• The economy is facing what might turn out to be the worst downturn since shortly after WWII, but the Federal Reserve and government are using all policy levers to soften the blow.
• This is a multi-pronged challenge – a correction in valuations, a liquidity squeeze, a collapse in energy prices, and an upturn in defaults stemming from high corporate leverage and COVID-specific shocks.
• Uncertainty is exceptionally high, placing a premium on a strong framework for assessing new information. 

Risk off!

Last quarter, we wondered whether the market had gotten ahead of itself.  While we knew that good times were destined to end, we couldn’t identify the catalyst.  It’s now clear that the COVID-19 pandemic will end the record U.S. economic expansion.  Draconian public health measures focused on social distancing are bringing the economy to a standstill.  The U.S. is not alone, and we are entering a synchronized, global downturn.  The decline looks big, uncertain, and skewed to the downside, prompting an epic policy response.  Investors were positioned for a more conventional end to the extended business cycle with corporate credit suffering the most.  Outside of particularly vulnerable industries (travel, for example), the pandemic is especially daunting for the consumer and certain areas within commercial real estate, most notably retail and hotels.  This adds new fears about two segments that looked well positioned at the beginning of the year.  Given the severity of the economic disruption, few sectors are immune to the impacts of COVID-19 with large portions of the global economy (individuals and corporate borrowers) requiring additional liquidity to bridge the gap.

The resulting inability to box in the potential economic downside drove extreme market volatility in the quarter.  The Dow experienced its second biggest daily drop ever in mid-March.  The 20-day moving average of the Volatility Index (VIX) reached 60, rivaling the volatility we saw in 2008 at the height of the global financial crisis (the GFC).   After stellar performance through mid-February, almost all markets except government bonds declined precipitously.  Stocks were down 20-35% for the quarter, commodities fell almost 35%, and credit was hit especially hard.  High grade credit spreads rose by 179 basis points (bps), peaking at +373bps before rallying back to +272bps at quarter end.  Investment grade bonds produced excess returns of -13.50%, easily the worst quarterly result on record.  The spread on the high-yield index ended the quarter at 880bps, up 544bps, to yield 9.44%.  The treasury market went on a wild ride, with the 10-year treasury yield falling from 1.92% at year-end to only 0.67% at the end of the quarter.  At times, treasury bills have been bid to negative yields. 

Policymakers recognize that this is a multi-pronged challenge – a correction in valuations, a liquidity squeeze, a collapse in energy prices, and an upturn  in defaults stemming from cyclically high corporate leverage and COVID-specific shocks. The policy response exceeds the actions taken during the GFC. Programs are focused on maintaining market liquidity and softening the economic downturn, with particular emphasis on those hurt most by the pandemic.

The Federal Reserve (the Fed) pulled all stops. Policymakers cut the federal funds target by 50bps in early March and then, in a 100bps move, all the way to 0% on March 15. It then resurrected many of the programs from the GFC, including a new, unlimited QE program focused on treasuries and mortgage-backed securities, short-term funding support (TOMOs¹, CPFF², TALF³ for repurchase agreements, commercial paper, and asset-backed securities), easier terms for banks and dealers (discount window terms and the PDCF⁴), and dollar liquidity for foreign central banks (dollar swap liens and FIMA Repo⁵ facility). Recognizing that dealers have limited balance sheet capacity, they developed new facilities to fund the purchase of investment-grade corporate bonds in both the Primary-and Secondary-Market Corporate Credit Facilities (PMCCF and SMCCF).

Congress is doing its part, too. After passing legislation to fund COVID vaccine research ($8bb) and increased state aid ($104bb), it passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act. This act provides an unprecedented $2tr of support, targeting hard hit segments of the economy. It includes direct support for consumers and small businesses ($1.2tr), $500bb of first loss capital and direct lending to affected industries (including airlines), health care funding, and increased unemployment benefits (including broadened access).