Given the combination of: (1) significantly diminished global growth due to the fallout from the COVID-19 pandemic and recession all but certain in the near future; (2) a strong U.S. and global central bank monetary policy response in combination with fiscal policy stimulus; and (3) stable inflation, our portfolio positioning now favors a conservative asset allocation approach to global equities and fixed income with the following expectations:
- Long-term expected returns for all asset classes may be below returns experienced over the last 10 years; however, returns for equities could be above those for fixed income for some time.
- Several exogenous threats (COVID-19 pandemic fallout, potential for Federal Reserve Bank monetary policy mistake, tariff skirmishes, and political intrigue) may continue to unsettle capital markets at any time.
- Despite the recent selloff and subsequent recovery, global equity valuations are above long-term averages and long-term growth expectations.
- Real asset equity alternatives should offer lower correlation, inflation protection, and differentiated returns compared to Fixed Income.
- Fixed Income remains prudent for downside protection.
- Assuming your plan, risk tolerance, and investment policy are aligned, caution is warranted tactically, but in our view, long-term investors need not take drastic action.
“Remember, my son, that any man who is a bear on the future of this country will go broke.”
J.P. Morgan said that in 1908. That was after the severe Panic of 1907 (also known as the 1907 Bankers' Panic). It was an insane financial crisis that nearly crippled the American economy. The stock market fell 50% from its peak. Banks across the country were on the verge of bankruptcy. There was no mechanism to rescue them.
Until Morgan stepped in to help resolve the crisis.
Together with help from then-Treasury Secretary George Cortelyou, Morgan corralled his fellow bankers and organized a plan to solve the problem by redirecting money between banks and securing international lines of credit. Long story short, the whole thing worked out.
Thankfully, the country learned a thing or two about panics including the fact there may not be a Morgan around every time a panic comes about. Led by Senator Nelson Aldrich, the powers that be created the Federal Reserve Bank in 1913.
Fast forward to today, that same Fed, with some support from an unusually quick and robust fiscal stimulus response from our government, has helped to mitigate a financial panic and the subsequent economic fallout from the COVID-19 pandemic.
Long time readers may recall our relentless criticism of the Fed as the guilty party in killing business cycle expansions. Over the course of the Fed's 107-year history, all recessions - save the demobilization after WWII in 1945 - were the result of sustained Fed interest rate hikes that tightened financial conditions in the economy too much, too fast, or both. The recession, that is here in all but name today (technically, the National Bureau of Economic Research has to officially declare it and has yet to do it), now marks only the second occurrence the Fed was not responsible for. Rather, this recession was caused by the government-mandated quarantines, shelter-in-place orders, and social distancing guidelines leading to an unprecedented, forced, and artificial economic slowdown.
While we agree with Morgan that being bearish on America's long-term future will always be a losing bet, in the interim, the COVID-19 pandemic has made a large swath of the U.S. economy a losing bet (save things like Zoom, Netflix, booze, beer, and wine sales!). We do not think it is wise to attempt any type of economic forecast about the severity and length of the recession. Complicating any forecast is figuring out how we find the "new normal" in a post-COVD-19 world. How will human behavior change? How will economic decision-making change? What will be the "2nd order" effects of those changes, i.e., the unforeseen effects of the effects? These are important questions to ask, but they are mostly unknowable. And spending time on figuring out the answers to unknowable questions is a fool's errand.
Maybe our favorite deep thinker and brilliant investor, Charlie Munger (Warren Buffett's partner in running Berkshire Hathaway) said it best in a recent interview with Jason Zweig of the Wall Street Journal:
“Nobody in America’s ever seen anything else like this. This thing is different. Everybody talks as if they know what’s going to happen, and nobody knows what’s going to happen…Of course we’re having a recession. The only question is how big it’s going to be and how long it’s going to last. I think we do know that this will pass. But how much damage, and how much recession, and how long it will last, nobody knows.”
Knowing that a crystal ball is not a valid instrument for engaging with the market, our traditional investment process toolkit - measuring asset class valuation and momentum, and understanding the prevailing macroeconomic environment in which we are investing - remains helpful in adjusting asset allocation accordingly.
From a fundamental standpoint, equities today are overvalued compared to their average long-term valuation despite the carnage in the first quarter. This goes to show how overvalued they were prior to the selloff. At their peak in February, the total market capitalization of all the public companies in the U.S. was around $36 trillion. This compares to the aggregate annual value of economic activity in the U.S. around $22 trillion. At the nadir in March, the stock market's value was down to $23 trillion, a loss of $13 trillion! Today it is around $28 trillion so we lost $8 trillion in market value due to the COVID-19 virus fallout to date. Putting that loss into context, the best guess by the best economists suggest the economy will lose around $2.6 trillion of potential economic activity in the next two quarters. The important valuation point here is that in previous recessions, the value of the U.S. stock market goes below the value of the economy for an extended period.
It should not be a surprise to anyone that momentum - the velocity of price changes - in most asset classes is negative. Fixed income (including cash) remains a positive momentum standout. Monitoring momentum can be helpful in deducing when different asset classes may stop going down and start to stabilize and ultimately move higher.
Again, for reasons mentioned above, the macroeconomic backdrop is tough to figure out today. We will stay focused on our high quality leading economic indicators to help us understand the macroeconomic environment going forward and its effect on capital markets.
As responsible financial advisors, we have the humility to know we cannot predict the future with precision. With sound financial plans in place, as mentioned above, we believe a more conservative client portfolio asset allocation is prudent given the intermediate-term macroeconomic environment we are facing today.
As always, the future direction of macroeconomics and, more importantly, capital markets in 2020 is still anyone’s guess. As always, we focus on conducting ourselves as long-term investors delivering investment outcomes that help our clients meet their wealth-planning objectives.
For more information on this topic, contact your Sequoia advisor today or click here to talk to an advisor.