Back to the Future: Leaning In During Uncertain TimesJuly 10, 2020

by Andy Connerof Asset Strategy Consultants

Across every single industry, the pandemic has caused a significant shift in how people work and interact every day withothers. Teams find themselves working remotely and collaborating virtually, with teleconferencing, video chats andelectronic meeting materials becoming our new operating standards.

Against the backdrop of this new reality, and as most people are doing these days, I found myself browsing through Netflix.That’s when I noticed that the classic Robert Zemeckis movie, Back to the Future, was one of the trending titles. This mademe think: what if we could travel back in time, not even as far back as 1955, but rather to January 1 of this year?

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The world seemed entirely different back then.

2019 had just closed with a 31 percent return on U.S. equities, marking a decade that saw 13.5 percent returns per year.The economy had grown steadily at 2.3 percent, and the unemployment rate was at a historic low of 3.6 percent. Escalatingtensions between the U.S. and Iran, and the beginnings of the Senate impeachment trial dominated headlines, so it mayhave been easy to miss the first stories of a novel coronavirus spreading in the Hubei province of China. Perhaps youthought COVID-19 would be like other outbreaks, like SARS or H1N1, which were concerning, but ultimately contained.

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If you were able to go back to January 1, 2020, and find your slightly-younger self, you may have shared one key piece ofinformation: the world will not be prepared for what is to come. Over 448,000 lives will be lost globally to the coronavirus.Businesses, schools, government agencies, and religious and cultural centers will be closed, with individuals told to stay athome to reduce the risk of infection. The unemployment rate in the U.S. will skyrocket to 14.7 percent in April, and the Fedwill cut interest rates to nearly zero. Congress will pass rescue funding and stimulus measures totaling over $5 trillion, andthe real GDP will fall -4.8 percent annualized in the first quarter.

And what about the stock market? Your future self will share that the S&P 500 index will be down -5 percent through May31, 2020. But how is that possible? During the 2008 financial crisis, the GDP contracted -8.4 percent annualized in thefourth quarter of 2008, which represented the largest drop since World War II. Unemployment was at 10 percent in Octoberof 2009, and the S&P 500 fell by over -50 percent. During the Great Depression, the GDP contracted by -26 percent, theunemployment rate was nearly 25 percent, and the S&P 500 declined over -80 percent.

So, given the state of the world during the 2020 pandemic, you would think that the market would be down far more thanjust -5 percent. In fact, the market was down -35 percent from its intraday peak on February 19 to its intraday low on March23. The market does historically bottom well before the economy reaches its lowest point. When the market low came inMarch of 2009, the economy grew again in the third quarter of that year. But the swiftness of this current rebound defiesexpectations.

Could the market have gotten ahead of itself? Or maybe it knows something we do not and has priced-in a quick reopeningof the economy and recovery in earnings. The Fed did intervene to help stabilize markets, with actions that included alandmark program that had the central bank buying U.S.-listed ETFs that invest in corporate bonds for the first time ever. InJune, the Fed also announced that it would buy corporate bonds as well, which immediately boosted the Dow JonesIndustrial Average to a nearly 800-point gain at the open of the day after the announcement. However, these interventionsby the Fed still do not fully explain how the equity markets rebounded so quickly. Whatever the reason, the upside anddownside prospects in equity beta are not as compelling as some of the other alternatives. Thankfully, portfolios with asignificant equity exposure have returned to relatively healthy shape.

The equity markets have guided the recovery in risk assets. While other asset classes have rebounded off their lows, thereare still opportunities in other areas. As a rule of thumb, the more illiquid the opportunity, the more attractive it is, becausethat removes the opportunity from the liquidity poured into the system by the Fed and by fiscal policy.

You can see this with high yield spreads, which reached 1,100 basis points (bps) in late March and fell to 585 bps. This isstill nearly 230 bps wider than at the beginning of the year. These elevated spreads have often foreshadowed attractivereturns in the future. At the same time, there is a belief that a full credit cycle with accompanying defaults and distressedopportunities is on its way. Managers who have the chance to move through the cycle should find opportunities in stressedand distressed bonds and loans, structured credit, non-performing loans, and restructurings.

There are many other opportunities. These include:

Small caps were down significantly more than large caps in the first quarterInternational equities, which have lower valuations than domestic equitiesValue equities, whose spread versus growth is historically highEmerging markets value are the cheapest asset class right nowDirect lending and real estate, should benefit from a general re-pricing of risk and reduction in credit availability

It may be challenging to think about “leaning in” at a time when the state of the economy still feels uncertain, but it may beadvantageous right now to move portions of a portfolio out of domestic long-only equities, which have rebounded strongly,and into other areas where there is more room to grow.

Andy Conner is a Principal and Chief Investment Officer at Asset Strategy Consultants.

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