James Ragan, CFA, Director of Wealth Management Research
The week ended 3/6/20 was among the most volatile we can remember. While the S&P 500 ended the week with a 0.6% gain, the index rallied more than 4.0% on Monday (+4.6%) and Wednesday (+4.1%), only to lose most of those gains on Tuesday (-2.8%), Thursday (-3.3%), and Friday (-1.7%). Following Wednesday’s gain, the S&P 500 index had recovered about 40% of its 12.8% decline during the period between 2/19/20 to 2/28/20, but by Friday was testing the lows again. We are not surprised to see the market retest the 2/28/20 S&P 500 closing low of 2,954, as this is common in market corrections as investors search for a bottom. During trading on Friday, the S&P 500, at times, was substantially below 2,954, and the fact that the index rallied to close above that level was perhaps a positive sign. While the current equity market decline remains well within the range of six other market corrections since 2010 (current decline down 12.8% vs. average decline of 14.9%), we acknowledge the elevated fear levels that exist. Those fears are driven by U.S. economic uncertainty caused by the global coronavirus outbreak, which is gaining steam in countries outside of China.
While reported economic data in the U.S. continues to reflect relatively solid numbers through January and February (the labor department reported that nonfarm payrolls increased 273,000 in February, exceeding the 175,000 estimate), corporate commentary across multiple sectors suggests that economic activity has slowed significantly since late-February. We expect weakening data points to emerge in most categories (consumer spending, business investment, exports, and inventories) as March data is reported. On 3/3/20, the U.S. Federal Reserve held an unscheduled Federal Open Market Committee (FOMC) meeting to announce a 50 basis point (bp) reduction in its target overnight fed funds rate to a range of 1.00% to 1.25% from 1.50% to 1.75% prior. This action came two weeks prior to a regularly scheduled FOMC meeting on March 17th & 18th, and is a preemptive action that reflects a sense of urgency from the Fed. In a prepared statement the Fed said “the coronavirus poses evolving risks to economic activity.” Fed Chair Jerome Powell discussed signs that the virus, and measures taken to contain it, have already affected the tourism and travel industries, and other industries that rely on global supply chains. Clearly, the Fed action does nothing to stop the spread of coronavirus and the toll on human life around the world, but the Fed believes a lower interest rate policy will support accommodative financial conditions at a time when the financial market could tighten up, and also could help to sustain household and business confidence. We believe the Fed action will not prevent the near-term economic headwinds that are building, but will help boost and sustain the economic recovery when the virus outbreak begins to slow. We believe long-term investors with diversified portfolios of high quality companies will be rewarded for staying the course, and for adding to selected positions where there is opportunity. Of course, all investors should adhere to their investment plans, and long-term investors should continue to assume that market corrections are normal and can create volatile returns. Our S&P 500 fair value estimate remains 3,350, which is 12.7% above Friday’s closing price.
U.S. interest rates across the yield curve moved substantially lower over the past week and long-term rates fell to uncharted low levels. The U.S. 2-year Treasury yield closed at 0.52% on 3/6/20 (from 0.88% the prior week) and the 10-year Treasury yield was 0.77% (from 1.14%). This reflected an ongoing “flight to quality” as nervous investors rotated away from equities and into U.S. Treasury bonds and, more significantly, reflected investor concern that the economic disruption caused by the outbreak could be severe and require ongoing fed funds rate reductions. The success of ongoing Fed rate cuts could be less successful than in past economic downturns because interest rates are at very low levels already. Remarkably, the fed funds futures market is currently pricing in a 100% chance of an additional 50bp fed funds rate cut at the March FOMC meeting in two weeks (taking the target to 0.50% to 0.75%). The depth of the economic downturn ahead is extremely hard to predict, but could be severe for a short period of time. As the coronavirus containment visibility improves, we expect economic activity to resume and move back to normalized levels, which were somewhat better than expected to begin the year. In the short-term we believe the odds of a U.S. recession (six months of negative GDP growth) have increased, which is something we will be watching closely. We could see signs of Q1 weakness in business investment and inventories, with weakness accelerating in Q2; but, unless coronavirus remains uncontrolled in July and August, we expect economic activity to improve in the second half of 2020.
Predictably, as is common in times of fear, investors were increasingly defensive this past week. Not only were they aggressively buying Treasury bonds, but while the S&P 500 gained 0.6%, defensive sectors drove the gains, led by Utilities +7.9%, Consumer Staples +6.2%, Health Care +5.0%, and REITs +4.8%. We would expect these defensive groups to outperform while economic uncertainty remains high, but by year-end we expect cyclical sectors to outperform again.
Copyright D.A. Davidson & Co., 2019. All rights reserved. Member SIPC.
Important Disclosure: The information contained herein has been obtained by sources we consider reliable, but is not guaranteed and we are not soliciting any action based upon it. Any opinions expressed are based on our interpretation of data available to us at the time of the original publication of the report. Assumptions, opinions, and estimates constitute our judgment as of the date of this report and are subject to change without notice. Investors must bear in mind that inherent in investments are the risks of fluctuating prices and the uncertainties of dividends, rates of return and yield, as well as broader market and macroeconomic fluctuations and unforeseen changes in the fundamentals or business trends affecting the securities referred to in this report. Investors should also remember that past performance is not indicative of future performance and D.A. Davidson & Co. makes no guarantee, express or implied, as to future performance. The information is not intended to be used as the primary basis of investment decisions. Because of individual client requirements, it should not be construed as advice designed to meet the particular investment needs of any investor. It is not a representation by us, or an offer, or the solicitation of an offer, to sell or buy any security. Further, a security described in a report may not be eligible for solicitation in the states in which a client resides. D.A. Davidson & Co. does not provide tax advice and investors should consult with their tax professional before investing. Further information and elaboration is available upon request.
Market Indices: The information on indices is presented for illustrative purposes only and is not intended to imply the potential performance of any fund or investment. Indices provide a general source of information on how various market segments and types of investments have performed in the past. Index performance assumes the reinvestment of all distributions, but does not assume any transaction costs, taxes, management fees, or other expenses. You may not invest directly in an index. Past performance is not an indicator of future results. The Russell 2000® Index is a market cap weighted index that measures the performance of the 2,000 smallest companies in the Russell 3000® Index. The S&P 400 Index is a market cap weighted index comprised of U.S. stocks in the middle capitalization range, generally considered to be between $200 million and $5 billion in market value. The S&P 500 Index is a market cap weighted index that is designed to measure the US large-cap equity performance. The index is composed of the 500 leading publicly traded US companies based on size, liquidity, industry, and profitability criteria. The Dow Jones Industrial Average is a price weighted index that tracks 30 large, publicly-owned companies trading on the New York Stock Exchange (NYSE) and the NASDAQ. The MSCI EAFE® Index (Europe, Austral, Asia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the US and Canada. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. The Shanghai Stock Exchange Composite Index is a market composite comprised of all of the A-shares and B-shares that trade on the Shanghai Stock Exchange.