Having entered this business in the mid-1980s, I‘ve seen the ’87 Crash, the early ’90s savings and loan and real estate lending crisis, the bursting of the tech bubble, 9/11, the corporate malfeasance scandals of the early 2000s (remember Enron and WorldCom?) and, of course, the global financial crisis of 2008 – 09.
I thought I’d seen more than my share of “once-in-a-lifetime” happenings.
I was wrong.
Today, the world is under lockdown, more than 20 million Americans are registering as unemployed and economists are bracing for a rerun of the Great Depression. All markets have reacted to this extraordinary environment, adding yet more stress to the already nerve-racking health crisis we’re all experiencing.
Through March, the response to all of that was mostly damage limitation. At some point, we’ll need to think seriously about the long-term implications of multitrillion-dollar central bank balance sheets and fiscal deficits. But for the past couple of weeks, as the dust has settled a bit, we’ve engaged concertedly with our investment teams to think through our economic outlook for the next 12 to 18 months, and to gather their best ideas for the post-crisis recovery.
Given the level of uncertainty, we tried to envisage a wide range for our base-case, best-case and worst-case scenarios, and devise investment playbooks for each one.
In our base case, which we consider most likely, the world experiences a deep recession in the first half of 2020, followed by a recovery beginning in the latter part of the year that still leaves U.S. GDP down 6%, Europe’s down 8%, Japan’s down 3% and China’s up just 2%. That assumes a peak in U.S. COVID-19 cases during May/June and the U.S. starting, ever so slowly, to get back to work over the June/July period.
We also recognized a best-case scenario in which COVID-19 is more rapidly and successfully suppressed and fiscal support absorbs the worst of its impact, where the U.S. economy shrinks by 3%. In our worst-case outlook, new waves of infection confirm that a vaccine is the only way out of our lockdown, U.S. GDP finishes 2020 down 10% or more, and the global economy struggles to recover through 2021.
Even in our base case, we see the Federal Reserve holding short-term rates at zero at least through 2021, and central bank asset purchases in the trillions of dollars, focused on supporting high-grade credit markets and keeping rates low across the board. The dramatic and significant U.S. fiscal response will likely widen deficits to levels we last saw during World War II.
In response to the economic decline, we think companies will generally deleverage, cut investment and manage balance sheets very conservatively, possibly for years to come.
Low core bond yields make equity allocations crucial for most investors seeking to achieve their long-term return objectives, and in our view they may also result in higher valuations of future earnings. But the level of earnings is likely to be hit by business disruption, a lack of investment and higher corporate taxes.
In our base-case playbook, we therefore favor companies with strong balance sheets and durable earnings and dividends. Those looking for more growth might consider companies exposed to long-term themes that are being accelerated by the current crisis, such as 5G connectivity and e-commerce.
Given the overall uncertainty and wide range of outcomes, we think volatility could be elevated for a while. To capitalize on it, investors could explore strategies designed to capture the volatility risk premium.
Similar themes guide our base-case playbook for fixed income. Conservative balance sheet management is likely to favor bondholders in general. While there will likely be select opportunities in better-quality high yield, pockets of distress and illiquidity there mean that our main focus is on investment grade credit.
We also think current valuations make investment grade attractive even in our best-case scenario, and in the worst case, central banks appear ready and willing to support this market.
Dislocation and Distress
For once-in-a-generation market-dislocation and distressed opportunities, private markets look promising.
The private equity industry was fortunate to enter this crisis with a lot of uninvested dry powder. Many fundamentally sound smaller companies will likely need that cash to recapitalize and restructure for survival. We think some Limited Partners will need to raise liquidity or rebalance portfolios, so we would also be on the lookout for substantial opportunity in the private equity secondary market once it reopens.
In the meantime, distressed credit investors are already scouring for opportunities in the U.S. leveraged loan market, a quarter of which is now trading at distressed levels, and the junior tranches of collateralized loan obligations (CLOs).
Our playbooks for the best- and worse-case scenarios look different.
We think it’s unlikely anyone will regret holding investment grade credit or genuine market-dislocation opportunities, however events play out.
In our best-case scenario, there is a case for tilting toward opportunistic credit—including emerging markets debt, more high yield and CLO equity—and introducing more emerging markets, value and small-caps orientation into equity portfolios.
If our worst-case outlook materializes, a tilt toward uncorrelated strategies and core government bonds may be more appropriate.
Right now, the U.S. equity market in particular appears to be running ahead of even our best-case scenario. That’s why we believe now is a good time to think through possible scenarios and their probabilities, put together a playbook for each one, and stick to it—to avoid being whipsawed by volatile markets.
In our view, the most important thing is to be patient and trust that opportunities will persist. The entire global economy needs to restart in a way that is safe and orderly, and that’s unlikely to be either easy or quick. We may well see more “once-in-a-lifetime” events before this is all over.
Last week, Joe Amato, Erik Knutzen, Brad Tank and Tony Tutrone held a webinar to discuss scenarios and investment themes from the recovery Playbook. You can listen to the replay here.
In Case You Missed It
- U.S. Retail Sales: -8.7% in March
- NAHB Housing Market Index: -42 to 30 in April
- U.S. Initial Jobless Claims: +5,245,000 in the week ending April 11
- U.S. Housing Starts: 1.22 million units in March, a SAAR of -22.3%
- U.S. Building Permits: 1.35 million units in March, a SAAR of -6.8%
- China 1Q 2020 GDP: -6.8% year-on-year
What to Watch For
- Tuesday, April 21:
- U.S. Existing Home Sales
- Wednesday, April 22:
- Japan Purchasing Managers’ Index
- Thursday, April 23:
- Euro Zone Purchasing Managers’ Index
- U.S. Initial Jobless Claims
- U.S. New Home Sales
- Japan Consumer Price Index
- Friday, April 24:
- U.S. Durable Goods Orders
Statistics on the Current State of the Market – as of April 17, 2020
|S&P 500 Index||3.1%||11.3%||-10.5%|
|Russell 1000 Index||3.0%||11.4%||-11.2%|
|Russell 1000 Growth Index||5.3%||12.5%||-3.3%|
|Russell 1000 Value Index||0.2%||9.9%||-19.5%|
|Russell 2000 Index||-1.4%||6.6%||-26.0%|
|MSCI World Index||2.3%||9.0%||-13.8%|
|MSCI EAFE Index||0.8%||4.1%||-19.6%|
|MSCI Emerging Markets Index||1.5%||6.3%||-18.7%|
|STOXX Europe 600||0.1%||3.4%||-21.7%|
|FTSE 100 Index||-0.9%||1.8%||-22.5%|
|CSI 300 Index||1.9%||4.2%||-6.3%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.0%||0.0%||2.8%|
|Citigroup 10-Year Treasury Index||0.6%||0.4%||12.2%|
|Bloomberg Barclays Municipal Bond Index||0.5%||0.5%||-0.2%|
|Bloomberg Barclays US Aggregate Bond Index||0.7%||1.5%||4.7%|
|Bloomberg Barclays Global Aggregate Index||0.6%||1.0%||0.7%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||1.2%||4.7%||-5.6%|
|ICE BofAML U.S. High Yield Index||2.6%||5.4%||-8.5%|
|ICE BofAML Global High Yield Index||2.5%||5.3%||-9.6%|
|JP Morgan EMBI Global Diversified Index||0.7%||2.3%||-11.4%|
|JP Morgan GBI-EM Global Diversified Index||0.3%||2.2%||-13.3%|
|U.S. Dollar per British Pounds||0.3%||0.8%||-5.6%|
|U.S. Dollar per Euro||-0.5%||-0.8%||-3.0%|
|U.S. Dollar per Japanese Yen||0.9%||0.4%||1.1%|
|Real & Alternative Assets|
|Alerian MLP Index||10.0%||22.7%||-47.5%|
|FTSE EPRA/NAREIT North America Index||-5.0%||6.7%||-24.5%|
|FTSE EPRA/NAREIT Global Index||-2.9%||5.0%||-24.8%|
|Bloomberg Commodity Index||-2.2%||0.4%||-23.0%|
|Gold (NYM $/ozt) Continuous Future||-3.1%||6.4%||11.5%|
|Crude Oil WTI (NYM $/bbl) Continuous Future||10.0%||22.2%||-59.0%|
Source: FactSet, Neuberger Berman.