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March 9, 2020 Article 9 min read
A confluence of factors gripped global financial markets, and stocks became volatile as the day progressed. Read the full commentary.
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Executive Summary

  • A confluence of factors gripped global financial markets over the past few days, leading to a sharp decline in global equity markets and a flight to quality that drove U.S. Treasury yields to historical lows.
  • A steep drop in oil prices was precipitated by an inability of Organization of the Petroleum Exporting Countries (OPEC) and Russia to reach a deal to cut production, leading to Saudi Arabia to effectively declare a price war by instead expanding its production.
  • Concerns surrounding the continued spread of the coronavirus remain heightened as reported cases outside of China continue to rise rapidly and increasingly aggressive steps are being explored and, in some cases, implemented to attempt to control its spread.
  • Risks to the global economy have increased, but a number of catalysts could help to negate these headwinds, including a fiscal boost, continued Fed easing, and the benefit of lower oil prices to consumers.
  • It’s unclear how long the current period of volatility might last, but we urge investors to maintain a long-term view, while maintaining adequate liquidity to meet cash needs.

What caused volatility to spike in financial markets in recent days?

A confluence of factors gripped global financial markets over the weekend, leading to a sharp decline at the open of U.S. equity markets this morning sending stocks down by 7%. That sharp decline triggered a market circuit breaker that temporarily halted trading. Stocks were quite volatile as the day progressed.

The primary catalyst was a sharp drop in oil prices globally. In recent weeks, oil prices have been under pressure due to concerns that the spread of coronavirus would weigh on the global economy, causing a significant reduction in energy demand. Over the weekend, oil fell to a low on Sunday night of $27.34 per barrel after closing at $41.28 on Friday, March 6 — a decline of over 30%. Since then, oil rebounded into the $30 range as of this writing, yet the drop overnight represented the second largest decline on record, behind only the plunge during the Gulf War in 1991. The sharp decline in prices was a direct result of news that an OPEC deal led by Saudi Arabia vying for production cuts was rejected by Russia and a few others. That split in OPEC-Plus (which includes Russia and Mexico) prompted Saudi Arabia (the largest global producer) to threaten to ratchet up production and offer heavily discounted pricing to gain market share, in what amounts to a price war between oil-producing countries. Unfortunately, this plunge in oil may have knock-on effects such as increased risk on leveraged exploration and production (E&P) energy companies operating in U.S. shale regions whose debt makes up about 14% of the high-yield bond market. Bond defaults by the energy sector and E&P businesses specifically are a potential risk to be considered, and one that significantly impacted the energy sector today.

Secondly, concerns surrounding the continued spread of COVID-19 — the novel coronavirus — remain heightened as reports in a number of countries outside of China indicated the number of cases was still growing at an increasing rate. As of this morning, there have been over 111,000 cases of people contracting the virus globally, with nearly 3,900 deaths. In the United States specifically, a state of emergency has been declared in New York, California, and Oregon. Out of an abundance of caution, a growing number of events have been cancelled, and many businesses and organizations are formally implementing restrictions on both international and domestic travel for an extended period. There are also growing signs that individuals are increasingly changing their travel plans and buying habits. The bottom line is that these concerns are being fueled precisely because we don’t yet understand the full impact of the virus in terms of its human or economic toll.
Finally, while it didn’t get as much attention, North Korea fired three projectiles as a reminder of the geopolitical threat it poses. On a different day, that might be the headline, but it seems that North Korean leadership decided that it was an opportune time to remind the world of its desire to be relevant on the world stage and its ability to be a disruptive force in the region.

Market Reaction

The bond market reacted dramatically to the collapse of oil prices and heightened concerns surrounding COVID-19. As of this morning, U.S. Treasury yields across the curve fell below 1%, with the 10-year Benchmark U.S. Treasury Note near 0.40% at one point, well below 0.71% where it ended Friday. An allocation to high-quality fixed income has been beneficial for investors as a ballast to equity market volatility. However, credit spreads continue to widen, led by energy names within the high-yield sector, over concerns of potential bankruptcies and job losses. Wider spreads may indicate further stress on the corporate bond sector as these conditions persist.
A rout in global equity markets ensued as well on Monday with various Asian market indexes down 2–7% and European markets down around 8%. Unlike a typical economic slowdown, which has historically been caused by either a supply shock or a demand decline, the impact of a global coronavirus outbreak is weighing on the global economy on both fronts. Global supply chains have been disrupted materially and the risk to global demand is also rising.

Throughout this economic cycle, the U.S. consumer had been the lone constant in terms of providing consistent support to economic growth. Consumer spending has been broadly solid against the backdrop of a very strong labor market. Additionally, the savings rate has been rather high from a historical perspective, and thus, the consumer appears broadly equipped to weather a temporary storm such as the coronavirus. Even so, a marked slowdown in travel, more restrained consumer spending, or a sustained period of cancellations, closures, and prohibitions on travel or public gatherings could create a significant headwind to consumer spending.

Potential positive catalysts

While volatility can blur one’s longer-term perspective, at some point, we’ll see a return to calm. Through these turbulent times, though, it can be helpful to focus on what may help the economy moving forward. Some of these potential catalysts include:

  • Fiscal measures: Over the weekend, the Trump administration initiated the drafting of a spending bill to combat the economic impact of COVID-19. Among the options being discussed are provisions for paid sick leave to those impacted by the virus.
  • Monetary policy: Last week, the Federal Reserve announced an emergency, intermeeting rate cut of 0.50% to help buffer the economic impact from the virus, but more importantly to try to provide reassurance that it stands ready to take action as needed to support the economy. This includes additional rate cuts, which increasingly appear possible in the near term. Fed fund futures are calling for up to 0.75% in additional easing at the Fed’s March 18 meeting. In addition, the Fed may also use its balance sheet to support healthy credit and liquidity conditions across financial markets. The specifics around any Fed action is quite fluid, and will require the Fed to balance market expectations, underlying economic conditions and risks, and the policy stance and potential actions of other global central banks.
  • Lower rates: While low interest rates weigh on certain sectors of the economy, they can help consumers who are looking to refinance existing debt or utilize credit to fund a purchase. Lower rates should allow for easier consumer credit conditions generally.
  • Lower oil prices: This acts like a “real-time” tax cut for consumers, who should benefit from falling gasoline prices in the near term. Lower energy costs should provide a bit more flexibility in household budgets, supporting consumer spending which has been critical to the longest economic expansion on record.
  • Cure or vaccine for COVID-19: A cure or vaccine for COVID-19 is being actively pursued by numerous companies and, at some point, we’ll likely have a treatment that targets the infection caused by the novel coronavirus. Even so, it’s unclear how soon a solution might be available.
  • Portfolio rebalancing: Extreme market volatility typically leads to dislocations and can lead to meaningful mispricing in assets. Rebalancing a portfolio to align with strategic asset allocation targets is a prudent way to respond to market volatility. Additionally, we’ll continue to closely monitor global financial markets to identify any appropriate changes in investment portfolio positioning.

Navigating volatility amid uncertainty

While a period like this can be quite challenging to investors, we look back to prior outbreaks and prior volatile periods in global financial markets to remind us that these dislocations can and do create opportunities. As prices for equities and other risk assets decline, expectations for future returns actually rise, making the outlook for long-term investors better than they were before prices corrected. In addition, history tells us that it’s exceedingly difficult to time markets and that remaining invested through short-term volatility will in time reward long-term investors.

The volatility we see across global financial markets today stems from meaningful developments, but ones that are also temporary in nature. At some point, the primary period of risk will pass as has always been the case in prior periods of uncertainty. As that happens, additional investment opportunities will be created by these dislocations. Such market downturns typically have created opportunities for investors as indiscriminate selling can excessively punish otherwise solid companies, sectors, or regions. Our active equity and fixed income managers in the portfolio are also searching for opportunities, evaluating their portfolio holdings, and taking action when they see appropriate risk-reward tradeoffs. We too are closely monitoring market events as they unfold and are evaluating potential changes in our portfolio positioning within a disciplined, fundamentally based framework. The key is operating within an investment time horizon that looks out several years and not just several weeks or months.

Diversification works. It’s important to point out that a properly diversified portfolio has behaved according to expectations, given market conditions over the past few weeks. High-quality bonds have provided a ballast against declining equity markets in a diversified portfolio and continue to act as an effective diversifier to risk assets broadly. This period has served as a valuable reminder of the important role that bonds play in investment portfolios.

As noted in our prior commentaries, it’s critical to have sufficient liquidity to be positioned to remain committed to one’s long-term portfolio strategy. That looks different for everyone, but a good starting point is having sufficient cash to cover six months (or more) of anticipated needs. Having that cash on hand should provide an investor with the needed flexibility to look through short-term market volatility and continue to invest in a manner consistent with their investment policy.

Against that backdrop, we strongly encourage investors to look through this bout of volatility and remain committed to their long-term strategy that was carefully crafted in line with their particular investment time horizon, risk tolerance, return needs, and unique goals and objectives. Within the context of your investment policy and as market conditions evolve, we’ll continue to monitor your investment portfolio for any need or opportunity to rebalance back to strategic targets. Additionally, we’ll actively monitor developments across global financial markets and the macro environment to determine whether there are any appropriate additional actions to take or changes in portfolio strategy within the context of a long-term, disciplined investment philosophy. As always, please reach out to your PMFA advisory team with any questions or concerns.

Disclosures

Past performance does not guarantee future results. All investments include risk and have the potential for loss as well as gain.

Data sources for peer group comparisons, returns, and standard statistical data are provided by the sources referenced and are based on data obtained from recognized statistical services or other sources believed to be reliable. However, some or all of the information has not been verified prior to the analysis, and we do not make any representations as to its accuracy or completeness. Any analysis nonfactual in nature constitutes only current opinions, which are subject to change. Benchmarks or indices are included for information purposes only to reflect the current market environment; no index is a directly tradable investment. There may be instances when consultant opinions regarding any fundamental or quantitative analysis may not agree.

Plante Moran Financial Advisors (PMFA) publishes this update to convey general information about market conditions and not for the purpose of providing investment advice. Investment in any of the companies or sectors mentioned herein may not be appropriate for you. You should consult a representative from PMFA for investment advice regarding your own situation.

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