Commentary as of April 20, 2020

Dan Hanson: It appears the market is looking broadly through a flattening of new COVID-19 cases to a reopening of the economy. To date in April, we've seen the best one-month returns in decades, and the best two-week period since the depths of the Great Depression. With the “Great Lockdown” beginning to wind down, as investors, we need to balance this view with the reality that we still need to get through the earnings hole.

From the outset, we have been framing this environment in the context of three pillars: the public health impact, the economic impact and impact on the markets. It is hard not to look at this environment without including a fourth factor: political implications. The decision to reopen is not just science driven; there will be political influence as well.

As we digest all this information, we see the market discounting getting back to normal. We still expect volatility to persist, because we still have uncertainty. Charlie Munger was quoted in the Wall Street Journal this weekend, and to paraphrase, everyone acts as if they know what will happen, and in fact no one really knows what will happen. We would echo that sentiment by saying great investment results require a balance of arrogance and humility: arrogance to have a view that we can deliver long-term outperformance driven by bottom up, fundamental insights, and the humility in recognizing the markets are fairly efficient. That balance comes out in asset allocation decisions, through portfolio managers sticking to their knitting, and executing proven philosophies and processes. We're not looking to generate alpha by calling the next data point: we're calling on the long-term disciplines that have driven alpha over full cycles. We expect continued elevated volatility, which supports remaining broadly invested and heightens the risks to not following through on long-term disciplines.

How has this anticipation about reopening the economy influenced your views?

Derek Hamilton: The market is starting to shift toward what the process of opening up really looks like, and we'll likely have fits and starts. Europe is already moving that direction, with Germany leading the way by allowing small retail businesses to reopen. Others will phase in over the course of the next couple weeks. Masks and social distancing will be a part of this reopen, but at least they’re moving this direction.

The U.S. is moving toward a gradual reopening as well. Roughly half of the U.S. population is scheduled to begin reopening around the first of May. This will be very limited at first, and social distancing measures will limit the number of customers in a shop or restaurant, but we are moving that direction. We expect to see decent U.S. gross domestic product (GDP) growth in the third quarter by historical standards.

One aspect of the reopening to highlight is antibody testing. New York is going to start conducting these tests on a limited basis today. This is one of the milestones states will observe when thinking about reopening, because it is a good way to see how much of the population could be immune to this virus. Even with more testing, there is still a lot of uncertainty. If we experience another severe outbreak later in the year with a second shutdown, we'll have to revise our expectations lower.

It is important to understand the original goals of the shutdown and social distancing measures, too. Initially, the lockdown was intended to prevent our healthcare system from becoming overwhelmed. As we gradually reopen, there is the chance the future potential shutdowns aren't as broad or severe. Our healthcare system may be better prepared, depending on the efficacy of newly developed treatments and more widespread testing.

We have also been looking at how much slack is in the economy. If you consider the productive capacity of the U.S. economy, and where activity is relative to that capacity, that's called the output gap. It helps us understand the depth of the recession and what is required to get back to more normal levels. Even if we do have a sharp snapback in the third quarter, our forecast shows the output gap at around 6% of GDP, which is as large as it was in the Global Financial Crisis.

Putting this shutdown into perspective, we still expect bankruptcies to accelerate, with fewer jobs available to U.S. workers. The healing process will take time: it will likely take a couple of years to return to where the economy was before the pandemic.

As the country starts to reopen, what industries are likely to benefit first? How will it impact unemployment claims going forward?

Derek: The industries that have been hardest hit in this downturn are retail, hospitality and restaurants. Using what other countries are doing as a template, we could expect a gradual opening of small retailers followed by restaurants. There are likely to be limitations on how many customers can be shop or dine at a time. However, these businesses will be coming off an environment where sales were zero, so the change is likely to be most noticeable there.

As we move that direction, unemployment claims could start to come down rather quickly. There are two unemployment claims numbers reported every week. The first is initial claims, which have totaled more than 22 million claims in the past few weeks. We are likely to see those figures drop fairly rapidly as business activity resumes. The second measurement is continuing claims, which measures the number of people that receive unemployment benefits. We believe that figure will show a more gradual decline.

What are some of the implications for manufacturing and potential on-shoring as a result of this environment?

Derek: Any movement of manufacturing back to the U.S. is likely to happen in phases. Items that are vital, like pharmaceuticals, are likely to be brought home as quickly as possible. A second phase could be more focused around security of supply chains. Some supply chains will, at a minimum, be more geographically diversified, if not brought home entirely.

An outlier is the outcome of the elections in November. Will a return of manufacturing be mandated or voluntary? This is certainly a net negative for China, but all manufacturing won't leave. They still need to meet domestic demand, and China will still be a regional manufacturing hub for emerging consumers in that part of the world.

How would you characterize valuations at this point?

Dan: At the end of the day, investment returns are all about long-term earnings power relative to the price paid. As fundamental investors, we think about valuations bottom up, company by company. Today we think valuations are fairly balanced and support sticking with long-term disciplines and allocations. Earnings for the broad market are likely to drop around 30% year-over-year. And, that would be consistent with other historical peak-to-trough drawdowns. Looking at prior cycles, it typically takes at least a couple years for markets to return to prior peaks, which reflects the nature of the economic cycle. In the current environment, while near-term corporate earnings are plummeting, for high quality businesses with sound balance sheets, we see a relatively negligible impact on long-term earnings power. And we see the magnitude and breadth of stimulus measures supporting a recovery in corporate earnings.

Regarding valuations, the puts and takes include:

  • Don’t fight the Federal Reserve. We have enormous fiscal and monetary support not just in the U.S., but around the world.
  • It’s not if, but when we will exit the “Great Lockdown”. We expect reopening, combined with fiscal and monetary stimulus, to support a sharp inflection in economic growth in the third quarter, from decline back to expansion.
  • Low interest rates around the world, which we expect to persist, highlight the opportunity cost of sitting in cash. Further, prior market cycles have illustrated the high costs of sitting on the sidelines. These factors may have helped support the rebound in stock prices over the last few weeks.

Past performance is not a guarantee of future results. This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through April 20, 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This information is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

Risk factors: Investing involves risk and the potential to lose principal. Fixed-income securities are subject to interest rate risk and, as such, the value of such securities may fall as interest rates rise. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets.

The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. In addition, the impact of infectious illnesses in emerging market countries may be greater due to generally less established healthcare systems. Public health crises caused by the COVID-19 outbreak may exacerbate other pre-existing political, social and economic risks in certain countries or globally. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.