Stay informed on the novel Coronavirus (Covid-19)

March 31, 2020

Head—Bernstein Private Wealth Management

The Sum of All Fears

We’re living in extraordinary times where no single historical analog—whether among natural disasters, financial crises, or even war—seem to apply. In some ways, they all do. And while near-term predictions about anything right now must be approached with great humility, it seems likely that we are nearing a peak in the uncertainty that’s currently gripping the globe. No matter what we learn from here, knowing more will help calibrate what’s already happened against what lies ahead.

Everyone will be touched by COVID-19 in some way. Our hearts go out to the victims of the virus and their families, and the many more who are enduring extreme hardship, economic and otherwise, due to measures in place to fight the pandemic. At the same time, it’s impossible to express enough gratitude to healthcare professionals who are putting public good ahead of their own, and others working selflessly to keep food and other essentials available. Talk about perspective.

We’re also mindful of the anxiety that the steep declines in asset prices evokes. As much as we plan and prepare for episodes of volatility in designing and implementing long-term investment strategies, they are never easy to endure. With the caveat of recognizing what we don’t know in the short term, I’ll share perspective on what happened, what’s implied in current market prices, and some optimism looking forward.

Wither Liquidity?

The most stunning characteristic of the recent market sell-off was its speed and the impact on trading liquidity. The unprecedented velocity with which risk assets like stocks and credit-related securities fell from all-time highs in February was driven by broad underestimation of the economic impact of COVID-19 at the time. But the structure of markets also played a role. It explains why US Treasuries and municipal bonds, which usually perform well amid uncertainty, also declined on days of extreme pressure.

Since the Great Financial Crisis, trading in traditional assets like stocks and bonds has changed dramatically. A combination of stricter bank capital rules, fragmentation of exchanges, and proliferation of automated trading strategies (among other things), have combined to reduce the amount of capital available to support markets in distress—and have even contributed to it. Add to that the use of leverage. Margin calls can quickly make a bad situation worse by forcing price-indiscriminate selling by indebted investors desperate to raise cash. These changes are evidenced by the episodic bouts of selling we’ve seen not only this year but several times over the last decade, most recently at the end of 2018.

What should a long-term investor make of this? One important takeaway is that some markets, which are assumed to be liquid because their underlying securities’ price in real time, are a lot less so in reality, at least at times when access to capital is most prized. The first implication is that—despite rock-bottom rates and little prospect for return—cash will continue to be viewed as the ultimate liquid asset, maybe more so (Display 1). We find that having enough of it on hand to meet spending and capital requirements for 6–12 months, or access to a reliable line of credit, works well for most people.

Net Flows into Cash Investment Products Surged in March

The second implication of reduced liquidity in public markets is that investors who previously shied away from locking up capital in less liquid asset classes might, ironically, reconsider. For example, history shows a long-term return premium greater than 3% for private equity over public equities,[1] implicitly compensating investors for illiquidity. Of course, private companies are no more immune to the challenges of slowing economic growth than those that are publicly traded. But the control position that owners of private assets often have confers an advantage in working through difficult times compared to minority owners of public shares who lack a voice. An added benefit is that predetermined liquidity windows can save people from themselves when it comes to emotion-driven trading, and instead reinforce appropriate investment time horizons for growth-oriented assets.

What’s Priced In?

Given where markets currently stand, are they discounting too much or not enough of the unfolding financial pain around the world? The answer depends on the length of the shutdown and its effects on various industries. Still unknown are the impact of containment efforts aimed at slowing case rates as well as progress identifying an effective antiviral drug. We also need to see how central bank asset purchase programs improve liquidity in markets struggling with price discovery, and the effectiveness of fiscal spending programs to provide bridge support to workers and businesses who have been involuntarily idled.

While COVID-19 is clearly a global issue, looking at the impact to the US economy is instructive given its size and importance. Consensus estimates incorporating what we believe are realistic declines in industry-specific activity lasting three months imply a decline in US GDP of 20%–30% in the second quarter. With credit for two positive months in the first quarter and some recovery in the second half of the year, overall GDP decline for 2020 would be lower, in the range of negative 2% (Display 2).

Estimates for Q2 GDP Vary Widley but Are Generally Expected to Be Between Zero to Down 5% for the Year

How does this compare to the stock market? US GDP was just over $21 trillion in 2019 and lost output implied by the lowest consensus estimate for the year equates to roughly $1.5 trillion. At its peak in mid-February, the capitalization of publicly traded US stocks stood at roughly $35 trillion.[2] With some 35% of value, or $12 trillion, erased near the lows of March, the market sold off about 8x more than low-case lost GDP. To be sure, a lot is still unknown, and there is a difference between the output that GDP measures and corporate earnings on which stock values are based. But this gives a rough sense of how stocks have compensated for the initially slow recognition for what COVID-19 would mean for the economy and markets.

Where to from Here?

No long-term model has ever built in an assumption for a near complete shutdown of global economic activity. But our Capital Markets Engine asset return forecasting tool does anticipate drawdowns of the magnitude we’ve just experienced. For example, our analysis prior to the current period assigned a 1 in 3 probability of a peak-to-trough loss of 20% for a balanced mix of stocks and bonds occurring in a 20-year time period (Display 3). The same methodology predicted greater than a 1 in 6 chance every 10 years.

Volatility Similar to the March 2020 Experience is Embedded in Our Long-Term Capital Markets Forecast

Before the virus-induced shock, our outlook called for a continuation of below-average (but nevertheless positive) economic growth of around 2%. This forecast was based on the combination of low interest rates and accommodative financial conditions, combined with weak capital spending that yielded little in the way of late-cycle excess. It’s difficult to say how quickly the economy can recover even once we know when activity can restart. But the fact that consumer income and balance sheets were solid going in, and supply chains were set to recover from last year’s trade standoff, reassures us that it ultimately will. Normal will never be the same—hopefully in some good ways—and we are ever mindful that future growth will also be affected by ongoing trends in nationalism and the erosion of global institutions that seem likely to persist.

Looking back at returns on a five-year rolling basis shows that while stock and bond gains for the current period have been reduced substantially, this is not unusual given market volatility and the above-average gains that tend to follow (Display 4). At times like these, having a goal-oriented plan with an appropriate horizon is more important than ever. There will be a time to recalibrate and review risk and return trade-offs, along with liquidity needs, but for now we strongly advocate staying the course. Rebalancing and tax-loss harvesting aside, the only thing that should change a long-term asset allocation is a change in the asset owner’s long-term plan. History shows that timing markets is futile (and expensive) and while there are still a lot of unknowns at the moment, that’s one prediction that’s always a sure thing.

Progress Never Follows a Straight Line - Trailing 5-year Returns Are Typically Volatile

On behalf of everyone at Bernstein, I want to extend my sincere appreciation for your trust during these difficult times. We know now is when we earn the right to continue to serve you and I am confident our team is up to the challenge. And a challenge it is. It has been two weeks since we moved our operations to remote locations with the wellness of our people and communities in mind. I’m proud to say our staff and technology have risen to the occasion such that we have been able to work efficiently and securely without compromising any of our services. In many ways, especially around culture, community, and communication, we’ve never been stronger.

Here's to better days ahead, and to the health and safety of you and yours.

David Barnard Signature

David Barnard

[1] Bain & Company, Global Private Equity Report 2020.
[2] Wilshire 5000 Total Stock Market Index.

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