Comfortable With Uncertainty
As the world continues to battle the coronavirus pandemic, we hope you all remain safe and healthy at home as we together face the challenges ahead. We would also like to take this opportunity to thank the healthcare professionals on the front lines for their difficult work and sacrifice to help the world ‘flatten the curve.’ We are all deeply appreciative for what you do.
It is now becoming clear the US is the new epicenter for the virus. As confirmed cases rise, capital markets will become even more fixated on finding the critical point where the exponential growth of cases becomes linear. President Trump recently announced an extension of social distancing guidelines through April 30 in hopes that continuing this practice will have the same impact of reducing the rate of transmission seen in other countries. If Italy serves as a reasonable proxy for the US experience, we could see initial evidence of cases breaking from the exponential growth as early as next week. This is not the same as projecting a peak in overall cases, however, which is probably still several weeks away.
The monetary and fiscal response to this crisis has been swift and decisive. As a colleague recently put it, the Federal Reserve and the US government are reacting to this sudden stop of economic activity with ‘muscle memory’ from the 2008 experience. Though the circumstances are much different, there was a quick realization of the need to provide support to the consumer-driven US economy. On March 27, President Trump signed the highly-anticipated CARES (Coronavirus Aid, Relief and Economic Security) Act to provide $2.2 trillion of fiscal stimulus to the economy. Nearly 50% of the spending package is direct funds for households and small businesses.
As BCA Research commented in a recent note to clients, the passage of this bill shifts the stimulus question from ‘How big?’ to ‘How effective?’ Time will tell, but these actions will clearly help soften the blow from the pandemic fallout and assist an eventual snap back of growth once the world’s greatest economic engine starts again.
From an investment perspective, it is important to remain focused on the long-term horizon. Some investors are describing last week’s broad stock market gains as a clearing or relief rally in which prices rise sharply, but perhaps just briefly, from an oversold condition. Others are confident that the worst is now behind us. Both views attempt to answer the same question: Was that the bottom? It’s tempting to play that game, but ultimately we don’t know. There is undoubtedly going to be shockingly negative real-time economic data being reported over the next few weeks and ongoing market volatility is likely. While we hope the ‘V’ shaped recovery takes hold, we have to acknowledge that it could be a bumpy road that gets worse before it gets better.
However, recognizing we can’t reliably time the bottom is not a reason to wait on the sidelines until things improve. Markets are forward-looking and the bottom will likely occur long before the news improves. On October 17, 2008 Warren Buffett wrote a New York Times op-ed titled ‘Buy American. I Am.’ describing his optimistic view of the US stock market based on investor fear at the time. What happened next depends on your perspective. The S&P 500 fell an additional 25% to its ultimate low in March 2009 before launching into one of the greatest bull markets in history. Does Warren Buffett regret not timing the low? I doubt it. He was comfortable with uncertainty.
Times like this require investors to remove emotion from the equation, as hard as that is, and look past the short-term environment to opportunities that lie ahead. Following is one example of a recent market dislocation that appeared over the last couple weeks.
Municipal Bond Dislocation
As liquidity dried up during the acute phase of the initial sell-off, truly unprecedented yield relationships developed among, of all things, short maturity municipal bonds. An insatiable desire for cash and liquidity prompted outflows from ETFs and mutual funds that own municipal bonds. Lacking sufficient market depth in part due to regulatory constraints from the 2008 financial crisis, the overwhelming amount of bonds out for bid led to lower prices. The lower prices in turn led to additional fear and more selling by investors wondering why this was happening. The selling pressure increased and the negative feedback loop was well underway.
At the peak on March 20, AAA municipal bonds were trading at a 2.83% yield-to-maturity for 3-month and 6-month maturity bonds. Treasury bills paid less than 0.10% at the time. Think about this. For an investor in the highest federal marginal tax bracket, that is a tax-equivalent yield of approximately 4.5% for a AAA municipal bond with a 3-month maturity, or a 440 basis point spread over Treasury yields.
The chart below provides visual context for how unusual this dislocation was within the asset class. It illustrates the average 2, 5 and 10 year maturity yield ratio of AAA muni bonds to equivalent-maturity Treasurys (muni yield divided by Treasury yield) going back to 2000. This ratio hit 604% on March 20. For perspective, at the peak of the 2008 financial crisis this measure reached only 250%. Low Treasury yields distort this calculation somewhat, but it is still an incredible data point.
A week later, this relationship has already begun to normalize as municipal bond yields decline and the supply/demand imbalance improves. This example serves as an early reminder during this uncertain time that short-term price volatility feels unsettling in the moment, but it can also generate dislocations from fair value.
Ultimately, we don’t know the path of this economic crisis the same way we didn’t know the path of prior recessions (and this will soon be an official recession). Market volatility will create opportunities along the way and a thoughtful, long-term investment plan remains the best way to avoid ill-advised reactions to market gyrations. The investment team at Oxford is working tirelessly to uncover great long-term opportunities, sometimes temporarily disguised as scary and uncertain.
Thank you for the trust you place with Oxford. Speaking on behalf of the entire Investment Management Group, we take that responsibility very seriously and look forward to guiding client investment portfolios through this most recent challenge.
The above commentary represents the opinions of the author as of 4.1.20 and are subject to change at any time due to market or economic conditions or other factors.The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice.