Q2 market update: Recession and bear market
The global response to COVID-19 pushed the economy into recession.
The growing scope of the clampdown on normal activity suggests it’s too soon to forecast the slowdown’s length, but we expect the eventual recovery to be gradual.
The consensus expectation among Fidelity analysts is that the biggest economic effect from COVID-19 will be a negative demand shock, with supply-chain issues and lower demand likely to weigh on profits.
We also expect the shock from COVID-19 to place significant downward pressure on near-term inflation trends.
Longer term, we believe the global regime of investment-friendly policies, politics, and regulation is nearing an end, driven largely by populism, geopolitical destabilization, and de-globalization pressures.
In March, the clampdown response to COVID-19 plunged the world into recession and financial markets into a broad-based drawdown. A historically rapid and expansive US monetary and fiscal policy response helped mitigate the most acute near-term liquidity issues and should provide a partial offset to the economic damage. Uncertainty and volatility are likely to remain high, thus a more cautious near-term portfolio tilt, without any significant asset class tilt, may be warranted.
The US stock market entered bear-market territory less than a month after hitting an all-time high, and equity markets around the world sold off aggressively. Government bonds benefited as safe-haven assets, but almost all asset categories suffered amid a liquidity crunch in March. Riskier credit bonds saw a dramatic reversal from previously tight spreads, and commodity prices declined sharply alongside global demand.
Economy/macro backdrop: From mature business cycle to global recession
As COVID-19 and government-ordered shutdowns proliferated throughout the world, a mostly late-cycle global economy descended swiftly into recession. While the spread’s progression was not uniform, drastic restrictions on travel and other activities reinforced the global nature of the downturn. The onset of US recession began in March; meanwhile, China’s economy showed some signs of bottoming, albeit at still contractionary levels.
Record-low unemployment reversed abruptly, as new unemployment claims surged to historic highs. Industries most directly and immediately impacted—such as travel, leisure, restaurants, and hotels—account for a significant portion of US output and employment. The growing scope of the clampdown on normal activity suggests it’s too soon to forecast the slowdown’s length, but we expect the eventual recovery to be gradual.
Entering March, corporate profit growth already was in a downward, late-cycle trend due to rising margin pressure. The consensus expectation among Fidelity equity and fixed-income analysts is that the biggest economic effect from COVID-19 will be a negative demand shock, with the combination of supply-chain issues and lower demand likely to weigh heavily on profits. The virus-related impact began showing up in downgrades to Q2 earnings expectations, but we believe the shock to profit growth is likely to be deeper than anticipated for 2020 overall. Lower revenues will limit share buybacks, which in recent years have provided a healthy boost to EPS growth.
We also expect the shock from COVID-19 to place significant downward pressure on near-term inflation trends. A majority of purchasing managers across several regional surveys reported receiving weaker prices in March. Amid the global demand shock and increased supply from Saudi Arabia, oil prices posted their steepest quarterly declines on record.
In the decade prior to recession, easy global monetary policies helped generate lower volatility, higher demand for bonds, and lower bond yields. This in turn encouraged a substantial increase in the issuance of global corporate debt, particularly in lower-quality US corporate credit. Foreign borrowers, including many emerging markets (EM) countries, took advantage of low-rate US dollar financing, exposing themselves to currency fluctuations, changes in Fed policy, and the dollar liquidity shortage that grew more severe during Q1.
Policymakers initiated unprecedented support to the financial markets and economy. Global central banks engaged in significant monetary accommodation in Q1, implementing policy rate cuts, forward guidance, and large expansions of quantitative easing. The US Federal Reserve’s balance sheet increased by more than $1 trillion in March, fueled by purchases of Treasurys and repo, plus a commitment to support mortgage and credit markets. Meanwhile, new US virus-relief legislation provides more than $2 trillion of fiscal support to health care relief efforts, households, and businesses.
On a longer-term basis, we believe the longstanding global regime of relatively stable and investment-friendly policies, politics, and regulation is nearing an end, driven largely by rising populism, geopolitical destabilization, and de-globalization pressures. We expect greater government intervention may inhibit corporate profitability, distort market signals, and lead to higher political risk in investment decisions throughout the world. For instance, countries, industries, and companies that have benefited the most from a rules-based global order may face risks from geopolitical shifts and domestic political pressures in many advanced economies.
Asset markets: Significant and widespread declines
Almost all asset categories logged sizable losses during Q1, with equities suffering significant drawdowns across styles, sectors, regions, and factors. Treasurys and other high-quality bond categories, in addition to gold, were among the few to post a positive result. On a relative basis, small-cap, value, and energy stocks suffered the worst losses among equity segments, and riskier credit categories were the fixed-income laggards.
Earnings growth across all regions continued to slide during Q1, with trailing profit growth in US, developed markets (DM), and EM markets all in contractionary territory. Forward estimates pointed to market expectations of a rebound in earnings growth over the next 12 months, but those expectations may be difficult to achieve given the damage to the global economy still underway.
Cyclically adjusted price-to-earnings (CAPE) ratios for international developed- and emerging-market equities fell further below US valuations, providing a relatively favorable long-term backdrop for non-US stocks. In Q1, the US dollar appreciated against many of the world’s major currencies, causing US dollar valuations to grow relatively more expensive, which also favors the valuation of non-US financial assets.
In fixed income, Fed rate cuts and a steep drop in inflation expectations weighed heavily on interest rates, with US 10-year Treasury yields settling below 1% for the first time in their more than 150-year history. Weakening credit fundamentals and poor liquidity conditions caused credit spreads for both US investment-grade and high-yield corporate debt to widen to their highest decile, a dramatic reversal from the far below-average spreads seen at the start of 2020.
Inflationary pressures often recede during recessions, and our near-term outlook is for inflation rates to drop. However, market expectations for inflation (represented by breakeven rates for Treasury Inflation-Protected Securities or TIPS) are lower than averages observed during past recessions and remain at the lower end of their decade-long range, suggesting inflation protection is relatively inexpensive.
The business cycle can be a critical determinant of asset performance over the intermediate term. Stocks have consistently performed better earlier in the cycle, whereas bonds tend to outperform during recession. While we believe a business cycle approach to actively managed asset allocation can add value, portfolio returns are expected to even out over the long term (>10 years), regardless of the starting point of the cycle phase. The important thing to remember is that timing the market can be difficult or impossible. Regardless of an investor’s starting point relative to the business cycle, period returns generally even out over time so it can make sense to stick to a long-term plan.