment discipline-planning?
Since we disavow market timing strategies, we are often asked what we are doing in reaction to extreme stock market volatility like we have experienced over the last several weeks. The simple answer is that we are continuing to implement our time-tested, disciplined investment and financial planning process. In today’s environment, this approach has three primary components.
- First, we are rebalancing client portfolios to their target asset allocations, which generally means reducing fixed income (bond) exposure and adding to equity (stock) holdings at lower prices. This is a way of executing Warren Buffett’s advice to "Be fearful when others are greedy and greedy when others are fearful."
- Second, we are taking advantage of the opportunity, sometimes on a daily or weekly basis, to harvest tax losses for our clients in their taxable accounts (revocable trusts, individual accounts, etc.). Up to $3,000 of these losses can be applied against ordinary income on your tax return. More importantly, these tax losses can be used to offset realized capital gains on other assets, and any unused losses can be carried forward indefinitely to be used in future years. Tax-loss harvesting can have a meaningful impact on long-term after-tax returns. If missed, the opportunity goes away. It is worth noting that rebalancing and tax-loss harvesting efforts may lead to more trading than you may have become accustomed during the relatively calm market of the previous decade.
- Lastly, we are updating many clients’ financial plans. As the current economic circumstances have impacted income sources, retirement timing, and overall spending needs, we are helping clients adapt their retirement planning scenarios. Financial planning is a fluid process and many of our financial plans include “stress tests” of bear market scenarios similar to the one we are currently experiencing.
Broadly however, in keeping with our intent to invest your portfolios over a longer timeframe (read 3-5-10 years rather than the next few weeks or months), there have been a few broad themes to our recent changes: favoring higher quality equities (preferably with dividends), reducing risk in fixed-income portfolios, writing options to take advantage of higher-than-expected volatility/premiums, and continuing to add investments that are less-correlated with the ups and downs of public markets, such a Private Investments in categories including Private Real Estate and Global Infrastructure.
- Finally, what are market expectations for the 2020 Presidential elections?
Given the COVID-19 news, election headlines have been pushed firmly to the background.
From the start of 2020, the crowded Democratic field has been winnowed down to Vice President Joe Biden. Further, after reviewing most prediction markets and ever-changing polls, we believe it will be a toss up as to whether President Trump or the Democratic nominee (Biden) will prevail. From here on, how the current Administration handles the pandemic and the critical steps they take to minimize the impact of the economic recession will be instrumental in determining the fate of what was already a much-hyped 2020 Presidential election.
As always, feel free to reach out to us with questions by email or over the phone. More importantly, stay safe and healthy!
Jodi Vleck, CFP® & Giri Krishnan