The minute-by-minute evolution of information regarding COVID-19 (“coronavirus”) has created extreme volatility in equity markets.  The VIX, widely considered the market’s “fear gauge,” oscillated between 45 and 55 for much of the week before spiking to an intra-day high of 76.8 on Thursday.  At the peak of the credit crisis, the VIX reached a high of 81.6.

During the week, U.S. equity markets entered bear market territory, plummeting 20% from recent highs.  From Monday to Thursday, the S&P fell 16.5%, slightly better than the 16.8% drop of the MSCI All Country World ex-U.S. Index but worse than the 12.7% retreat of the MSCI Emerging Markets Index.  Thursday marked the worst day in equity markets since “Black Monday” on October 19, 1987.  On Friday, markets opened on sound footing but by mid-day were off their highs.

Markets were already grappling with the uncertainty related to COVID-19 when Russia and Saudi Arabia failed to agree on oil production cuts prior to the start of trading on Monday.  A price war erupted based on this indecision, sending oil prices down almost 25%.

Hedge funds generally protected capital relative to the broad equity market, with shorts and portfolio hedges proving their worth.  High levels of volatility have created opportunities to add undervalued longs and to take profits on—and add to—short positions, particularly in energy.  With no signs of meaningful changes to portfolio positioning, hedge funds are staying the course and reminding investors of their place in a diversified portfolio.  Absolute-return-oriented managers with reduced equity allocations have generally held up well during the sell-off.

We note some scattered signs of illiquidity in bond markets.  High-yield spreads widened 176 bps, and investment-grade spreads rose 65 bps from March 6th to March 12th.  Market participants have reported that selling credit has been more difficult, particularly in lower trade sizes and for lower rated credits.

Even more surprising, pockets of illiquidity developed in the Treasury market.  There appears to be a scarcity of Treasuries available in the market for use as either hedging programs or as collateral in repo markets.  Possibly in response to this, the Federal Reserve implemented a series of changes to its repo operation and is also modifying its bond buying program to shift the focus away from Treasury bills to include a wider variety of maturities.  The actions taken by the Fed are intended to improve Treasury market liquidity and to keep funding markets operating smoothly.

Meanwhile, the U.S. government reported that it continues to work on an emergency coronavirus bill in addition to an $8.3 billion spending deal that was signed by President Trump last week.  On Friday, Treasury Secretary Steven Mnuchin publicly stated that the administration and Congress were close to reaching a stimulus deal.

Foreign governments and central banks also stepped in to help ease investor concerns.  The European Union pledged emergency funds intended to stabilize the bloc’s economies, while Germany announced its preparedness to deploy cash to companies impaired by COVID-19.  In Asia, the People’s Bank of China cut reserve requirements for banks, and the Bank of Japan purchased government bonds.  These are just examples of this week’s coordinated global response to the sell-off.  It is likely we will see additional fiscal and monetary actions in response to the fluid situation.

The economic impact from the coronavirus and oil shocks remains uncertain, but forecasters are increasingly reporting that the U.S. could be in or nearing a recession.  During the week, professional and amateur sports seasons were truncated, canceled, or postponed (NHL, NBA, NCAA, MLB, PGA, and more).  By Friday afternoon, numerous educational facilities across the nation had closed, but the federal government had yet to impose any mandatory closures.  Similarly, it had not officially restricted domestic travel or business operations.

In these uncertain times, we believe it is important to remember that we cannot control the markets but we can control how we react to these events.  Risk asset valuations have sharply repriced downward, and we believe it is likely that the economy may be close to entering or possibly in a recession.  While changes in the business cycle can be difficult to endure, they also can be cleansing.  These situations tend to remove excess from the system, and strong companies tend to weather the challenges.

We continue to encourage clients to maintain an even hand and steady course.

We are confident that both the economy and capital markets will recover, though we cannot predict whether it will be V-shaped or U-shaped.

We firmly believe that the best way for investors to respond to the volatility seen over the past few weeks is to implement a dedicated rebalancing strategy that emphasizes diversification.  We have developed with each client an investment course of action, which is codified within the investment policy statement; navigating volatile markets is much easier when a plan is in place.

 

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