Second Quarter of 2020: The Recovery Begins

It was great to see so many of you at our annual dinner in February and the feedback from that event has been very positive. Here we are only 4½ months later, yet it seems like a lifetime ago. The economy has been sucker punched by this new virus and the impact has been so great that this is likely more than a temporary crisis. It is a permanent disruptor and possibly a once-in-a-generation type crisis. There will be long-term implications that could not have been foreseen only weeks ago, resulting in winners and losers across every industry.

In February, the economy was enjoying its longest expansion ever, which began at the end of the Great Financial Recession in 2009, and ended up lasting almost 11 years. The market was at all-time highs on February 19th. The word “unprecedented” has been overplayed of late, but it does describe what happened. Never before has the government willingly decided to shut down so much of the economy in response to a health crisis; and this wasn’t just a US phenomenon, with approximately one-half of the world’s population locked down. From the February 19th highs to the lows on March 23rd, the S&P 500 Index fell 36%. This time period represents the 14th bear market since 1928. The average bear market decline across all those episodes was 39%, lasting 20 months. This current bear market decline was almost as severe in magnitude, but lasted only 4½ weeks. We will only know with the certainty of hindsight, but it looks to us as if this will be the shortest recession ever. More American jobs were lost in one month than were gained in all of the years after the Great Financial Recession.

The National Bureau of Economic Research has now officially declared the economy to be in a recession. Now that was stating the obvious! Ground zero for the most significant impact has been small businesses, as many were deemed to be “non-essential”. Some of these businesses have been around for decades and will not survive. The degree of pain in this area should be the worst since the 1930’s. I doubt any of them came into the year planning for a time when their businesses would have zero revenues. Forthcoming economic data will be mixed with backward-looking data, such as the change in Gross Domestic Product (GDP), which might well be the worst we will see in our lifetimes (the Atlanta Fed GDP estimate for the second quarter is for a contraction of 40%). Conversely, economic data that we consider to be leading indicators, such as durable goods orders and employment, are expected to show considerable increases, albeit from very depressed levels. The contrast between the first and second quarters of 2020 couldn’t be starker: a serious recession lasting weeks gives way to the recovery. We do not know if the recovery will end up looking like a “V” or a “U” or a square root symbol, etc, but we believe the bottom may have been set the third week of March. To be sure, a lot of damage has been done. Some parts of the economy will take years to recover.

In the conversations I have had with many of you, a common question has been, “Why has the market rallied so much off of the March lows, while life around me has continued to go mad?” There are three important reasons why this has happened:

1. The market is a discounting (or forward-looking) mechanism. The market was crashing before the worst of the economic downturn, as it was looking into the future at the pain to come. Conversely, the market has historically bottomed and turned positive, coming out of recessions, before the economy does. In the 14 bear markets since 1928, the market has, on average, bottomed four months before the real economy. Based on history, the market’s behavior tells us the economic recovery started this quarter.
2. The magnitude of government support to the economy has been substantial and immediate. On the fiscal side, the federal government quickly moved in with the $2 trillion CARES Act and the Payroll Protection Program. The increase in government spending provided a lifeline to the economy. This comes with the consequence of higher federal deficits, which are projected by the Congressional Budget Office to be $3.7 trillion for 2020. On the monetary side, the Federal Reserve also stepped in with shock-and-awe type injections of liquidity to help fight the deflationary aspects of this pullback. The federal funds rate was brought to near zero and programs to restart quantitative easing, including the purchasing of instruments such as corporate bonds and exchange traded funds, were put into place. It wasn’t a coincidence that the market low on March 23rd was the exact day the main federal programs were announced. These moves have helped stop the indiscriminate selling that had been occurring, which was causing a great deal of stress on the capital markets. At its peak, the Fed was printing $1 million per second in new money. For a sense of the magnitude of the liquidity injection, the chart below shows the annualized rate of change in the M2 money supply.
   
   
   Image Source: Strategas Capital Partners
3. American ingenuity can never be underestimated and some of the best and brightest minds in health care, backed by some of the most successful companies on the planet, are highly focused and incentivized to discover treatments and a possible cure for COVID-19. The market has been bolstered by positive news on the progress of vaccines and therapeutics.

What we have unfolding before us is an epic battle of the largest economic shutdown ever against the biggest deployment of fiscal and government stimulus that has ever been put into the economy. The latter represents an enormous level at near 20% of U.S. annual GDP. Our team has been working to reduce cash levels in your accounts, and for those of you who have added to your accounts, we have been putting that cash to work as well. The magnitude of the market’s rally from its March 23rd lows is consistent with previous rebounds at the tail-end of major recessions in the modern era--periods such as 1962, 1974, 2003 and 2009--which have historically proved bullish within a 12-month time horizon.

Evaluating stocks based on some traditional metrics such as valuation becomes almost impossible to do during a period of such extreme change. Most public companies have withdrawn guidance on their earnings with the level of uncertainty being so high. The stress level to the economy has been so great that our immediate focus was to re-evaluate holdings to ensure we were investing in companies with reasonable debt levels and sufficient expected cash flows to weather the storm. An important consideration is how life might be different from here, and the resulting winners and losers. One theme we observe is that long-term changes that were already underway before the pandemic have now been placed on the
fast-track across many industries. Examples include the move from shopping at the mall to buying online, streaming movies at home versus watching movies in a theatre, and using digital rather than physical forms of payments. There are too many other changes and implications to list, but the following are a few that are top of mind:

• We are home more than ever. This is great for home improvement spending, the demand for strong bandwidth, and cloud computing. There is likely going to be demand destruction for certain subsectors of commercial real estate, the auto industry and fossil fuels.
• We appreciate the reliability of our electronic devices. You may have heard this part of our
  discussion at the annual dinner, but the move to 5G is important and just beginning.
• Digital video meetings will increase, whether it is a meeting with your doctor online, with family across the country, or as a substitute for an in-person business forum. This presents a tailwind for PC computing and accessories, video conferencing apps and cybersecurity.
• America’s relationship with China was already struggling and now geopolitical tensions there are on the rise. Global supply chains are already moving out of China.
• Honorable mention of one near and dear to our hearts: One-third of our team has college-aged children and starting in mid-March, they were all taking classes on-line. Are expensive centers of education going to be worth their cost? Another third of our team has school-aged children and are paying close attention.

There are, of course, many more changes that we are analyzing. As growth managers, we are mindful of the rapid period of transition brought about during this time and you’ve already seen some different holdings in your portfolios as a result. The main near-term driver to the markets should be news related to the virus: eventual positive news on case counts, treatments from the health care community, and so on will be bullish and vice versa.

The price of West Texas Intermediate Crude Oil briefly went negative during April. This is something else that I’d never thought I’d see. Oil has, for the first time, experienced both a demand shock, which is from the current economic pullback, and a supply shock, with increased production from Saudi Arabia (that has since been pulled back). Oil prices have now recovered to their pre-COVID-19 level. Also, it’s been easy to forget with so much else happening, but there is an election coming up in just over four months. Policy differences between the candidates will begin to take up more of our thoughts as we approach the election.

Our estimated performance for the quarter and year-to-date are listed below. For those of you holding bonds, those gained during the quarter as well as the first six months as interest rates have moved lower yet again.

Some silver linings can be found during this time. The CARES Act suspended all IRA Required Minimum Distributions for all of 2020. This even applies to Inherited IRA’s. So, if you do not need to take a distribution this year, you have a great incentive not to do so. Federal income taxes have been due each April 15th since 1955 until this year, as you will have until July 15th to file.

We appreciate the confidence you have placed in us and wish you the best.

Sincerely,

Mark E. McMeans, CFA

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The net performance results are stated net of all management fees and expenses and are estimated and unaudited. These returns reflect the reinvestment of any dividends and interest and include returns on any uninvested cash. In addition to management fees, the managed accounts will also bear its share of expenses and fees charged by underlying investments. The fees deducted herein represent the highest fee incurred by any managed account during the relevant period. Past performance is no guarantee of future results. Certain market and economic events having a positive impact on performance may not repeat themselves. The actual performance results experienced by an investor may vary significantly from the results shown or contemplated for a number of reasons, including, without limitation, changes in economic and market conditions.

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