Side-by-Side into the Great Unknown

I am glad you’re joining me today. I have very much been looking forward to taking a breather while we sit and try to relax over this decaffeinated cup of coffee. 

The last three weeks have been nothing short of historic with the protective measures put in place from the on-going coronavirus pandemic thus prompting unprecedented distortions in the financial markets. With the recent volatility at such extremes, we’ve witnessed extraordinary actions taken by government entities to protect our society, economy, and financial markets. It goes without saying that the current landscape has left many individuals filled with anxiety about what lies ahead. Let me be the first to say, you’re not alone.

Over coffee today, I am going to provide some context on why we’re seeing historic volatility within the financial markets and highlight the recent central bank actions that have taken place over the past few days. With most investors placing a tremendous amount of attention on the stock market, and rightfully so, we believe it is equally important to be cognizant of the economic drivers causing asset prices to decline. In these times of systematic risk (the risk that affects the financial markets in aggregate), it is extremely challenging to predict the outcome as there are so many changing variables. Nonetheless, we are working tirelessly to assess the impact on economic conditions and financial markets. Times of uncertainty are no new friend to society and although the path still leads to the Great Unknown, we will be together side-by-side.

While today is designated to provide context surrounding the financial markets it is nonetheless important to recall our outlook of slowing economic growth that we’ve been highlighting since Q1 of 2018 as we believe it plays a significant role in the volatility we’re seeing today. As readers of our work know, we have been highly vocal that the business cycle has been in the latter stage of economic growth. While it is hard to refute that the recent and tragic outbreak of coronavirus is causing severe economic disruption, we believe that the price dislocations we’re currently experiencing have been exacerbated by typical late-stage business cycle dynamics.

Although investment practitioners and financial media spend the majority of their time focusing on the stock market decline, we believe that there are more undercurrents at play that investors need to be mindful of. As mentioned earlier, it goes without saying that the coronavirus situation is not only tragic but a major shock to the economic system. Over the recent weeks, we have essentially seen economies not slow their growth but grind to an abrupt halt thus prompting the seizure of consumer spending, business activity, and disruptions in global supply chains. And while these types of adverse responses have happened in the past, what has shocked the financial system this time around is the historic speed at which the economy has come to that halt. What makes this more profound is that during the latter stage of economic cycles, we see companies and countries have lower quality balance sheets based on record levels of debt obligations and low levels of financial stability assets such as cash & cash equivalents.

When you couple late-stage business cycle characteristics, like the ones mentioned above, with an economic shock akin to the coronavirus, the velocity in which financial assets lose value is eye-opening. What tends to happen during these periods of extreme economic stress is that companies and individuals begin to dispose of assets in favor of cold hard cash. With the immediate closure of regions across the globe, companies began to dispose of investment assets in favor of US dollars as they are unclear on when they will be able to earn revenue. To compound this, companies maintain credit lines at major financial institutions so they may have the liquidity to pay their upcoming financial obligations. When you think about it, this is no different than an individual investor who must dispose of assets in favor of cash as they are similarly unclear on the viability of their future earnings and ability to pay their financial obligations. When these scenarios collide, we tend to see extreme financial stress as everyone dashes for cash.

 

While the path ahead is still the Great Unknown we remain hopeful that once we are through the severity of this pandemic, the economy should repair relatively quickly. Over history, shocks of these magnitudes cause deep declines in growth but tend to repair quickly when consumer financial health is in good order. At present, US households have the benefit of elevated savings, low debt service ratios, and low inflation which will hopefully allow them to weather these uncertain times. With the injection of financial aid via monetary payments to lower-income households, we hope they too will weather these turbulent shocks. 

With appropriate fiscal policy being enacted and a do-whatever-takes from the federal reserve, the financial markets should become less volatile. Nonetheless, these are not buy-the-dip moments as typical bottoming processes take time and space to formulate. It is not uncommon to see a final retest of market lows. While there is a bit more to go on this rocky road, we are walking with you every step of the way. Please do not hesitate to reach out to me or anyone on the team for any questions you may have. We look forward to providing you more in detail regarding our investment outlook and portfolio construction methods on Monday next week.

Sincerely,

Andrew H. Smith
Chief Investment Strategist
andrew@delosca.com
asmith971@bloomberg.net

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