Analysis
Covid-19 Update #2: Irrational Feelings

Amid panic, liquidity concerns have now taken hold.

March 13, 2020
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By
Dominic Nolan

Dominic Nolan, senior managing partner of Pacific Asset Management (PAM), provides his analysis below of the fixed-income markets currently battered by the COVID-10 pandemic. In this fluid economic environment, it’s important to note that these were his views as of March 13, 2020.

It’s been 33 years since the S&P® 500 index had a worse single-day session. In a continuation of recent selling and liquidity strains, coupled with inaction out of Washington D.C., the S&P 500 lost 9.5% on March 12, its worst day since Black Monday in October 1987. Liquidity concerns have now taken hold, resulting in what I would now categorize as investor panic.

In Search of Fiscal Response

After March 11’s close, markets were expecting a fiscal response but instead received a travel ban. While the travel ban can be viewed as a prudent act, the lack of fiscal stimulus further spooked markets. Futures dropped substantially and followed through with March 12’s action. At this point, I believe it is fair to say the coronavirus and markets are moving faster than the government can keep up. Any effective fiscal response would have to be sizable, in the hundreds of billions of dollars, in my opinion. Markets are losing faith in D.C.’s understanding of the economic severity.

The Fed

March 12, the Federal Reserve Bank of New York announced a $1.5 trillion capital injection. While it does indicate an awareness of the growing liquidity strains, markets quickly moved past the injection. I am hoping, and largely expecting in the next few days (the March Federal Open Market Committee meeting begins on March 17), the Federal Reserve (Fed) to fire a bazooka round with a large rate cut and additional liquidity. If the Fed does not deliver, market strain will likely increase.

How Bad of a Recession?

Is the market pricing in as of March 13? A back-of-the-envelope calculation would suggest an average recession is currently being priced in. Since World War II, the average bear market for the S&P 500 has been a drop/drawdown of 31%. As of March 12, the market has dropped approximately 27% from the peak in February. The staggering part is the velocity. In the post-World War II sample, the average bear market bottomed after 290 trading days, and the current market is down 27% in just 16 trading days. I’m not sure if that is a good sign or not.

Panicked Markets

While I am unsure and highly doubt this is the bottom, we are entering levels that feel irrational. As one of my esteemed colleagues quoted earlier today when asked if markets are panicking, “When rational people are forced to do irrational things, I would call that a panic.”

Across the board, markets have been getting hit. Equities, bonds, REITS (Real Estate Investment Trusts), municipal bonds, and gold are all being liquidated. U.S. High Yield, as measured by Bloomberg Barclays U.S. Corporate High Yield Bond index, now yields over 8%. Year-to-date, the index is down almost 9%, which would rank as the second worst year in the history of high yield.

From a historical standpoint, March 12 was the single worst day in the history of the loan market. Yes, folks, that includes any day from 2008. The S&P/LSTA Leveraged Loan 100 Index closed down 3.08%, which surpasses the previous worst day of October 10, 2008 when loans were down 2.90%. That means two out of the three worst days ever have been the week of March 9. (On March 9, loan market closed down 2.73%.)

Containment to Mitigation

I believe most Americans are resigned to the fact that this virus cannot be contained, but businesses are reacting quickly in an effort to slow the pace of contagion. In the past 24 hours, the NBA, NCAA, and MLS have suspended games; there have been two statewide school closures; and for the first time in its history, Disneyland Resort is closed for the remainder of March. Given the actions of Italy, France, the United Kingdom, and now New York to move efforts from containment to mitigation, I believe this will more than likely be the playbook over the next few weeks. These efforts are largely being done as to not overwhelm our medical system and preserve lives. While we are still unsure whether our hospitals and medical infrastructure will not be overwhelmed, without these efforts, it would be a certainty.

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