As volatility soars to historic levels amid the COVID-19 outbreak, investors continue to be challenged by a daily barrage of news and unprecedented economic uncertainty. To help them navigate this difficult period, each week we are featuring answers to some of the top questions we have received.
March 25, 2020
Extreme volatility continues this week, as the market digests the latest COVID-19 developments. These include sharply higher infection cases in the U.S. and Europe, further expanded measures by the U.S. Federal Reserve to ease illiquidity and improve market function, and the seemingly near passage of a $2 trillion U.S. fiscal stimulus package.
Here are answers to some of the most common questions we are receiving this week.
As of yesterday, the municipal bond market had suffered through the worst month-to-date performance in 40 years. Today, it experienced the biggest rally in a decade. Let me explain: In recent weeks, the muni market faced the double whammy of challenged liquidity and potential credit downgrades. From a liquidity perspective, the clear trend that unfolded was that investors were seeking the safety and security of the Treasury market. Cash was king… but only if in Treasuries. For short -term municipal bonds, this meant intense selling pressure that created some potential dislocations and market dysfunction. And for longer-dated municipals, the selling pressure had been acute.
Importantly, a recent policy announcement from the Fed is designed specifically to alleviate this pressure. The Fed expanded its emergency lending program to include short-dated municipal bonds and subsequently added variable rate demand notes, commonly held in municipal money market funds, to the list of securities it can purchase. These programs cover maturities up to 6 months and have effectively assuaged investor concern in the money market space.
For longer duration municipal bond investors, liquidity and credit concerns have remained. With deep economic dislocation across the U.S., stable sources of revenue are clearly at risk over the short term. This has not gone unnoticed. The White House and Senate stimulus package reportedly includes $500 billion that can be used to support state and local governments and contains language authorizing the Fed to buy longer-dated municipals and loans directly from issuers. This drove a meaningful rally in muni bonds today.
While money market funds came under considerable stress last week, it’s important to remain calm and recognize that principal preservation and liquidity are a priority for the industry as well as regulators and policymakers, including the Fed. It’s also important to note that, overall, money market credit quality remains high and that credit spread widening last week was due to a lack of liquidity, which is now being robustly addressed by the Fed.
The Fed is addressing illiquidity in multiple ways, including by re-establishing three credit facilities used during the 2008 financial crisis. The first targets commercial paper issuers, companies that issue short-term promissory notes in which money market funds invest. The second provides cheap credit to primary dealers, which distribute government debt to money market funds, to facilitate greater liquidity. And the third is specifically designed to provide liquidity directly to the money market industry by making loans available to eligible financial institutions that purchase assets from money market funds. This particular facility was expanded Monday by increasing the scope of security types that financial institutions can pledge as collateral in exchange for loans.
These measures have already made many parts of the short-term markets in which money markets trade liquid again.
While attempting to time the market is always tempting, especially when it’s in anticipation of a further drawdown, this strategy is likely to result in underperformance over the long-term. We know from history that rebounds happen quickly and that missing just a few days of the rebound can lead to considerably less dollar wealth over time. The trading over the last two weeks provides a relevant example, and a cautionary tale: Not only have we seen extreme day-over-day gains and losses, but we have also seen extreme intra-day volatility. These are perilous waters for investors.
The chart below highlights the significant risks of missing the best performance days over the past 30 years:
The Cost of Market Timing
For risk assets, the best medicine is time. We can’t predict the bottom, but we do know that, on average, a 10% market decline lasts about a year, and a bear market, defined by a 20% drop, lasts about a year-and-a-half. While loss aversion is a behavioral bias to which we are all vulnerable – particularly in times like these – also appreciating the risk of missing the rebound is crucial.
This is impossible to predict, and we should all be wary of anyone claiming to have this answer. Market timing is notoriously impossible to forecast, and there are too many unknowns at this point. These include, most importantly, when infection rates will begin to decline, as well as the magnitude of earnings declines and the impact of monetary and fiscal policy measures, which is not immediate.
A market bottom won’t occur until we have more normal liquidity conditions across asset classes. We already see that some of the most dysfunctional markets — for example, the investment grade corporate bond market—have already begun to stabilize. One way to observe this is by looking at the discount/premium to net asset value (NAV) in the exchange-traded fund (ETF) world. As liquidity became extremely challenged, many large funds were trading at significant discounts to NAV, a clear signal that there was stress in the system. Since the Fed expanded the bond buying program to include corporate bonds and related ETFs, we have seen these spreads normalize.
Investors won’t regain durable confidence until there is clarity on the spread of the virus. We have often noted that this is a global health crisis; the economic downturn is the consequence, not the cause. The health crisis must be dealt with first. We need to see a slowing of the infection rate, a “flattening of the curve.” Our internal expert concurs with many of the infectious disease specialists and epidemiologists in forecasting a slowing in the growth rate of new infections in April and peak cases in the June/July timeframe.
There will be a flood of information coming at us over the next days and weeks: details on the fiscal plans out of the U.S. and Europe, global economic data that will doubtless reflect deep damage, signals from corporate America as we embark on the first quarter earnings season, and daily updates on the spread of COVID-19. We will assess this information as it comes, integrate it into our forecast and ultimately gain confidence on the timing and shape of the eventual recovery.
This issue has become front and center for investors as challenges in the corporate and municipal bond markets, concurrent with deep drawdowns in global public equity, have revealed the need for “ready cash.” For each investor, the answer to this question depends on a number of variables that are all unique to that investor.
At Northern Trust, we help clients identify the appropriate allocation through a Portfolio Reserve strategy and as part of our Goals-Driven Wealth Management framework. The Portfolio Reserve is an allocation to cash and high-quality bonds designed to fund your core lifestyle for a set number of years. In determining the correct allocation to cash, we take into account all sources of cash flow, the timing of the cash flows, and ultimately, the roadmap for required distributions. The Portfolio Reserve is a carefully constructed plan, designed to provide liquidity in the form of cash reserves as well as the diversification benefits of an allocation to high quality fixed income.
To determine the number of years of spending you would like to protect, it helps to look at history. In one extreme, it took more than 15 years for equities to fully recover from their 83% drawdown during the Great Depression. On the other hand, in a less extreme example, it took less than two years for equities to recover from their approximate 30% drawdown after the 1987 stock market crash.