The current bear market is unique. The global coronavirus pandemic has brought large segments of the world economy to a halt. Some economists are forecasting a 25% decline of the U.S. GDP (annualized) for the second quarter. However, they also warn of a strong rebound once the pandemic is over and people return to work. While the volatility in the market is reminiscent of 2008, the current crisis is rooted in the real economy. The headlines are very dramatic, and security prices are swinging wildly, in a cycle of abrupt daily market drops followed by strong rebounds. In order to figure out what’s sensible for portfolios, it is useful to review what is driving the current drop in asset values.
First, the crisis changes the fundamentals of security issuers in many ways. Corporate earnings will decline for some time (although the magnitude of a future decline in earnings is unknown). Like they did in 2008–2009, many corporations will reduce or suspend the payment of dividends. Many corporate bond issuers will find it challenging to pay the interest on their bonds. And lastly, governments will have to issue massive amounts of bonds to finance the rescue package for the economy. This supply of new bonds will possibly impact their prices.
Secondly, securities are currently hit by a credit crunch: the flow of income to businesses and workers is severely disrupted. This explains why rescue packages from governments and liquidity injections from central banks are so important: they are aiming to replace the cash flow stream from normal economic activity. However, these interventions take time to bear fruit. Meanwhile, businesses and individuals need to find cash to survive. They generate this cash by selling securities.[i] This is why, during the first full week of the crisis, bond ETFs in the U.S.—in particular high-quality bond ETFs— were hit with a substantial outflow of $19 billion: people and businesses needed immediate cash.
Finally, there is a third element at play in the pricing of securities: high uncertainty. We don’t know how long it will take to resolve the public health crisis, how effective government rescue programs will be and how much the crisis will damage the economy. Consequently, some investors are willing to buy securities in the current environment, at a deep discount. This explains why market crises are almost invariably followed by a strong rebound: once the uncertainty dissipates, prices return to the fundamentals, and the discount for high uncertainty vanishes.
I realize this description of security market repricing sounds dismal. But let’s pause here. The credit crunch is not going to last forever: it has been proven many times over that central banks are able to start up the credit system with massive injections of liquidity. It’s just a matter of time before access to credit improves and, as a result, the liquidation of bonds will stop. The same goes for the high uncertainty: time will pass, the pandemic and its economic consequences will run their course and uncertainty will return to normal levels. That leaves us with the long-term effects of the crisis on corporate earnings, borrowers’ creditworthiness and the government bond supply.
To conclude, investors who bail out of the markets during episodes of crisis take a big haircut, largely due to temporary factors that are going to vanish over time. That’s one of the reasons why I believe bailing out during market crises is a recipe for disastrous returns.
[i] They will also generate cash by drawing on their line of credit. To meet with these additional credit drafts, banks will have to sell securities.
