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BMT Monday Market Insights – March 9, 2020

Market Insights

Top Weekly Themes

  1. Equity market volatility has risen dramatically and will likely stay elevated, at least for the foreseeable future, as investors continue to digest the continuous stream of Covid-19 (coronavirus) headlines. The number of reported cases of virus infection has surpassed the 100,000 mark, which dwarfs the 10,000-figure quoted by the medical community as of the beginning of February. As we’ve mentioned in the past, we cannot accurately quantify the implications this pandemic will have on human health, global economies, or financial markets.  However, we can analyze other “black swan”, or unforeseen events and the effects they have had on asset prices.  Since the last week of February, equity markets in the United States have already experienced seven days of more than 2% daily price fluctuations on both the positive and negative side.  On five of these days, stocks fell more than 2.5%.  Stocks got bid higher after the results of “Super Tuesday”, with Joe Biden emerging as the likely candidate to win the Democratic Presidential nomination. Investor optimism quickly faded the following day with the S&P 500 posting another loss of more than 3%.  To say this degree of market volatility is atypical would be an understatement.  However, this level of volatility is not unprecedented over the entire of history of publicly traded markets. We looked at daily S&P 500 prices going back to 1928, which is close to 24,000 data points.  Equity markets declined more than 2% approximately 800 times over this period. Based on our calculations, the subsequent 1-year return after stocks fell more than 2% the previous trading session was roughly 7% on average, with a wide range in terms of the distribution of outcomes.  While this number is below long-term historical averages, the magnitude of daily declines we’ve recently experienced aren’t necessarily a precursor for a prolonged bear market.  As volatility spikes occur, we believe that it is prudent for investors to re-examine their risk tolerance levels.  Equities are still just roughly 10% off their all-time highs (and back to levels last seen only a few short months ago).  There is still an opportunity to make the necessary portfolio adjustments if wild daily fluctuations are causing considerable angst.
  2. The Federal Reserve (Fed) stepped in to defend the markets once again and surprised investors with a 50-basis point (0.50%) emergency rate cut, bringing the federal funds target range down to 1.00% – 1.25%. This is the first time since the 2008/2009 Financial Crisis that the Fed lowered rates outside the confines of a scheduled Federal Open Market Committee (FOMC) meeting.  This move by the Fed did little to alleviate investor concerns as stocks continued to fall. So, why did the Fed implement an emergency rate cut knowing that lower rates in an already low rate environment is not a solution for disrupted supply chains, mandated or self-imposed quarantines, and potentially less consumption?  We think the Fed is hoping to accomplish two things: 1) They wanted to take presumptive measures to ensure financial conditions don’t tighten further given the potential impediment to future growth caused by Covid-19. 2) Provide additional liquidity to fuel a more robust recovery once the economic effects of the virus begin to dissipate.
  3. U.S. economic data released this past week did not signal impending doom. ISM Non-Manufacturing survey results, which provides some visibility about the health of the all-important services sector of the economy, surprised to the upside.  In addition, Initial Claims, which measures new unemployment benefits, was below consensus estimates and is still considerably low given the length of this business cycle.  While the economic condition could materially worsen over the ensuing months, at least the U.S. economy appears to be on solid footing entering his turbulent period.

Returns Table

Week (%) YTD (%) 1-Year (%) 3-Year (%) 5-Year (%) Div Yield (%)
Equities
S&P 500 1.6 (6.1) 10.6 34.6 59.4 1.90
Russell 1000 Value 0.3 (9.9) 2.5 13.0 33.6 2.71
Russell 1000 Growth 2.4 (2.3) 17.7 57.4 83.9 1.13
Russell 2000 (1.2) (11.2) (4.3) 10.5 28.5 1.52
MSCI EAFE (0.5) (8.5) 2.6 16.7 17.1 3.19*
MSCI Emerging 0.9 (6.6) 1.4 21.3 22.4 2.64*
Week YTD 1-Year 3-Year 5-Year Yield 
Fixed Income
Bloomberg/Barc US Aggregate 1.5 4.6 12.6 17.6 20.7 1.50
Bloomberg/Barc US High Yield 0.2 (0.5) 7.0 16.1 30.2 5.91
Bloomberg/Barc Muni Bond (0.1) 3.0 9.4 17.3 21.9 1.29
Bloomberg/Barc Global Agg. Ex U.S. 2.2 2.5 8.1 16.2 16.6 0.66
Week YTD 1-Year 3-Year 5-Year Current Level
Commodities
Crude Oil (WTI) ($/bbl) (2.5) (24.8) (18.8) (13.9) (9.6) 45.9
Natural Gas ($/mmbtu) 1.1 (19.0) (38.6) (37.3) (37.6) 1.8
Gold ($/ozt) 1.6 9.7 30.0 36.0 39.3 1,666.4
Copper ($/mt) 1.4 (7.5) (13.1) (3.6) (2.8) 5,694.5
1 Week Ago YTD 1-Year Ago 3-Years Ago 5-Years Ago Current Level
Currencies
Euro/USD 1.10 1.12 1.13 1.06 1.10 1.12
USD/YEN 109.99 108.68 111.90 114.50 120.17 106.67
Pound/USD 1.29 1.32 1.31 1.23 1.52 1.29

As of March 5, 2020 (close)
*Dividend Yield For MSCI EAFE and MSCI EM are from 12/31/2019

Chart of the Week

Click the chart to enlarge it.

Exogenous Events Unfortunately Do Happen

Chart: Black Swan Events
Source: Cornerstone Macro

Key Takeaways

  • As we stated before, “black swan” or exogenous events (Blind Spot in the charts) happen on a periodic basis with no advanced warning. The charts above juxtapose two different periods, today and the late 1990’s which had multiple “black swan” events (Asian Financial Crisis, implosion of hedge fund Long-term Capital Management, and the Russian Default Crisis). In 1998, the Fed performed three emergency rate cuts that sparked a V-shaped recovery.   The circumstances today are quite different in a lot of ways, but we can’t rule out the possibility of a strong recovery as coronavirus worries and its effects on economic activity lessen.
  • The precipitous decline in long-term rates, as illustrated by 10-Year Treasury yields falling below 1% this past week, has prompted a surge in mortgage refinance activity as seen in the chart above. In the late 1990’s, there was also a spike in mortgage refinance, which helped prolong the economic expansion for another 24-30 months.  There are many circumstances today that are quite different relative to the mid to late 1990’s.  However, we think elevated mortgage refinance activity is quite positive for U.S. consumers, who are already on solid footing.  This additional source of capital could bolster consumer spending further as the global economy begins to get past the fears associated with the coronavirus.
  • In the bottom-half of each chart, the Initial Claims for Unemployment Insurance is displayed. Similar to the late 1990’s, this data series has continued to trend lower, which gives us some assurance that the economic expansion will likely continue.  Prior to the past several recessions, Initial Claims started to trend higher before economic conditions started to materially weaken.

Commentary

The dispersion of returns amongst certain sectors, market cap ranges and investment styles has been quite extreme, as illustrated by the chart below.  It’s been somewhat of a strange market dynamic given the strong performance of Utilities (low beta, defensive) and Technology (high beta, large cap growth).  It seems as if many investors have gravitated to Technology stocks, while hedging that position with an allocation to Utilities.  On the flip side, small cap value stocks, which tend to be more cyclical in nature, have materially underperformed.

Trailing Two-Year ETF Returns – Ending 3/6/2020
Utilities, Small Cap Value, Technology, S&P 500

Trailing Two-Year ETF Returns – Ending 3/6/2020
Sources: FactSet, Inc.; BMT

Takeaway

While the trend highlighted above could continue given the combination of all-time record low interest rates and the likelihood of slower economic growth, it looks to us like we are reaching an extreme in terms of the divergence in returns.  Small cap value has lagged the Utilities sector by over 5500 basis points (55%) on a cumulative basis over the previous two years.  If the economic impact of the coronavirus is not as bad as many fear, and we see an even modest economic acceleration towards the later months of this year and into 2021, we could easily see material improvement in the relative performance of small cap value stocks.  While we have no clear visibility in terms of when this pattern will reverse, we are aware that extreme return divergences tend to mean revert over time.

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