Quarterly Commentary: Q2 2020
The first quarter revolved around the unprecedented Coronavirus pandemic. The uncertainty about its rate of contagion and severity sent financial markets and economies into worldwide turmoil. Equity markets began 2020 on a positive note, helped in part by the “Phase One” trade deal with China. After much negotiation, tensions eased and global growth was poised for a rebound. Domestically, economic data remained encouraging. Unemployment in February recaptured the 10 year low of 3.5%, and personal income rose. The U.S. manufacturing sector, which had been slowing in 2019, appeared to be picking up momentum as factory activity improved. A low-interest-rate environment benefited the housing market and building permits hit a 13- month high. Optimism and better than expected corporate earnings pushed equity markets to all-time highs on February 12.
S&P 500 – First Quarter 2020
In March, the dramatic response to COVID-19 plunged world financial markets into a broad-based downturn. Extraordinary volatility led to automatic trading halts on the exchanges on more than one occasion. The U.S. stock market fell into a bear market, declining approximately 37% from peak to trough, the fastest decline in history. All sectors within the S&P 500 posted negative returns for the quarter, regardless of asset class or style. On a relative basis, small-cap, value stocks, and energy stocks suffered the worst losses while Information Technology, Consumer Staples, and Health Care fared better. The declines brought an abrupt end to the record-long bull market that began in 2009.
Sector Performance – First Quarter 2020
In order to calm the markets and support liquidity, the Federal Reserve cut short term interest rates to 0% and increased its balance sheet by more than $1 trillion in March, supporting the mortgage and credit markets. Additionally, policymakers launched unprecedented fiscal support for the economy in the form of the CARES Act, providing $2.2 trillion in emergency economic relief/stimulus.
On March 27th, the president signed the long-awaited Coronavirus Aid, Relief and Economic Security Act (CARES Act). The $2 trillion aid package provides financial aid to families and businesses impacted by the
COVID-19 coronavirus pandemic. Highlights of the Act include $290 billion in direct payments to eligible taxpayers, $260 billion in expanded unemployment insurance, $150 billion for state and local governments, $510 billion in expanded lending for businesses and local governments, $377 billion in new loans and grants for small businesses and $127 billion for hospitals to procure ventilators and other essential equipment. While Congress was hammering out the details of the CARES Act, the Federal Reserve was also instituting policy to help soften the economic effects of the “shelter-in-place” orders issued by nearly every state in the republic. The FOMC took quick action regarding interest rates by reducing the Fed Funds rate by 50 bps prior to the scheduled March meeting and then reducing it by an additional 100 bps at their March 15th meeting to a target of 0% to 0.25%. FOMC guidance indicates that rates will remain low until the economy has “weathered recent events”. The Fed has resumed purchasing securities in the fixed income markets so that credit will continue to flow. This is a program first instituted during the Great Recession. After first committing to purchase up to $700 billion in US Treasuries and mortgage-related securities, the Fed, on March 23rd, made the program open-ended to further reassure investors. The Fed also reinstituted the Primary Dealer Credit Facility, another Great Recession program that lends to the 24 primary dealers, in an effort to keep capital flowing. Additional programs include backstopping money market funds and the repo market and offering direct lending to banks through the discount window. While several of the Fed’s programs preceded the CARES Act and provided some assurance to investors, it was not until the details of the CARES Act were made public that market participants began to realize that the government, combined with the Federal Reserve, would do whatever is necessary to backstop the economy during a government-induced economic shutdown. The big question now is how far the Fed can expand its balance sheet to backstop the credit markets. The CARES Act alleviated many concerns for now. We will have to wait to see if Congress can keep this up if the pandemic continues into the summer.
Oil prices registered their worst quarterly performance on record during the first three months of 2020, contributing to the turmoil within the financial markets. Global demand is down approximately 30% and as the coronavirus pandemic forced countries around the world to effectively shut down, daily activities came to a halt. The restrictions created an unprecedented demand shock in energy markets, and the price of crude oil hit its lowest level in 18 years. Oil product prices followed, with gasoline and heating oil moving lower as well.
WTI Prices – First Quarter 2020
In addition to the decline in demand for oil, the failure of OPEC and others (Russia) to reach an agreement on production cuts led to concerns of a supply surge. Both Saudi Arabia and the United Arab Emirates pledged to ramp up production and flood the world with crude and embark on a global price war. (Saudi Arabia plans on boosting production by 25% over previous months.) The extreme inventory build-up from overproduction will cause an issue of global storage capacity, prolonging low oil prices, and forcing all producers to contribute to the market rebalancing.
The US is the leading producer of crude oil in the world as output reached a record high during the first quarter. Fewer regulations under the Trump administration and a more
favorable corporate tax policy improved the landscape for US producers. The escalation of oil and natural gas extraction from shale has reduced the U.S.’s dependence on imports and is adding to the domestic economy in the forms of jobs, investment, and growth. But some worry that our days as a net petroleum exporter may be limited as plunging oil prices pressure production here at home. Over the past six weeks, the U.S. has shipped out more crude than it brought in, but the margin is becoming thinner. When the prices decline, shale output will decrease, and the U.S. can import cheaper oil from abroad. Domestic drillers are facing a million-barrel drop in production that could curb U.S. exports and set back its progress toward energy independence. The price action in March could cause U.S. production to decline as the price has dropped to a level that is not economic for output. If shale output slips by more than 1M barrels per day this year, that could be enough to take the U.S. from net exporter back to net importer.
Top Oil Producers
A significant drop in oil prices can have a rippling effect throughout the economy. Not only having a negative impact on employment for the industry and surrounding businesses, but the banking and investment sectors tend to suffer as well. Sharply lower oil prices could make it harder for energy companies to continue operation and may need to shut down, draw on cash reserves and credit lines, making it challenging to stay current on their loans. A rise in defaults would be painful for banks with sizable portfolios of energy loans. Banks are, however, well-versed in the risk/reward trade-off in energy companies, but the losses can still destroy capital when they happen. Job losses, capital losses, and prolonged reduction in oil prices can trim the growth of the U.S. economy. The three major oil producers in the world are Saudi Arabia, Russia, and the United States, and a significant decline in the price of oil hurts all. It is in the best interest of all three nations for the oil price to remain at a level that is high enough to allow oil and profits, but low enough to keep inflationary pressures in check. Even with a reduction in prices and the resulting loss of growth, the U.S. economy isn’t nearly as tied to the price of oil as some of the other top producing nations. The U.S. economy is incredibly diverse. Although oil and gas production has been one driver of recent growth, it is far from the most important sector of the economy. It is, of course, connected to other sectors, and losing growth in one can weaken others, but sectors like manufacturing gain more than they lose. We would expect the volatility experienced in the first quarter to continue.
Fixed Income Markets
As the severity of COVID-19 became clearer, fixed income markets reacted dramatically, but differently than the equity markets. Uncertainty in the markets leads investors to seek safer assets. But this time investors were not totally moving out of riskier assets (stocks) and purchasing more secure assets (high-grade bonds) but were, in fact, moving into cash. Typically the bond market is extremely fluid and high-quality bonds are seen as potentially easier to liquidate, and certainly a more desirable asset to sell than stocks. With equity markets down so much during the quarter and most parts of the U.S. bond market in positive territory, investors needing to raise capital had incentive to sell investment-grade debt instead of locking in losses in their equity positions. The yield curve has been inverted recently in many sectors of the corporate bond market and was a telling sign of a lack of liquidity in the system. As both individuals and fund managers rushed to unwind their bond positions and move into cash, volatility increased and liquidity dried up and yields moved higher in the U.S. bond market.
Weakening credit fundamentals and poor liquidity conditions caused credit spreads (the difference in yield between two bonds of similar maturity but different credit quality, usually comparing to a similar treasury note. to widen considerably. Since February, both U.S. investment-grade and high-yield corporate debt widened to 10-year highs as spreads more than tripled their recent averages.
In an effort to calm the fixed income markets and help liquidity issues, the Federal Reserve was quick to respond. The Fed cut short-term interest rates to zero and made multiple liquidity injections, including increasing bond purchases of Treasuries and agency mortgage-backed securities, investment-grade corporate bonds and also announced it would help maintain the flow of credit to municipalities around the country and establish a lending program for small businesses. The Fed’s programs went beyond those enacted during the financial crisis in 2008, attempting to provide adequate credit, loans and liquidity provisions for households and financial institutions. At this writing, it is too early to tell, but these programs are likely to evolve. The Fed has introduced credit facilities in both the primary and secondary corporate debt markets, which will ease concerns for those companies needing to raise short term funding through the debt markets, where they may not have had the option before the Fed stepped in with liquidity injections. It remains highly likely the Fed will still have more to do.
With the Fed intervention beginning in mid-March and a steep drop in inflation expectations the yield curve (line that plots yields of different maturities) moved lower. Yields on the 1 month and 3 month Treasury Bills dipped into negative territory and the yields on the 10 year Treasury and the 30 year Treasury hit all-time lows, at 0.54% and 0.99% respectively. Never before has the entire Treasury yield curve been completely under 1.00%.
10 Year U.S. Treasury Yield
The recent disconnect in the pricing for high-quality, short term bonds has largely been a result of technical factors in the market rather than fundamental ones. While it is true that many corporations are heavily leveraged and there will be quality downgrades as a result of the current environment, approximately 96% of the universe of corporate bonds will not suffer downgrades. While it’s impossible to predict the bottom of any market, we believe that high quality fixed income assets continue to be a necessary part of a well-diversified portfolio and we continue to be very deliberate in our security selections.
As we move forward, markets are likely to remain very volatile. The good news is that the Fed and the U.S. government continue to indicate it will do whatever is necessary to support the economy. Not until the spread of the coronavirus has decreased and/or a vaccine has been developed, will we all be able to get back to work and back to normal. The questions remain as to the timing and shape of the recovery. What will the investing landscape look like? Will some businesses even be able to reopen if shutdowns drag on too long? All important issues that we will need to address once we get to the other side of this.
When volatility increases and market risk is elevated, fear and uncertainty take over for many investors. The desire to take action can compel one to make emotional decisions we would not otherwise make. However, it times of instability, doing nothing can be the most prudent decision. Chesapeake Wealth Management continues to advocate the investment philosophy that well-diversified portfolios perform better over time. We also subscribe to the theory that adjusting asset allocation should only be done if one's longer-term financial and personal goals and objectives change, not due to market fluctuations. We build portfolios with broad diversification on both the equity and fixed income side, focusing on quality holdings across multiple asset classes.
Elizabeth D. Swartz
Brian T. Moore
March 31, 2020
1. S&P 500 - First Quarter 2020 Standard & Poors 500 Index, Market Cap Weighted Index.
2. Sector Performance – First Quarter 2020 Morningstar: S&P 500 Sector Index
3. WTI Prices - Crude oil prices, West Texas Intermediate – Dollars per barrel.
4. Top Oil Producers - U.S. Energy Information Administration.
5. 10 Year U.S. Treasury$ Yield - Federal Reserve Economic Data.
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