The Way Forward

First Quarter 2020 Commentaries

The longest running bull market finally met its demise in the form of a global health pandemic. The cessation of population movement quickly mutated into the stoppage of all economic activities and the result was the fastest descend into bear territory. For the quarter, S&P 500 was down 19.6%.

This crisis, like all before it shall pass in time. During its passage, landscapes are forever changed. In its aftermath, new rules of survival must be adopted. “What does corrections correct?” the famous financial historian and newsletter writer Jim Grant quipped in a recent CNBC interview. It serves to separate “the sound from the unsound.” He answered. Enormous damages have been done to financial markets and a great deal more is yet to be done. As investors hunker down and survive through, there will also be generational opportunities. This is the kind of turning point that breaks or makes. As an eyewitness and survivor of multiple financial crises, here I lay out my go forward playbook and strategy.

During the 2008 financial crisis, it took 68 days from the start of bear market for Congress to pass the initial fiscal stimulus package and it took another 127 days before the Federal Reserve opened its balance sheet for quantitative easing. This time both fiscal and monetary policy initiatives were enacted swiftly with awe inspiring size. In total, fiscal and financial stimuli around the world may equal 10% of global GDP. Given the flood of liquidity, investors may be tempted to buy. Alas, this is a health crisis. Government largess certainly calmed an otherwise chaotic market, but it can’t stimulate an economy in quarantine. So long as the pace of infection is still accelerating, markets can’t reach a realistic assessment about the length of economic stoppage; nor the depth of damage caused. In this environment, any rally in stocks should be considered temporary. This is phase one.

Bear markets are not just characterized by heart stomping declines, but also fast and furious rallies. This one shall be no exception. However clumsily the nations of the west came to the implementation of social distancing, its necessity and effectiveness are now consensus. With time, the infection rate will peak and a date for containment can be fathomed. Judging by experiences of past financial crises, a tradable rally may materialize with the possibility of retracing half of the losses. This is phase two.

As quarantines are lifted, reality of post virus world will gradually sink in. Experiences of Hong Kong, Singapore and Mainland China can serve as blueprints here. The pace of re-integration will be slow. The hardest hit industries including hotels, airlines, restaurants and retail shops will still suffer from the general weariness of their customers and will likely incur additional losses even as they start to open for business. The secondary effects of a deep recession will also be felt at this time. Losses are piling up; Debts are coming due; Capital projects are delayed; Earnings are decimated, and stock buybacks are all canceled. New lows in stocks are still possible; more importantly, any selling will no longer be indiscriminate. This will be the time when sound is separated from the unsound. Some companies will begin to reach new highs and others may not recover for many years. This is phase three.

After the crisis is over, two important consequences will endure for at least the next decade, likely even longer. This pandemic arrived when corporate leverage was at a historical high. Unsurprisingly, the corporate credit market manifested as one of the epicenters. For the Federal Reserve, stock market is in fact not that important in the grand scheme of the economy. But credit is the lube. In order to help the corporate bond market, the Federal Reserve must sidestep the inconvenience of its legal authority which stipulates that it can only purchase securities backed by government entities. The solutions are called special purpose vehicles housed at the Treasury department, executed by Treasury officials but backed by the balance sheet of the Federal Reserve. Chaos was indeed slayed, but I suspect this marriage of convenience cannot be easily torn asunder. In effect, the executive branch has taken over the monetary branch. Crony capitalism is now the official doctrine of the United States; henceforth, all bailouts shall be political and depending on which political entity is in power, winners and losers could be very different.

In the past forty years, interest rates have marched in only one direction and the Federal Reserve had effectively came to the rescue whenever levered economic entities stepped outside rational boundaries. This is the basis of our present prosperity. It served to provide us good paying jobs, ever increasing home prices and 401k portfolios. With Fed funds rate at zero and an inability to normalize without causing another recession, the effectiveness of the Fed put is in serious doubt.

The 2020 recession will serve to mark an epochal change. It is difficult to predict the exact nadir of the era of expanding leverage or the start of the deleveraging cycle. Suffice to say, we are entering a more fragile and volatile world.

Dong Hao Zhang

President & Chief Investment Officer