March 20, 2020


Nine points to consider on the outlook for equities

Given the volatility in the financial markets beginning the week of February 20th, it’s helpful to
review the state of the U.S. economy entering into this stressful period, what’s happened since,
and some of the potential economic impacts. Here is my take on those topics.

 At the beginning of 2020, the U.S. economy was in very strong shape, with
unemployment falling and the labour force participation rate and wages rising.

 Compared to 2008-09, this is not a financial crisis but rather a health crisis, which
tends to be much shorter in duration (typically several months) and which should
lessen in magnitude as the Northern Hemisphere approaches spring and
summer. Banks are in the strongest capital positions ever, and strong banks with
the ability to lend are obviously important to the sustainability and health of the
economy during times of crisis. Further, the ratio of consumer debt to gross
domestic product (GDP) is about 75 percent, its lowest since 2002, down from
almost 100 percent in 2008.

 Lower interest rates will help governments, consumers and corporations
refinance debt, leading to lower debt burdens within those sectors of the
economy. However, lower interest rates, along with lower stock prices, will put
further stress on state and local pension plans, many of which are already
severely underfunded. In order to minimise risk, we have been avoiding buying
bonds from a significant number of these states. A sustained period of low rates
will also impact savers, increasing the need for other parts of the portfolio to
generate the returns needed to fund retirement and other goals. We also expect
that we will see yields on short-term fixed income, such as money market funds,
drop substantially as well, increasing the “cost” of cash.

 While bad for energy companies, their stockholders and potentially their
bondholders, collapsing energy prices are effectively a big “tax cut” for
consumers. Also, companies that are heavy energy users (e.g., airlines) will
benefit, to some degree offsetting the losses associated with lower energy prices
in other sectors of the economy.  However, there is significant risk to the high-
yield corporate bond market, as there is $85 billion of high-yield debt issued by
energy companies, and with oil prices below $40 a barrel, many of these
companies will struggle to generate profits. Much of that debt matures in the next
four years. In this type of environment, one can expect the high-yield corporate
bond market to be highly correlated with the stock market, which is one of the

reasons we generally do not recommend high-yield bonds as part of client fixed-
income portfolios. High-yield bonds do not provide effective diversification within
a portfolio that already owns stocks.

 The U.S. has the lowest percentage of trade relative to GDP, at about 12 percent
(country trade-to-GDP ratios). In comparison, most of Europe varies from around
50 percent (Germany) to the high 80s (Belgium, Netherlands). Japan is about 16
percent and the UK is about 30 percent. So, if there is a prolonged deterioration
in trade, the U.S. should be less impacted than most countries.

 If the economic disruption associated with the coronavirus worsens, governments
are likely to take action to address issues, such as coming out with loan
programs to bail out specific industries (as the government did during the 2008-
09 crisis for General Motors and the banking industry) and enact fiscal stimulus
(tax cuts or other programs to more directly help those financially impacted by
the coronavirus) [1] . Given possibilities like this, one must also keep in mind that
markets are forward-looking, recovering well before the economy does, just as
they tend to fall before the economy is materially disrupted.

 Markets generally do a good job of incorporating both good and bad news and
anticipating potential impacts on the economy. When we see markets change, it
is almost always because of new information that couldn’t have been reliably
forecast in advance. However, markets can also fall for noneconomic reasons
due to a cascade of sellers who reach their get-me-out point, have margin calls,
or are covering short put options positions that are held by sellers of volatility
insurance and sellers of structured notes (which limit downside equity risks); or
market participants who are trading with the trend. In addition, banks and
investment firms using value at risk (VaR) metrics to assess possible losses on
their books for any single day may have to sell off risks as volatility
increases. Market participants can sometimes exacerbate downward trends in
markets, but we still believe it’s best not to try to predict these occurrences but
rather to be aware they are possible. Further, if you sell, you have no way of
knowing when to get back in or when trends like the above could reverse.

 While stocks and risky fixed-income assets or pseudo fixed-income strategies,
such as dividend paying stocks, REITs (real estate investment trusts), etc., are
falling in value, safe bonds are rising in value, demonstrating their value as
dampeners of portfolio volatility, which is why we include them in portfolios.
Some “true” alternative strategies, such as marketplace lending, reinsurance and
trend-following, have held up very well and have generally generated positive
returns on a year-to-date basis.

 Finally, remember that bear markets are periods when stocks are transferred
from weak to strong hands, as does wealth when recoveries occur. We have
recovered from every past crisis, which we tend to experience with great
frequency, about every two or three years. Further, we recovered quickly in the
past from the health crises of SARS, MERS and Ebola.

[1] On Sunday night, March 15 th , the Federal Reserve announced that it cut the Fed funds rate to
effectively zero, a drop of a full 1 percent. In addition, it announced a massive $700 billion
bond-buying program. These actions will provide cover for other central banks to cut rates
without fear of their currencies collapsing. Congress is also working on a massive stimulus bill,
on top of the $8.3 billion approved last week by the Senate. Governments around the world are
certain to follow with packages of their own.

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