Volatility associated with recent deleveraging should start to dampen going forward; higher-quality companies with durable business models and good earnings visibility should weather this storm better than most.
- A recession is likely, yet compared to recent weeks, there are encouraging signs in policy response and market activity.
- We are now likely at the lower end of leverage in the system and the volatility associated with recent deleveraging should start to dampen.
- Higher-quality companies with durable business models and a high degree of visibility into their earnings profiles should weather this storm better than most.
The brunt of the damage done by the coronavirus (COVID-19) has shifted from Asia to Europe and the U.S. in recent weeks. Along with the westward move of this unfolding health care crisis, markets have declined and become increasingly volatile. Steeply falling oil prices have worsened the situation. The toll on those affected will be large, though there is some growing (if still early) solace in recent developments. Based on the experiences of China and South Korea, we know that with significant testing and severe restrictions on social interaction the virus can be contained. China has now reported consecutive days of no new local cases. While still a difficult situation, Italy appears to be making progress and cases may have peaked.
The current decline differs from prior ones insofar as it appears no asset class or industry has been spared. Assets across the board have seen losses on a global basis. It is somewhat frustrating to date, as there is no or little differentiation, within U.S. equity markets at least, in terms of factors: quality, size, beta, balance sheet, dividends. But this is not to say differentiation will not come.
To provide some context on the current volatility: behind the correlated selling is a liquidity event. Across the globe there has been an insatiable thirst for dollars and liquidity. The financial system has already seen an enormous amount of deleveraging. Commodity trading accounts, volatility funds, risk parity funds and other client-oriented funds, as well as hedge funds, levered ETFs, MLPs — you name it — have delevered in the past two weeks. We are now likely at the lower end of leverage in the financial system. The volatility associated with this deleveraging should start to decrease as we go forward.
We are trying to make a bottom, but that is a process and not a day. It will ultimately depend on news flow and our ability to get a handle on the depth and length of the crises. If you look at the recessions we’ve had going back to the 1940s, from peak to trough, the markets lost 32% on average. Before the rally on March 24, we were near that 32% level. At the start of the year, markets had clearly priced in a soft landing where earnings growth was projected to return to 10% in 2020. With the high likelihood of a recession, valuations need to come down very dramatically. This has happened to some extent: the forward 12-month price-earnings ratio for the S&P 500 Index was 18.2x on December 31, 2019, and 13.9x on March 19 (Exhibit 1).
As of March 19, 2020. Source: ClearBridge Investments, FactSet. PE-NTM is an abbreviate for expected price/earnings ratio in next 12-months. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
From a social and economic perspective, the more drastic and restrictive we are in terms of movement and distance — the more seriously we take it — the deeper the pain will be shorter term, but I also believe the shorter the duration of the recession and the quicker people can go back to work. There is evidence that these actions work. The U.S. is focused on solutions, and compared to roughly a week ago, I'm much more encouraged today.
State and federal governments are taking this seriously. Significantly, the response has been more reminiscent of 9/11 than 2008: there is less a feeling of blame and more a feeling of coming together. That’s important in terms of getting this solved.
The Fed and global central banks around the world have not only lowered rates to zero, but they’re also purchasing all types of collateral to ensure the plumbing of the financial system operates. This is unprecedented: they will basically do whatever it takes. We would like to see fixed income spreads stabilize — this is important for both the broader financial system and the equity markets.
Today’s volatility is ultimately an opportunity to upgrade portfolios and focus on long-term strategies.
Fiscal actions being taken are also unprecedented. Despite some back and forth, Congress is providing enormous resources. The talk is of extending or flattening the curve — reducing the number of immediate cases to prevent health systems from being overwhelmed. From the stock market perspective, the goal is to compress the curve, making it shorter, but deeper. The role of Congress and the enormous resources it is providing — a total of roughly $2 trillion in direct financial aid to individuals, robust unemployment insurance, loans to small and large businesses and resources to health care providers — will help us bridge a portion of the economic gap. Such measures are reminiscent of wartime measures, yet they are appropriate and encouraging.
Medicines, treatments, vaccines are coming, although they won’t come immediately. There is an unbelievable amount of time, money and intellectual power going into developing solutions, and they will be coming.
I’ve been managing portfolios for almost 30 years, and I’ve been trained to look for high-quality stocks with good dividends, strong balance sheets and sustainable growth. Now I see them available. I believe clients are going to make reasonable returns if they hold these types of stocks over time. This is no different from the long-term perspective ClearBridge takes at all times.
The volatility is not over. This is the most oversold market in terms of investor sentiment measures since 1983. It has been a monolithic asset liquidation where the market has not differentiated between good and bad and most companies have become cheap. Many businesses will face net losses, but for most companies it will be short-lived. It is a good time to focus on stocks with strong balance sheets, free cash flow generation and durable business models. Today’s volatility is ultimately an opportunity to upgrade portfolios and focus on long-term strategies. That is what we are doing.
Beta measures the sensitivity of an investment to the movement of its benchmark. A beta higher than 1.0 indicates the investment has been more volatile than the benchmark and a beta of less than 1.0 indicates that the investment has been less volatile than the benchmark.
Bottom in this context refers to the process of stocks reaching a low point in the sell-off before beginning a new upward move.
A central bank is a national bank that provides financial and banking services for its country's government and commercial banking system, as well as implementing the government's monetary policy and issuing currency.
Correlation is a statistical measure of the relationship between two sets of data. When asset prices move together, they are described as positively correlated; when they move opposite to each other, the correlation is described as negative or inverse. If price movements have no relationship to each other, they are described as uncorrelated.
COVID-19 is the World Health Organization's official designation of the current coronavirus disease.
Deleveraging is when a company or individual attempts to decrease its total financial leverage. In other words, it is the reduction of debt.
An exchange traded fund (ETF) is a fund that tracks an index, but can be traded like a stock.
The federal funds rate (fed funds rate, fed funds target rate, fed rate or intended federal funds rate) is a target interest rate that is set by the FOMC for implementing U.S. monetary policies. It is the interest rate that banks with excess reserves at a U.S. Federal Reserve district bank charge other banks that need overnight loans.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
Master limited partnership (MLP) is a limited partnership that is publicly traded on a securities exchange. It combines the tax benefits of a limited partnership with the liquidity of publicly traded securities in certain businesses; mostly pertaining to the use of natural resources, such as petroleum and natural gas extraction, transportation and some real estate enterprises (e.g. real estate investment trust). In practice, MLPs pay their investors through quarterly required distributions. Failure to pay the quarterly required distributions may constitute an event of default.
Multiple is another term for P/E ratio.
The price-to-earnings (P/E) ratio, also referred to as the earnings multiple, is a stock's (or index’s) price divided by its earnings per share (or index earnings). The forward P/E ratio is a stock’s (or index’s) current price divided by its estimated earnings per share (or estimated index earnings), usually one-year ahead, or next 12- months (NTM).
Risk-parity funds refer to a set of rule-based investment strategies that combine stocks, bonds and other financial assets
The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.
A spread is the difference in yield between two different types of fixed income securities with similar but not identical characteristics, with the possible differences including creditworthiness, maturity date, or other factors.