COVID-19 Market Stress: Twin Surges

The Monthly Five Author Avator

Katie Nixon, CFA, CPWA®, CIMA®

Chief Investment Officer, Northern Trust Wealth Management

April 3, 2020

The news flow remains heavy and constant. Headlines about the spread of COVID-19 are now competing with the release of economic data that is living up to our fears regarding the damage being done to the global macroeconomic outlook by the pandemic, complicated by a quickly evolving energy landscape.


Europe Is Flattening the Curve

It is early days, but recent data indicates that Italy and Spain may be past the worst in terms of the growth of infection and deaths, and may provide a useful template for France, the U.K. and, in particular, the U.S., which seems to be roughly two weeks from the peak. We have seen extreme economic damage in Europe through some of the recent survey data, and we expect that hard economic data will meet these low expectations and lead to a -5% 2020 GDP drop for the Eurozone.

In thinking through the potential recovery in Europe, we take a three pronged approach: The ECB and fiscal authorities have stepped up support, with a particular focus on income replacement and maintaining corporate access to liquidity. This is not stimulus, but is a necessary element to create economic resiliency and set the stage for the recovery. We think that there is more to be done and that further fiscal measures will be taken. This may include the use of the European Stability Mechanism fund and/or the longer-shot possibility of joint issuance of “coronabonds” to fund programs. In short, more is needed and more will come. Most important, however, will be the longer term healthcare response that enables workers to safely return to work. Measures will likely require a tremendous amount of testing and may include an “immunity passport,” which would indicate that people have immunity to COVID-19. Further, we must continue to make progress on treatment options and, ultimately, it may take the development of a vaccine to send the all-clear sign.


Twin Surges

This week, we have seen meaningful increases in both the unemployment picture and oil prices. Starting with jobs, the U.S. economy saw 6.6 million jobless claims this week and a 701K jobs loss reflected in the March non-farm payroll report – before the strictest containment measures took hold. Therefore, we expect the April report will be even worse. The March data drove the unemployment rate to 4.4% and represents the worst month since March of 2009, breaking our 113-month streak of jobs growth. Relatively benign market reaction to this obvious sign of economic weakness reflects that the market was largely expecting this. Investors are prepared for a lot of challenging economic news in the weeks and months to come and have priced that into asset values. It is also probable that the worse the news becomes, the more likely it is that we will see a fourth stimulus package from Congress.

On the subject of surges, the price of oil has been on a wild ride in 2020, falling significantly as Saudi Arabia vowed to increase production despite the significant drop in global demand. A Thursday Trump Tweet sent Brent Crude above 16%, with U.S. WTI +12%. It appears that OPEC + may be ready to agree to production cuts of 10% and will be holding an emergency virtual meeting on Monday. It is important for oil to stabilize at a higher level here for a number of reasons – not least of which are the importance of the shale and energy industry to the U.S. economy and financial market through the credit channel, and the importance of driving economic stability in financially fragile areas of the world where energy exports are essential.


Private Equity, Under the Hood

While private asset valuations have not been marked to market, suggesting “status quo,” PE fund managers and underlying companies have been very busy during the past several weeks. From an underlying private company perspective, the most important near-term priority is liquidity, as companies have drawn down available revolving lines of credit to shore up their balance sheets and provide an important financial buffer in anticipation of a prolonged period of economic weakness. Interestingly, investors (limited partners, or “LP”) have seen an increase in capital calls at the fund (general partner, or “GP”) level, leading some to wonder whether funds were finding opportunities for investment amid the volatility. In fact, it appears that many GPs are calling capital to pay down existing lines of credit that were drawn up to a year or more ago in order to fund prior deals.

The decision at the fund level to draw on credit vs. a capital call is important given that credit has been readily available and relatively cheap – hence, it had been preferred in some cases to calling commitments from LPs. Ultimately, this decision can have a meaningful (and positive) impact on internal rate of return (“IRR”), the performance metric used to assess a fund manager’s acumen. Last, while there are some obvious areas of challenge in the private markets, like brick and mortar retail, energy and travel, there are also areas of tremendous opportunity, like technology (think Zoom, Slack) and biotechnology. Lessons from the last crisis suggest that these periods of steep distress are rare and typically provide good long-term opportunities.


So, There Is One “V” to See

Critics, who feel the Fed is being too slow in providing accommodation, need to take several seats as the pace and magnitude of recent policy moves are revealed. While we know of the programs being put in place to provide liquidity and support to the financial markets, and we expect to hear more about support for Main Street, it is easy to lose sight of the aggregate magnitude of accommodation being offered.

One way to see clearly the “awe” of the “shock and awe” is to look at the Fed’s balance sheet. The previous peak of the Fed’s balance sheet occurred after the third round of QE, which had ballooned the Fed’s total assets to just under $4.5T (that’s trillion), a significant increase from the pre-Global Financial Crisis level of $870B. The Fed has attempted to shrink the balance sheet and was successful, beginning in March of 2017, under a slow and steady program of allowing bonds to mature and roll off. This resulted in the trough of balance sheet assets of $3.7T in September of 2019. Subsequently, the Fed had to provide liquidity to short-term funding markets in the fall and winters of 2019 and, more recently, has implemented expanded asset purchase programs to ease broader liquidity issues across credit markets. If you are looking for a “V” shaped recovery, look no further than the Fed’s balance sheet.

Fed Balance Sheet Expansion

Source: Federal Reserve Bank of St. Louis, Jan. 18, 2017 – March 18, 2020


The Road to Recovery

While we must remain vigilant in our containment measures against COVID-19, we also need to begin to plan for the recovery. We know that the longer the related economic downturn persists, the more difficult the eventual recovery will be, so it is important to lay the groundwork right now for the most important elements that can support the recovery. As we have reiterated many times, this crisis began with the coronavirus, and it will end with the coronavirus. Ensuring citizens that it is safe to go back to their normal lives is absolutely key to recovery.

We can look to China, where it is estimated that the economy is operating at 80-90% of prior capacity. This is not just the official data, which is always consumed with a grain of salt, but through other metrics like electricity usage, traffic patterns and pollution. It will be critical to watch China carefully for any signs of a second wave of infections and to assess how much/how quickly social distancing measures can be relaxed – as well as what the post-crisis implications are for consumer behavior. A risk case is that we could be in for a longer-term adjustment for growth and a longer road to recovery, which will lead to continued bids for safe haven assets and drive more market volatility.


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