Q1 Capital Markets Update: Bright Spots Amid COVID-19 Clouds
Don Calcagni (Chief Investment Officer), Drew Kanaly (Client Advisor and Investment Committee member), and Doug Fabian (EVP and Science of Economic Freedom Podcast host) of Mercer Advisors discuss why the fundamentals of strategic long-term investing remain unchanged in the current economic environment.
Much like communities, businesses, and families have begun emerging—cautiously—from lockdown as the spread of COVID-19 starts to flatten, there are gradual signs of recovery stirring in the financial markets as well.
During our Q1 2020 Capital Markets Update webinar on Wednesday, Don Calcagni and Drew Kanaly of Mercer Advisors pointed out a few bright spots amid the overall declines that many investors have weathered so far this year. The pair also teamed with webinar host Doug Fabian to answer questions about the current economic and financial landscape, what may lie ahead, and how Mercer Advisors is guiding clients along this bumpy ride.
Calcagni stressed that although COVID-19 is in many ways an unprecedented crisis, it has not altered the fundamentals of a sound long-term investment strategy. “All bear markets have different causes, but at the end of the day they all rhyme,” he said. “This isn’t the first difficult market we’ve seen, and the financial planning techniques that we use are the same.”
Below is a summary of the quarterly markets update and responses to attendees’ questions. The presenters’ comments have been edited for length and clarity. You can also replay the full webinar at the Mercer Advisors Resource Center.
At the time of the webcast, average global equity market returns so far in 2020 had fallen sharply compared with 2019 levels. The U.S. S&P index was returned -11.7%, the AC World ex-U.S. index stood at -21.1%, returns in emerging markets were at -20.7%, and the EAFE index was at -21.2%. However, the S&P 500 Index was up about 30% from its March 23rd low.
Over the same period, fixed income investment vehicles yielded mostly positive returns. U.S. Treasury 2-year bonds were up 2.85%, 5-year bonds were up 6.86% (5-year), and 30-year bonds topped the list at +31.15%. U.S. Aggregate bonds had returned +4.99%, though some other fixed income asset classes, such as convertibles and high-yield, were running in negative territory.
Calcagni and Kanaly pointed to the volatility in Q1 as a prime reason why investors should diversify their portfolios with stocks and bonds. While a portfolio with $100,000 in bonds on February 19 would have been worth $102,643 on April 27, a portfolio consisting of $100,000 in stocks would have declined to $85,311 during the same period. By contrast, a portfolio with 60% in stocks and 40% in bonds that was worth $100,000 on February 19 would have stood at $92,244 on April 27. “Diversification does cushion the blow when these sorts of things happen in the world,” Calcagni said.
The presenters also recapped how worldwide oil prices have plunged this year due to a COVID-19-related drop in demand and an oil price war between Russia and Saudi Arabia. Kanaly noted that U.S. oil production is likely to decline rapidly, by upwards of 70%, until consumer demand rebounds.
How can I plan for the future—and how can Mercer Advisors give advice—when what we’re going through now is so unprecedented?
Calcagni: We’ve seen markets decline before—whether because of the global financial crisis 12 years ago or (when) the dot-com bubble (burst in 2000), or the 1987 crash. We have advised clients through many market cycles, including those that have seen negative impacts on commodities prices, like the one we’re seeing now with oil.
What a firm like ours is really adept at is counseling clients through these macro-level disruptions. We’ve been doing it since 1985. The financial techniques we use are the same such as portfolio rebalancing and tax-loss harvesting, as well as the many other things our advisors do for clients.
Why aren’t stocks down more?
Kanaly: Stocks are off significantly. When you see unemployment numbers move like we have, it makes sense that you’re going to get this type of correction. The difference this time around is that (during the global financial crisis) in 2008-09, there was a cataclysmic credit disruption. We don’t seem to have, so far, the same type of credit concerns this time around. Also, there’s reason to believe that some of the current unemployment is transitory, that once we re-open the economy, a lot of these folks will go back to work. And whenever the market seems to get information—(like) a new treatment or a new cure for the virus—stocks respond immediately because they’re looking ahead 18 months.
What’s the time cycle for a market recovery?
Calcagni: It’s really difficult to predict when this “ends.” I don’t see us getting past this particular crisis until we have better and more widespread (COVID-19) testing. Ultimately, we need to see a vaccine. Once we can develop a vaccine, I think consumers will be more relaxed. They’ll be more confident that the worst of this is behind us.
Most of the scientists that we hear on television are saying 12 to 18 months before we could have a viable vaccine. But remember, the market is forward-looking. So the market is looking past this crisis. The economy will lag behind the market. I do think we’ll start to see a recovery toward the end of this year, maybe into early next year. That’s my personal view.
The U. S. government has passed a battery of legislation totaling about $6 trillion, including the CARES Act and what the Fed has done. What are the long-term economic implications of so much debt and money-printing?
Calcagni: Drew and I have this conversation quite often. Economic theory tells us that if you pump this kind of cash into the economy, either through borrowing or through the Fed expanding its balance sheet—which is a euphemism for printing money—we should see a significant uptick in inflation. The reality is that since the Fed expanded its balance sheet by $4.5 trillion to combat the global financial crisis, over the past 10 years we’ve been more worried about deflation than inflation.
We need to be careful about trying to draw very simple cause-and-effect relationships when it comes to our highly complex economy. I share those concerns; that we’re now expanding the balance sheet even more and the government is borrowing even more, (which) should push inflation up. But like I said, we have this big drop in oil that’s a deflationary pressure. So, I’m not convinced we’re going to see massive inflation as a result of the new CARES Act package or the Fed expanding their balance sheet. Long-term, though the reality is this is going to drag on growth. Our government has borrowed a significant amount of capital from the future. So, the $23 trillion in debt that the U.S. government has—that was future economic activity that was pulled into the present to pay for things that we wanted as a nation. We’ve already seen that economic growth in the last decade was very anemic. It’s been in the low 2% in real terms.
What effects does the strength of the U.S. dollar, relative to other currencies, have on our investment portfolios?
Calcagni: When we look at equity returns globally, we are in a strong dollar cycle. Anytime there’s a crisis, the worldwide demand for dollars goes up significantly. The dollar is still the world’s preferred global reserve currency. But when you have that stronger dollar, it does hurt the returns we earn on our non-U.S. investments. In my view, we will ultimately see the (relative) value of the dollar decline as time goes on. I can’t predict when, but these things move in cycles. That’s another reason why investors are best served to be globally diversified.
Kanaly: When you think about the pillars of a good economy, a strong dollar is one of them. And what we’ve learned about how we source things from around the world is that you’re paying for them in stronger currency, which is to your advantage going forward. The answer to what happens to the dollar isn’t so much that the dollar goes down, it’s that other currencies go up because other economies begin to recover. Like you saw after the dot-com bubble, you better thank your lucky stars if you owned international stocks and enjoyed some of the currency differential, as well as our economic growth that came out of it.
As a retiree, the long-term effects of COVID-19 on the economy look pretty bad to me. Should retirees be thinking about moving some money out of stocks?
Kanaly: Remember that when you’re doing financial planning, you’re planning for three potential outcomes: Living too long, dying too soon, or impairment in between. Having stocks in your portfolio equates to having the financial resources to live out a comfortable retirement or to handle an impairment. Fixed income is not going to provide for retirement, especially at these rates. We’re not going to see fixed-income returns like this again for quite a while. You’re going to have to remain diversified.
The foundation of a good financial plan includes having some liquidity outside the portfolio for unplanned expenses or for moments just like this (coronavirus crisis). So as long as your plan has those features in place, you should stick to the plan.
Calcagni: Also, be careful about putting too much weight in current events. If we were to rewind the tape and go back to the global financial crisis back in 2009, nobody in their right mind would have made the argument that the U.S. economy was going to fully recover and the stock market was going to more than triple in the decade ahead. In the aftermath of the dot-com bubble bursting, nobody would have thought the stock market would have given you a positive return, but it did.
Should Mercer Advisors be trading more actively in the market-timing component of our portfolios, since it looks like we are going to be in a sideways market for a long time?
Calcagni: There are a couple of things I would say. First, we are not in a sideways market. It has been up and it has been down. Second, I think there’s a misnomer that our strategy is just “buy and hold.” Nothing could really be further from the truth. We are not going to be swapping out of ETFs and mutual funds constantly. But if you actually look inside our portfolios, they are exceptionally active. The question is, how are they active? Are we shifting in and out of sectors or trying to make changes based on perceived economic forecasts? No, that’s not what we’re doing.
Our clients have heard us talk over the years about factor-based investing, which is really investing based on fundamentals. The quality stocks in our portfolios, we’re measuring those based on return on equity and operating profitability. And so, we are making shifts inside those portfolios. We see it all the time. I talk to our fund managers every single day. In terms of the actual holdings in the portfolios, inside the funds, inside the ETFs, there is substantial turnover. There is a lot of repositioning, which is what we pay them for, right? We want them to actively make changes, but do so in a very systematic and scientific way, rather than relying on Wall Street forecasts, which are notoriously inaccurate. We do rebalance portfolios, we do harvest tax losses in portfolios. And that’s all in an attempt to make sure that the activity in the portfolio is tax efficient and it’s actually adding value to the client.
What else should I be thinking about right now
Kanaly: If you’ve got a concentrated stock position or positions, you have just been given a do-over in the current environment. You get a chance now to diversify your portfolio at bargain prices, eliminate the concentration risk, and get on a better-balanced track. Bite the bullet and get diversified, even if you’re concentrated in a stock that’s down significantly. There’s no telling what kind of tax-loss harvesting we can do to help you mitigate any gains.
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