May 5, 2020 - Never in my career or in my life have I witnessed the breadth and speed of change that occurred during the first quarter of 2020. Without a doubt, this unprecedented period will change our country, the capital markets, and all of us as individuals. The scope of that change remains unknowable at this moment, but as a fundamentally optimistic person, I am confident that America’s core values, determination, innovative spirit, and free market economy will triumph.
The first quarter began with favorable conditions across economies and capital markets. The US economy was healthy with no recession in sight, while a trade deal between the US and China pointed to better relations with China and a possible normalization of global trade. Then, amid the global spread of COVID-19, we experienced the most significant GDP and job destroying event of our generation. In the annals of financial history, there has never been an incident where even one government, let alone multiple governments in concert, intentionally shut down their economies.
We are living through a period that I think will be considered historically on par with the World War II and the Cold War. It is understandable that we are having a hard time coming to terms with the severity of these circumstances, but we must keep reminding ourselves that we will come out the other side.
To capsulize the quarter, US equities were down 20%, with value and small cap segments suffering larger losses. Non-US stocks were similarly affected, with emerging markets falling in line with developed markets. Oil prices fell 66.5% during the quarter as measured by the Bloomberg WTI Crude Oil Index. (On April 20th, oil fell 200% in a single day, something we have never seen before.) US Treasuries and core fixed income held up better, benefiting from a global flight to safety. Among the bright spots, hedge funds generally did their part, with the HFRI Fund of Funds Index delivering a return 15% better than the S&P 500 Index. We have said for years that hedge funds play a role in diverse portfolios and that investors should maintain their positions despite relative underperformance; such persistence paid off this quarter.
Pitcairn Portfolios Held Up Under Stress
Pitcairn has always preached the benefits of diverse portfolios and diversification provided some cushioning against widespread volatility during the tumultuous quarter. Many of the asset classes investors liked least going into the first quarter provided the most protection during the downturn – they did their jobs.
Our asset managers also did their jobs and continue to do so. In fact, we identified more than 20 managers on our platform across asset classes who delivered a first quarter return between -10% and 0%. While it can be difficult to count managers who lost money as bright spots, the theory of diversification rests on it.
Within Pitcairn portfolios, the core fixed income allocation provided balance against losses, as it was supposed to. Eliminating MLPs in early 2019 was another notable positive for Pitcairn portfolios as this segment was crushed by energy volatility in the first quarter. Though many investors held MLPs for their high yields, we owned them as an inflation-resistant, dividend-paying energy conduit. When we determined that MLPs were over-correlated to oil prices, we sold at the right time. Pitcairn portfolios also had zero exposure to oil/energy coming out of January into February, another notable advantage. Additionally, we moved from money market securities into cash as a safety measure because the small excess returns were not worth the added risk.
Though we believe international stocks are an important source of growth over time, that was not the case this quarter due to the coronavirus pandemic’s global nature. In times of global crisis, a flight to safety typically pushes the US dollar higher, which dampens international equity returns.
Most importantly, we resisted emotional pressure to trade for the sake of trading, recognizing that this was not a time to be overly tactical. There will be opportunities for tactical ideas when we have more clarity, but people who were driven out of equities by fear in March missed a substantial five-week rally. That did not happen to our clients. I understand there is little consolation for the poor returns this quarter, but Pitcairn portfolios beat their benchmarks and every bit of capital preserved during a downturn improves return potential when markets recover.
US Markets Adjust to Uncertain Outcomes
It is very difficult to predict any outcomes at this time. There are things we don’t know and things we think we know that we probably don’t. The negative economic data are unprecedented, not because of their severity, but because this was done intentionally to fight the virus.
The sharp decline in GDP and 26 million job losses are scary, but the transmission mechanism of the US economy will still be in place once we contain the virus. (See Chart A: Weekly Jobless Claims.) Sections of the economy are still functioning, and we believe corporations will have earnings power when we turn things back on. Of course, the shorter the period of time until the economy reopens, the less damage to this transmission mechanism, but premature reopening could hamper recovery. If the economy does not see some form of reopening until September because of potential health consequences, there will be further financial impact.
For now, it appears US financial markets are adjusting. The panic of mid-March, when most Americans were told to go home and stay there, appears largely behind us. Some market stressors have subsided. Near-term economic numbers will be shocking, but not surprising. Central banks and governments across the globe have implemented stimulus measures that make “all in” an astonishing understatement. The Federal Reserve, Congress, the US Treasury, and the Trump administration have taken unprecedented steps; US stimulus has so far totaled about 8% of GDP, with significantly more likely. Global stimulus has been calculated as high as $23 trillion.
Equity investors seem to believe the worst is behind us. US equities have had quite a run, delivering a 27% gain in 15 days - the best 15-day trading period in history. We have written ad nauseum over the years about the risks of missing the market’s best single trading days and we have shown plenty of data to support this. None is as powerful as what we have seen in recent weeks. Market timing was definitely not a friend to investors who sold out in March.
When we look at historical results following quick equity market runs, we see that the performance for the next quarter is muted, performance for the following year averages about 12%, and for the next two years, averages about 21%. Whether such historical patterns will hold depends on the tenor of the virus news and whether viable therapies emerge.
Economic Stimulus, the Price of Money, and Consumer Confidence
With so much stimulus being pumped into the economy, there will be ongoing debates about the price of money, Fed action, and US debt levels. Despite massive stimulus, we still see no current inflation and even small inflationary pressures are likely to be overwhelmed by the massive deflationary force of the pandemic. We have noted in the past that the Fed seems to have more confidence in its tools to fight inflation than its ability to fight deflation, which is probably why it took such extraordinary steps to combat deflation after the 2008 financial crisis and is doing so again today.
High debt levels could affect confidence in US credit quality, but for now, the consensus seems to be against that. The Fed is walking a tightrope of preventing depression-level economic destruction while preserving confidence in the full faith and credit of the US. No one knows what, if anything, would cause global investors to lose faith in the dollar as “the store of stable liquidity.” But as it has historically done, the world rushed to dollars amid the recent turmoil, with full knowledge of the Fed’s massive support. This suggests the most probable outcome is that we are accumulating massive debt (as are many other countries) that will curtail GDP growth and future financial flexibility. Still, it’s important to recognize that the global economy is a relative game and the engine of US capitalism is extremely dynamic, making the Fed’s extraordinary action more tenable than many believe.
For now, fiscal and monetary stimulus provide critical support for US GDP. Not surprisingly, consumer activity has fallen precipitously, as has consumer confidence. (See Chart B: Monthly US Consumer Confidence.) However, I don’t see this continuing long term. Coming out of 2008, many predicted that consumer behavior was forever altered. In fact, consumers came back quite quickly. My view has always been that the potential for real change in the behavior of American consumers is usually overestimated. A consumer recovery will probably be slow, but I don’t believe it will be non-existent.
Forging a Path Forward
One of the things I like about living in Philadelphia is the proximity to our nation’s history. I can see the room where our forefathers wrote the constitution, a document that has created more human freedom and prosperity than any other in world history. But it fascinates me that our founding principles – life, liberty, the pursuit of happiness, freedom of speech, and assembly – are values that might inhibit our ability to fight this virus. Ben Franklin once wrote, “Those who would give up essential liberty to purchase a little temporary safety, deserve neither liberty nor safety.” This tension between liberty and safety is the crux of our path forward. I can only hope decision makers can successfully balance these factors.
The unpredictable course of the virus is still likely to be the primary determinant of near-term economic and market results. The disparity of COVID-19’s impact from region to region and country to country is concerning. As of April 23, there has been over 11,000 deaths in New York City and only 21 in San Francisco. The US has had more than 50,000 deaths, while India, a country of 1.3 billion people, has claimed fewer than 700.
If current trends hold and some level of herd immunity muffles the pandemic sooner rather than later, the equity market’s optimism of the past few weeks will be, at least in part, justified. On the other hand, if some regions are reporting favorable statistics simply because they haven’t yet felt the full impact, that would significantly alter expectations. Developing countries are much less equipped to handle this pandemic than developed western countries. There is still so much that is unknown and given the lack of consensus even among experts, there seems little to be gained from speculation.
The past quarter has been such an unsettling time that it’s natural to wonder whether everything will be different going forward. I would focus instead on how many things will stay the same. At some point, the threat of the virus will recede and people will again go to a baseball game, enjoy a concert, and do many of the things they have always done. This will come in stages, but it will come.
Pitcairn Stands Firm for Our Clients
Although we are working separately, your Pitcairn team is as committed as ever to your well-being. I can’t remember any time when I have seen the Pitcairn team work harder than this past month. Apart, but in unison, we are considering all factors and all opportunities for the benefit of our clients and we believe the current posture of our portfolios is the proper one.
At Pitcairn, we consistently talk about the importance of having a long-term plan that makes sense, one that contemplates disruptions, perhaps not exactly like this, but recessions and downturns and market shocks. We believe such plans will succeed in spite of COVID-19. The right response is not to cast those plans aside, but to revise and reaffirm them, while always remembering that success in this endeavor comes from being the turtle in a very long race.
I have been a forecaster for a long time, and this is by far the most indeterminate period of my career. Under normal conditions, the future typically unfolds as a bell curve with some reasonable ability to evaluate likely outcomes. Now the curve is flat with a wide range of possibilities, many almost equally likely to happen. Given the unusually flat curve, we are discussing a number of potential actions, even some that would be rather unprecedented for Pitcairn. The entire investment team is projecting scenarios and planning responses for a wide range of possible circumstances.
We remain resolute in our belief that steady participation in the capital markets will protect and grow your assets over time. But, could there be a time to take more risk off the table than we normally might? A time to take more tactical actions? The nature of this historical moment requires us to be as open-minded as possible as we monitor how the pandemic evolves.
The current environment is truly the most uncertain – both socially and financially – that we will likely see in our lifetime. But, remember that the same cannot be said of our parents or grandparents. Americans born in the early 20th century persevered through two world wars, the Spanish Flu pandemic, the Great Depression, and the Cold War. Those who came before us have surmounted events of equal and even greater magnitude than what we face today. I am confident we will rise to this challenge. At Pitcairn, we have always been optimistic about the future and we believe better times are before us. We are working as hard as we ever have and we are here for you, advocating for your financial and personal well-being. We appreciate your support and we hope you will call us with whatever questions or concerns you have.