Financial Markets Update - Headwinds Intensify

Dave Donabedian, CFA
March 09, 2020

An update on the financial markets from Chief Investment Officer Dave Donabedian, CFA.

Concern over the economic and financial impact of the coronavirus turned to outright fear over the weekend. As a result, stock prices declined at the market open Monday morning. Here are key developments that led to this next leg down in equity markets.

  • Coronavirus news flow
    An accelerating number of cases confirmed in the U.S. and many other countries.
  • Credit markets
    On Friday, credit markets showed signs of stress, with spreads on both investment-grade and junk bonds widening out significantly. That continued on Monday. Meanwhile, the incredible drop in Treasury yields signals that investors are increasingly pricing in a recession and continued financial stress.

Index of financial conditions

  • Oil price war
    After Russia refused to agree to production cuts to stabilize the price of oil, Saudi Arabia changed tactics and announced over the weekend that it would increase production to depress prices and flush out higher-cost producers. The result was a more than 20% drop in the price of oil, virtually overnight. This is another sign of rising deflationary and recessionary risk and puts further stress on a key American industry.

We believe the U.S. economy entered this maelstrom in fundamentally good shape, and that the country should ultimately experience a strong recovery. However, the force of these new headwinds complicates our perception of when—and from what level—the recovery will begin. Economic data is likely to deteriorate in March and get progressively weaker in the second quarter. Alongside this trend, it is likely that corporate profit expectations will be downgraded as well.

What we’re monitoring

In the days and weeks ahead, there are a few key areas that may determine the stock market’s path.

  • The consumer
    The American consumer has been the bulwark of this 11-year economic expansion, powered by a strong job market and low interest rates. Our baseline assumption is that the coronavirus health news will worsen in the weeks ahead, and that the virus will likely cause significant economic disruptions to daily life. Ultimately, the virus may impact consumer confidence and household spending, which in turn hits business confidence.
  • Policy moves
    The Federal Reserve’s decision to cut the interest rate by ½ percentage point last week was designed to create a sense of confidence. As subsequent price action validates, the move failed. We expect another ½ percentage point cut by the Fed at its meeting next week, if not before. Futures markets have nearly priced in a ¾ percentage point cut, so a rate cut alone will not be viewed as an upside surprise by investors.

    Attention is likely to turn toward fiscal policy. Several big ideas have been floated by academics and the press, such as cutting payroll tax cut, waiving tariffs, or even sending checks directly to citizens. This type of bold, economy-wide stimulus has not yet gained momentum at the White House or in Congress. Targeted plans to alleviate specific stress points, such as expanding paid sick leave and relief for small businesses and industries directly impacted by the coronavirus crisis, are more likely in the coming weeks.
  • Financial conditions and liquidity
    As illustrated earlier, financial conditions have deteriorated. Credit markets have not only repriced lower, but liquidity has also been tighter. This is an area where central banks can help, and we expect that they will. We will also be monitoring the shape of the yield curve. It is currently positively sloped, but not by much.
  • Glimmers of hope
    The news flow and markets are full of bad tidings and in such environments, it is easy to see       only challenges ahead. We have already listed many. But it is important to ask the question, “What could go right?” First, there is encouraging news from China on materially-reduced new coronavirus cases and a sense of business slowly getting back to normal outside of Hubei province. Cases may be cresting in South Korea as well. We will find out whether this pattern of fairly quick containment happens in the U.S. and other countries that did not implement the same draconian steps.

Some of the developments being treated as bad news could actually help the economy—eventually. The entire Treasury yield curve plunging below 1% is certainly a sign of market stress. But the low interest rates that will result should spark enticing financing rates for consumers on cars, houses, etc. Also, the panicked drop in the price of oil is expected to lead to a dramatic fall in gasoline prices and a boost to consumers’ discretionary incomes.

The importance of perspective

It has been a rough 2020 for equity investors, and it’s only March. The S&P 500 is down 14.7% year-to-date*.

For reasons mentioned earlier in this piece, the market environment could remain challenging in the weeks ahead. Ironically, today marks the 11th anniversary of the end of the last bear market. Therein lies an important reminder about investing in equities: Long-term historical returns of more than 10% per year come with an inherent trade-off of short-term risk. That is what we are experiencing now. The chart below puts the year-to-date correction in perspective:

Short-term pain, long-term prosperity

In the midst of this volatility, our equity teams are looking for opportunities to acquire high-quality companies at newly reduced prices. Our goal is to take advantage of market emotion to upgrade the long-term growth potential of our portfolios. Meanwhile, the CIBC Private Wealth external manager platform emphasizes strategies with a demonstrated ability to outperform benchmarks during difficult market environments in order to mitigate capital drawdowns.

Our fixed income team’s emphasis on high credit quality has been effective at protecting capital during this turbulent environment. In fact, high-quality bond benchmark returns are positive year-to-date and since the stock market all-time high on February 19**.

 

Dave Donabedian is chief investment officer of CIBC Private Wealth Management, serving in that capacity since 2009. His responsibilities include chairing the Asset Allocation Committee, as well as providing oversight of internal investment strategies and the external manager selection platform.

 

* (source: Bloomberg, as of 03.09.2020)

** (source: Bloomberg, as of 03.06.2020; indices referenced are Bloomberg Barclays Aggregate Index and Bloomberg Barclays Short/Intermediate Muni).

CIBC Private Wealth Management includes CIBC National Trust Company (a limited-purpose national trust company), CIBC Delaware Trust Company (a Delaware limited-purpose trust company), CIBC Private Wealth Advisors, Inc. (a registered investment adviser)—all of which are wholly owned subsidiaries of CIBC Private Wealth Group, LLC—and the private wealth division of CIBC Bank USA. All of these entities are wholly owned subsidiaries of Canadian Imperial Bank of Commerce.

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