What a difference a year makes. It’s hard to believe that an entire year has passed since March 2020, when the COVID-19 crisis set off a global panic and upended financial markets. Much has changed since then, with the actions of governments around the world and the distribution of vaccines helping to make way for brighter days. Let’s look back on this unprecedented year, discuss all that has changed and reflect on lessons learned for investors.
Markets Are Forward-Looking
A year ago, the COVID-19-induced lockdowns ended a nearly 11-year economic expansion and set the stage for the shortest U.S. recession in history. The U.S. economy declined 31% in the second quarter of 2020, manufacturing activity plummeted to a historically low level of 41.7 (below 50 marks contraction) and the unemployment rate surged to 14.8%. Meanwhile, all of the major equity indexes entered bear market territory (down over 20%) in March 2020, with the S&P 500 bottoming on March 23. Today, the financial markets and the economy have vastly improved (see Exhibit 1).
Exhibit 1: Then vs. Now
Even as uncertainty around the pandemic prevailed, stocks quickly rebounded from their waterfall decline. The S&P 500 delivered its fastest recovery from bear market territory in history, reaching its previous peak –– which was set on February 19, 2020 –– on August 18, 2020. However, at this time, parts of the economy were still struggling. For instance, weekly jobless claims had just dropped below 1 million for the first time since the crisis began, demonstrating that labor market healing still had a long way to go.
This confused many investors as the markets seemed to be moving upward even as there were few clear signs that the pandemic would end. There is good reason for this: Markets are forward-looking and attempt to discount nine, 12 or even 18 months into the future. Very early on in the pandemic, equity markets signaled that better days would lie ahead. Perhaps they anticipated that the swift fiscal and monetary stimulus response from central banks and governments around the world would be enough to help bridge us to the other side of the pandemic without serious economic malaise. Perhaps they were banking on the development of a vaccine. Perhaps it was a combination of both.
Equity markets were also quick to discount those companies that would not only survive the pandemic, but thrive and deliver growth in a COVID-19 environment. As such, companies tied to work from home, shop from home and telemedicine quickly appreciated. Conversely, companies that were more closely tied to the growth of the overall economy struggled. Whatever the reason, equity markets deserve an amazing amount of credit for their ability to predict that better times would be coming, perhaps faster than most of us believed at the time.
Our advice to clients during the uncertainty of last March was that the equity markets potentially offered “a much better entry point than exit point.” Investors who rebalanced and leaned in were the recipients of strong returns last year.
The stock market’s ability to predict economic outcomes was also one of the factors that formed our Investment Strategy Committee’s decision in August 2020 to continue to lean into more cyclical-oriented parts of the stock market in anticipation of an even broader economic recovery. While patience is often needed to allow a full economic cycle to play out, it is important to remember that the best investment decisions are often made when things are still partly cloudy. The stock market’s predictive power to see sunny days ahead was certainly prevalent during most of this pandemic.
Don't Let Emotion Guide Investment Decisions
One of the best ways to gauge fear in the market is the Chicago Board Options Exchange’s Volatility Index, better known as the VIX. History teaches us that when the VIX — often referred to as the “fear index” — moves significantly higher into a spike formation, equities should be bought, not sold.
When the VIX spiked to a closing all-time high on March 16, 2020, we advised investors to go against their emotion of fleeing the market and instead play offense. We recommended they rebalance their portfolios by increasing exposure to higher quality equities (sell international, buy domestic) in order to take full advantage of the lower prices offered by the market. This decision proved to be a prudent, real-time investment decision that was well rewarded as markets quickly recovered.
Bonds Remain an Important Diversifier
Amid the pandemic, investors turned to the perceived safety of government bonds, pushing yields around the globe to their lowest levels in history. The U.S. Treasury 10-year note hit a low of 0.76% last March, while yields around the world moved deeper into negative territory. The uncertainty also caused a widening of credit spreads as investors demanded an additional premium for holding bonds deemed riskier than higher quality U.S. Treasuries. High-yield credit spreads spiked to 1,087 basis points over Treasury bonds of similar maturity on March 23, 2020. This caused the price of lower-quality corporate bonds to plummet given the expectations that many of these companies would not be able to make it through to the other side of the pandemic.
During times of great uncertainty or economic stress, high-quality bonds are, by far, one of the most reliable diversifiers to stock market volatility because they perform well when the economic picture darkens. But the reverse is also true: High-quality bonds can underperform when an economy recovers. Yields on high-quality government bonds have steadily moved off the lows of last spring but that pace has accelerated of late. The recent move higher in intermediate- and long-term interest rates is the result of positive news on the vaccine as well as a robust stimulus package out of Washington, both of which have the potential to reinvigorate the economy in the second half of 2021. Simultaneously, high-yield spreads have declined in anticipation of stronger growth and are now sitting at levels not seen since the pandemic began.
Of course, with the improved economic outlook, fixed income performance has been challenged lately. But we continue to believe that bonds remain an important diversifier that can help buffer equity market volatility. We are currently recommending an underweight to bonds, especially to U.S. Treasuries, within a well-diversified portfolio in light of a move higher in interest rates as the economy strengthens and inflation expectations rise modestly. Exposure to high-yield bonds and even emerging market debt should also be incorporated as they tend to hold up relatively well even as the global economy expands.
Positioning for What's Ahead
While history lessons are always informative, the real question is where we go from here and how client portfolios should be positioned for the next 12 to 18 months. Although the second year off market bottoms tends not to be as rewarding as the first, the S&P 500 has historically delivered an average return of 12% during this time. Clearly the return potential is not as significant as we saw last year, but we believe there are opportunities, just in different investments than those that led us out of the depths of the economic trough of the COVID-19 crisis.
In our view, cyclical indexes such as U.S. small caps and emerging markets, as well as an emphasis on value, will serve investors well in the quarters that lie ahead. We began positioning portfolios for a reopening trade starting in the summer of 2020 and have continued this process in January and March of this year, with portfolio repositioning in each of those periods.
The COVID-19 pandemic has offered lessons across the disciplines of science, human behavior, policy and investing. The investing lessons are fundamental long-term investment principles that tend to repeat themselves in some form during each investment cycle: equity markets are discounting mechanism; don’t let your emotions make investment decisions; diversify with bonds and listen to the message of the market, even if it goes against current headlines. With history as a guide, we listened to what stocks were signaling, analyzed economic data and removed the emotion from our investment decisions when helping our clients navigate the treacherous waters of 2020. As we move to brighter days, we’ll remember our experiences from the past year and continue to apply these lessons to navigate whatever may lie ahead.