Quarterly Letter –First Quarter 2020

Following a banner year for investors in 2019, the coronavirus and mitigation efforts to contain its spread are exacting a significant toll on individuals, the economy, and investment markets. Thankfully, mitigation efforts appear to be having a favorable impact on limiting the spread of the virus and loss of human life; a loss that is already too high. The cost of this mitigation includes the loss of jobs, the shuttering of various industries and other forms of economic and human suffering. These costs are significant but should prove largely transitory while the value of human life, preserved through societal action and shared effort, is immeasurable and invaluable.

U.S. Equity Markets
If there’s one thing investment markets dislike more than bad news, it’s uncertainty. And the first quarter experienced plenty of bad news and uncertainty as investment markets erased much, if not all, of prior year positive equity returns. U.S. large cap stocks held up better than other areas of the equity market, though the S&P 500 still fell by 19.6%. This qualifies as the worst quarter for the index since losing 22.0% of its value in the fourth quarter of 2008. Energy, transportation and financial stocks were hit especially hard while healthcare, technology and consumer staples stocks weathered the volatility relatively well. Small-cap stocks suffered large declines given their majority share of revenue exposure to the U.S., where the virus impact was in an earlier phase relative to other parts of the world. The Russell 2000 index fell 30.6% during the first quarter, marking the worst quarterly return since the index was founded in 1979. This downturn moved small-cap stocks back to their levels of early 2017.

International Markets
Foreign developed and emerging market equities were also impacted in the first quarter market selloff. The MSCI EAFE index, which reflects developed country stocks, declined 22.8%, and the MSCI Emerging Markets index was down 23.6%. A stronger U.S. dollar, relative to other currencies, contributed to a portion of these negative returns for U.S. investors. Large parts of Asia appear to be on the other side of the coronavirus curve, as local life and economies are beginning to normalize. However, we anticipate these markets are likely to suffer economic headwinds until other parts of the world return to some level of normalcy.

Bonds not bearing the name of the U.S. Treasury were subject to significant liquidity pressures as credit markets began to seize in the first half of March. This strain quickly reduced both taxable and municipal bond prices at a pace and level not seen since the fiscal crisis of 2008. Short-term bonds suffered disproportionately. These bonds lack the duration that benefitted longer-dated bonds as market interest rates fell precipitously during the quarter. Fixed income markets began to stabilize prior to quarter-end as the Federal Reserve announced several actions to foster price stability and market liquidity. The massive amount of fiscal stimulus passed by Washington D.C. in late March also helped calm jittery investment markets. When the dust settled on the quarter, most municipal and taxable short-term bond funds, lacking in U.S. government exposure, generated single-digit negative returns. In comparison, many intermediate-term bond funds generated returns between +/- 2.5%. The rapid flight of investor capital toward the safety of U.S. Treasuries shifted the composition of bond indexes toward this segment of the market to a degree rarely seen. Meanwhile, market interest rates have fallen to historic lows. Ultra-low interest rates should help limit borrowing costs. However, this dynamic also results in meager yields and return potential for government bonds, money market funds and cash savings accounts.

Answers to Common Questions

What is the outlook for the economy?
The economic costs of mitigating the coronavirus are significant. While economic uncertainty remains elevated, the current consensus among economists is that U.S. GDP could fall by as much as 30% or more in the second quarter with some level of stabilization occurring during the third quarter. An economic recovery is expected to take hold later this year, though the pace of the recovery could be uneven. There are segments of the economy that, having sustained significant setbacks, may take longer to recover. However, as the U.S. accomplishes what other countries have already achieved with coronavirus containment, the adverse impact to the economy could be measured in months or quarters as opposed to years. By most accounts, the U.S. did a poor job of initiating an effective response to the coronavirus, but has made meaningful progress in recent weeks.

What will be the impact of Federal monetary policy and fiscal stimulus measures?
The scale and enormity of the fiscal response from the Federal government, combined with the monetary policy response from the Federal Reserve, is unprecedented. These measures are injecting well over $4 Trillion in various forms of stimulus and liquidity into the U.S. economy, which measures $21 Trillion in size. These actions should go a long way to supporting unemployed workers, individual taxpayers, and most businesses. Other developed countries have enacted similar stimulus measures. The prospect of another Federal stimulus package is already being discussed and could potentially be enacted before mid-year. Another stimulus package might include additional direct payments to certain taxpayers, infrastructure projects and related job hiring, a reduction or elimination of caps on Federal itemized deductions, and additional support for healthcare workers. The stimulus measures already enacted should help provide a safety net in the months ahead and are likely to strengthen an eventual economic recovery.

What about rising government spending and Federal debt?
When considering the government’s capacity to borrow money, the cost of debt can be more critical than the overall size of debt. Current borrowing costs are at historic lows, which allows the government to finance additional debt at very low long-term rates. As of this writing, the yields of 10-year and 30-year Treasuries are at 0.6% and 1.3%. This compares to April of 2007 when these term rates approximated 5.0%. Anyone that’s taken out a mortgage knows a large portion of debt cost, over the life of the loan, is comprised of interest. For the sake of simplicity, if we liken the current Federal debt level to an individual taking out a $500,000 mortgage, the total cost of the mortgage would approach $1m over 30 years at an interest rate of 5.0%. However, at an interest rate of 2.1% (which happens to be the Federal government’s current average cost of debt), the total cost of that same 30-year $500,000 mortgage falls to just under $675,000. Over the past decade, government borrowing costs have fallen as a percentage of GDP, even as the principal amount of debt has increased. This is due to significantly lower interest rates. Because the government is currently able to borrow at still lower rates, the average cost of government debt could fall further even as the principal level of debt rises. The Federal Reserve appears committed to holding down interest rates and borrowing costs for the foreseeable future, though an eventual rise in interest rates should corresponded with an improving economy and government tax revenue.

What to expect from investment markets?
Investor sentiment has stabilized in recent weeks, thanks in large part to the swift and extraordinary actions of governments and central banks to support markets and the economy. Early indications that virus containment efforts are having a favorable impact have also led to improving investor sentiment. Given the uncertainty relating to future corporate earnings and the timing of an economic recovery, credit and equity markets are likely to be driven by sentiment in the near-term, with fundamental economic factors becoming a greater factor over the long-term. The economy is now experiencing a shock caused by a major external factor. This contrasts with the financial crisis and dot-com episodes of prior decades, which involved intrinsic defects within financial systems. The near-term economic damage from Covid-19 appears both certain and significant. However, investment markets normally precede upturns in the business cycle with an average lead time of 2 to 8 months. This factor renders ‘market timing’ a very problematic, if not dangerous, investment approach. Don’t be surprised if equity and credit markets experience a recovery that is more rapid than the eventual economic recovery.

What should prudent investors do?
Rebalancing portfolios to align with a long-term allocation target and risk level allows investors to benefit from lower and higher prices over full market cycles. Having adequate cash reserves, and a stable but prudent level of long-term risk exposure, can allow investors to endure challenging market periods. History demonstrates that binary emotional investment decisions often lead to sub-par long-term outcomes. We also recognize the direction of the economy doesn’t always equal the direction and timing of investment markets. Over the near-term, investment markets are likely to remain highly volatile. By sticking to a long-term plan, disciplined investors can benefit when markets go ‘on-sale’, while being positioned to participate as markets recover and move higher.

The collective health and economic challenges we confront are indeed substantial and likely to bring lasting change to our society. The adversities we face today are likely to impart lasting change in our institutions, infrastructure, and ability to better cope with future challenges. For now, as both citizens and investors, patience and perseverance can guide us toward a future that is stronger and healthier than before.

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