The spread of COVID-19 has become a heartbreaking public health crisis, and fear of its impact has overwhelmed financial assets. These dynamics have produced levels of volatility not seen since 2008 and sharp losses across markets. In this research note, we seek to provide a broader context for returns through dislocations while assessing new risks, potential for further economic fallout, and the oncoming opportunity set as stimulus flows through the financial system.
While uncertainty is a regular feature of markets, there are times it can manifest itself in a fear of the unknown that underpins all-out deleveraging. Under such stressed conditions, asset price relationships become disconnected from their long-term drivers. In recent weeks, fear of uncertain outcomes from the spread of the COVID-19 virus drove intense selling pressure across financial assets which led many markets to their worst monthly losses since 2008.
Return Environment
Key Takeaways
- Many markets had their worst month since 2008 amidst a sharp and widespread deleveraging
- The sell-off was supported by concerns over the spread of COVID-19 and the oncoming major disruption in economic activity
Negative results across fixed income markets were considerable in March, as frenzied selling occurred almost indiscriminately. Amidst this turbulence, a lone safe haven was found in US Treasuries, but even these markets suffered in the mid-month deleveraging prior to recovering over the final two weeks.
Fixed Income Market Returns: March 2020
Source: Bloomberg, see notes for indexes & definitions
In this context, previously compressed levels of volatility spiked, and many fixed income sectors experienced some of their worst days on record. Without Fed assistance, liquidity conditions became stressed in the widespread flight to cash as the reduced balance sheets of traditional market-makers proved ineffective at absorbing the market shock.
The economic outlook has suffered a serious impairment as a result of the pandemic, and the returns of corporate assets particularly reflect this. The risk of default increased rapidly for many issuers, and equity markets crashing as much as -35% from their peak on February 19 offers a useful lens through which the performance of corporate credit can be evaluated. Impacts on sovereign debt, TIPS, and municipal bonds were less direct but nonetheless resulted in market stress
These dislocations, while deep, are not without precedent, and history provides a useful framework for assessing them and their potential outcomes.
Review of Market Disclocations
Key Takeaways
- The current dislocation is larger than recent episodes but has not reached the scale of 2008
- While every situation is different, fixed income markets have been resilient in previous years following significant sell-offs
Market dislocations stemming from COVID-19 have led to significant short-term pain for investors. Things can certainly get worse before they get better – particularly with unknowns like the spread of a virus – but looking at historical dislocations can offer useful perspective for long-term investors. While drawdowns in the past have been challenging, economic activity ultimately returns and markets recover.
To put context around March’s declines, we examined dislocations starting in 2008 and their ensuing recoveries for fixed income markets. While none of these scenarios represent a virus-specific sell-off, they offer a window into how these markets respond following a range of disruptions.
Prior Market Dislocations & 12-Month Forward Returns
Source: Bloomberg, see notes for indexes & definitions
The 2008 financial crisis produced the deepest dislocations, as house price declines, weak lending standards and excess leverage led to a breakdown of the financial system. The oil market crash that combined with China selling Treasuries over the second half of 2015 represents a less substantial disruption but remains relevant given current pressures as Russia and Saudi Arabia engage in an oil price war. And the fourth quarter of 2018 offers a prelude to the current market scenario, whereby volatility and uncertainty spiked, pushing stocks within a few points of a bear market as the US economy entered its tenth straight year of expansion.
While no two market sell-offs feature the exact same dynamics, the twelve months following each of these dislocations offer guidance on the potential trajectory of markets coming out of stressed conditions. Fixed income markets have historically been resilient across a multitude of scenarios, and we have no reason to believe this won’t be the case again once stimulus measures take hold and the economy stabilizes following the current pandemic.
Current Market Environment & Opportunity Set
Key Takeaways
- The economic shutdown is extraordinary, has significantly increased default risk, and could result in another leg down for markets if measures prove ineffective
- For long-term investors, however, dislocations resulting from these conditions offer a significantly expanded opportunity set for investment decisions based on the relative attractiveness of assets
- We believe using a balanced suite of factors to monetize this opportunity set is a prudent approach
Considering the increasing infections amidst a profound disruption in people’s daily lives across the globe, we may not yet be out of the woods when it comes to how markets price the effects of the COVID-19 virus. The catastrophic loss of human life will have a lasting impact on the world, and there remain significant risks on the horizon related to second waves and unforeseen frictions in restarting the global economy.
With that being said, the serial dislocations resulting from these conditions and overwhelming selling pressures have also been profound. Spreads to Treasuries have widened across markets to levels not seen since 2008 and provide a significantly expanded opportunity set to make investment decisions based on the relative attractiveness of assets. Combining time-tested factors of carry, value, and momentum can provide investors with a logical framework as they seek to capture excess returns between markets recalibrating to a new economic reality.
As historic amounts of stimulus begin to flow through the financial system, we expect differences in how assets have been impacted to become clearer with unequal outcomes across markets. In this environment, we believe factor-based investment processes that are driven by data and avoid directional risks will hold a significant advantage.
INDEXES:
10yr US Treasuries represented by the Bloomberg Barclays US Treasury 7-10 Year Index. TIPS represented by the Bloomberg Barclays US Treasury Inflation Notes Index. Municipal Bonds represented by the Bloomberg Barclays Municipal Bond Index. Emerging Market Debt represented by the Bloomberg Barclays EM USD Aggregate Index. High Yield Credit represented by the Bloomberg Barclays US Corporate High Yield Index. Bank Loans represented by the S&P/LSTA Leveraged Loan Index. Convertible Bonds represented by the Bloomberg Barclays US Convertibles Composite Index.
DEFINITIONS:
Financial Crisis: Dislocation 12/31/2007 - 12/31/2008, Forward Return 12/31/2008 - 12/31/2009
2H 2015: Dislocation 7/31/2015 - 1/31/2016, Forward Return 1/31/2016 - 1/31/2017
Q4 2018: Dislocation 9/30/2018 - 12/31/2018, Forward Return 12/31/2018 - 12/31/2019
***