After the Virus
Q1 2020 Investment Commentary
Queens Road Funds Investment Commentary
The market rout that began in late February is one of the most severe, fast and unsettling in history. The pandemic caused by the coronavirus came out of nowhere and has created the most unusual circumstances of our generation with unprecedented restrictions on personal movement and economic activity. The fact that this crisis came out of the blue has contributed to the speed at which markets have reacted. Uncertainty about the health, economic and cultural impacts of the virus have contributed to its severity. Exacerbated by a constant deluge of doomsday headlines by the media, many investors are shellshocked as they rush to shore up risky portfolios. Amidst this uncertainty, we are finding it helpful to focus on what we know and what we don’t know.
What We Know:
- We are in the midst of a severe and uncertain crisis.
- There will be significant impacts from the crisis.
- Global central banks and governments have unleashed unprecedented quantitative easing and fiscal stimulus to help the global economy weather the crisis.
- Equity valuations worldwide are much more attractive on an absolute basis than they were 45 days ago.
What We Don’t Know:
- How many will get the virus, how sick will they get, and how many will die from it?
- Can our healthcare system handle the numbers?
- How long will this pandemic last?
- What will be the lasting cultural impact?
- What will be the near-term economic impact?
- What will be the long-term economic impact?
As we think about what we do and don’t know, we are finding it helpful to turn to our disciplined investment process. We look at individual companies on a fundamental, bottom-up basis, searching for investment opportunities that provide a reasonable expected return and an adequate margin of safety. Taking a long-term view in these times of great uncertainty is certainly a challenge. Normalization of the long-term economic earnings potential of prospective investments is more difficult than ever. On the bright side, the recent sell off has improved valuations, and cheaper valuations most certainly increase our margin for error.
As the world deals with the virus, we will continue to look for companies with strong balance sheets and low levels of debt that are best equipped to make it through the challenges ahead and have a good chance to thrive on the other side of this crisis. We’ve taken the opportunity provided by the sharp drop in stock prices to both add to existing positions and to introduce some new investments to the portfolio (see Portfolio Update below). Our cash level, which had been elevated for an extended period, has come down sharply and we continue to systematically put that cash to work in what we believe are very attractive opportunities. We are doing so in a thoughtful, disciplined manner, adding companies with differing risk profiles in order to maintain an optimal level of risk in the overall portfolio.
Holding Our Breath vs. Holding Our Nose
While we are finding some interesting opportunities, we are not seeing valuation levels like we saw during the market lows of early 2009. I can clearly recall in February of 2009 how my finger trembled as I put in the order to buy shares of Winnebago. The company was valued as if they would never sell another RV and had more cash on the balance sheet than the current stock valuation. I remember telling myself, “If this doesn’t work, nothing will.” We bought Winnebago and quite a few other good companies at incredibly low valuations back then and made a lot of money for our shareholders. As hard as it was to hold our breath and buy back then, it was far better than holding our nose to buy at the rich valuations we’ve seen in recent times.
It’s hard not to worry about what might happen in terms of the spread of the virus. We all have family and friends that are older or have underlying health conditions that make them more vulnerable. It is helpful to remind ourselves that the most important thing we can do right now is so simple—keep our distance from each other and wash our hands.
It is also hard for investors to make good decisions during periods of worry and uncertainty. As with our health, it is helpful to remind ourselves to keep it simple, focus on what we know, and remain disciplined in our investment process. While it is not as simple as washing our hands, we intend to remain true to our motto of being Diligent, Disciplined and Patient.
We are pleased with the strong performance of the Queens Road Small Cap Value Fund (QRSVX). It has out-paced the Russell 2000 Value Index by over 13% year-to-date through 3/31/2020. Additionally, the Fund has beaten the Russell 2000 Value Index over the past 1-, 3-, 5-, 10-, and 15-year periods. Since its 2002 inception, the Queens Road Small Cap Value Fund has averaged 7.58% versus 5.66% for the Russell 2000 Value Index. Cumulative performance since inception is 267% versus 166% for the Russell 2000 Value Index.
The Fund also looks great compared with its peers. The Queens Road Small Cap Value Fund is ranked as the best-performing fund in the Morningstar Small Value Category for the 1- and 3-year periods ending 3/31/2020. The Fund is ranked in the top 3% for the 5-year period and 15% for the 10- and 15-year periods.
Morningstar has assigned a Gold Quantitative Rating™ and a 5-star Overall Morningstar Rating™ to the Queens Road Small Cap Value Fund. The quantitative rating is as of 2/29/2020 and the overall star rating is as of 3/31/2020. It has been gratifying to receive such high ratings from a trusted institution like Morningstar.
Average Annual Total Return through March 31, 2020 (%)
|YTD*||1 Year||3 Year||5 Year||10 Year||15 Year||Since
|Russell 2000 Value||-35.66||-29.61||-9.51||-2.42||4.79||4.11||5.66||166.58|
|Gross annual operating expenses 1.18%
*Not annualized. Fund inception June 2002.
|Important Performance and Expense Information
All performance information reflects past performance, is presented on a total return basis and reflects the reinvestment of distributions. Past performance is no guarantee of future results. Current performance may be higher or lower than performance quoted. Returns as of the recent month-end may be obtained by calling (888) 353‑0261.
Investment return and principal value will fluctuate, so that shares may be worth more or less than their original cost when redeemed. There can be no assurance that the fund will meet any of its objectives.From inception to 12/31/2004 the Fund’s manager and its affiliates voluntarily absorbed certain expenses of the fund and voluntarily waived its management fee. Had the Fund’s manager not done this, returns would have been lower during that period. The Fund’s manager and its affiliates do not intend to absorb any expenses or waive its management fee in the future.
The Queens Road Small Cap Value fund invests primarily in small-cap companies which may involve considerably more risk than investing in larger-cap stocks.
As share prices dropped during the first quarter, we added to several existing portfolio holdings as valuations became attractive enough to increase their position size in the portfolio. These companies are in a broad variety of industries including utilities, industrials, health care, technology and financials. The sharp sell-off created prices which we think will provide us with a reasonable expected return and a margin of safety in these very uncertain times.
In addition to adding broadly to existing positions, we added several new positions to the portfolio. Two companies that are worth noting are MSC Industrial, Inc. and MasTec, Inc.
MSC Industrial Direct Co, Inc. (MSM, 2.94%) fell from $78/share to $47 during the quarter. MSC provides industrial products and inventory management services for their clients. While economically sensitive, the highly fragmented industrial supply market is inherently broadly diversified. Although the company has a concentration in the metalworking industry, we are comfortable with the company’s broad customer base. MSC has an excellent management, a great business model, high client satisfaction, and an impressive track record. With a strong balance sheet and a track record of doing a great job managing through the financial crisis of 2008-2009, we are confident it can weather this storm and thrive as the economy rebounds on the other side.
We have followed this value-added industrial distribution company for some time and used the recent market volatility to initiate an overweight position. We feel like we made an investment that has very attractive return potential while also providing us with an ample margin of safety.
MasTec, Inc. (MTZ, 2.50%) fell from $64 to $23.50 over the course of the quarter. MasTec is an infrastructure construction company with roots in the communication industry. The business has expanded and diversified over the last 13 years through organic growth and acquisitions to include oil & gas, electrical transmission and power generation. The diversification across industries and its $8 billion backlog provides revenue visibility during this current crisis which gives us confidence that the company will be worth considerably more in three to five years than it is today. We also believe that the infrastructure bill currently being negotiated in Congress will pass and provide additional support for the company’s revenue base.
We thank you for choosing Queens Road for your clients. As the largest shareholders in the funds, our investment committee, independent board, employees and family members are thoroughly enjoying eating our own cooking right alongside you and your clients. Please contact Dave Kania if you have questions or would like to set up a call with me and the Queens Road team. ■
© 2020 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.The Morningstar Rating™ for funds, or “star rating”, is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product’s monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The Morningstar Rating does not include any adjustment for sales loads. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10- year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.Morningstar Quantitative Rating™ consists of: (i) Morningstar Quantitative Rating (overall score), (ii) Quantitative Parent pillar, (iii) Quantitative People pillar, and (iv) Quantitative Process pillar (collectively the “Quantitative Fund Ratings”). The Quantitative Fund Ratings are calculated monthly and derived from the analyst-driven ratings of a fund’s peers as determined by statistical algorithms. Morningstar, Inc. calculates Quantitative Fund Ratings for funds when an analyst rating does not exist as part of its qualitative coverage. Read more here about Morningstar’s Quantitative Rating and Pillar Methodology.
After the Virus
Things are never as good as they seem. Things are never as bad as they seem. My brother-in-law, Steve Scruggs, reminded me of that last Sunday afternoon during a conversation we were having about the coronavirus crisis and its impact on the global economy and the stock market. For this conversation, Steve and I were joined by my brothers, John and Phillips, and my father Frank at a called meeting in the barn on our farm. We had gathered to discuss the crisis and our clients. This was only the second “crisis meeting” we’ve had in the barn, the first occurring eleven years ago in late February of 2009 as the market neared its bottom during the financial crisis of 2008/2009.
I’ll never forget that first crisis meeting in the barn in 2009. Things were grim. Unemployment and foreclosures were soaring, corporate earnings and economic growth were falling dramatically, there was talk of the federal government nationalizing the banks, and the stock market was down more than 40% from its peak. The headlines were frightening, and we had been working overtime for the prior few months meeting with clients who were understandably worried. Making the situation especially difficult, the stock market had peaked a full sixteen months prior, in October 2007. It had been a long, difficult grind. In those days, whenever the stock market was open for trading, I recall having a perpetual knot in my stomach and a persistent muscle spasm behind my left eyebrow. Numerous people commented, “Hey, why is your eye twitching?” We were all stressed out.
Back then, the five of us gathered to ask ourselves some tough questions. How much worse will this get? Should we be taking a different approach with client portfolios in the midst of the crisis? Longer term, should we plan to change the way we manage money? Is there a better way? Surely there is a better way … this is too painful. We knew we needed to send out another letter to clients in short order. The letter needed to make clear our thoughts and it needed to tell our clients exactly what we were doing with portfolios and why we were doing it.
Well, we went around and around in the barn that day back in 2009. The more we talked, the more my eyebrow twitched. Steve couldn’t sit down; he kept walking circles around the barn. As always, my younger, smarter, brother Phillips had one idea after another. Older brother John brought calm. Dad offered his long-term perspective, but I could tell that even he was rattled, and nothing worries a son like seeing his father, the eternal optimist, worried.
When we finally left the barn that day, we were in agreement. We agreed that we didn’t know how much worse things would get or when the crisis would end. But we agreed that it would end. We agreed that when it ended, the economy would begin to expand and the stock market would go up. Finally, we agreed that in the long term, we would not change the way we manage money. We acknowledged that while there are different ways to manage money, we firmly believed the approach we used had the highest probability of success in helping clients achieve their financial goals.
At the time of our February 2009 meeting, we didn’t know that the market would fall another 18% before hitting bottom. Nor did we know that it would reach that bottom just three weeks later on March 9th. And finally, we had no way of knowing that from the bottom on March 9th, the market would gain 66% by the end of the year.
Last Sunday, at our 2020 version of the “crisis meeting” in the barn, the cast was the same, just older, grayer and hopefully a little wiser. The five of us spread out around the barn, maintaining our social distance, especially from the old guy. My eye twitched, Phillips generously shared his many thoughts, John was calm, Steve walked in circles and Dad was visibly rattled. The questions were similar and as you might imagine, our conclusions were the same. Specifically, we agreed that we don’t know how long this downturn will last but that it will end at some point and the economy and market will improve. And finally, we agreed that we will not change our long-term approach to managing money. I’ll share a few other things we discussed:
This crisis is different. Each crisis is different. Each brings uncharted waters, losses, human suffering and many questions about the future. In this case we have the virus pandemic, which we will get through. More significantly, we have the actions we are taking to control the spread of the virus. These actions are what make this crisis different. Never have we shut down major portions of the global economy, guaranteeing soaring job losses and enormous economic contraction in such an abrupt manner. There is much that is unknown about the long-term implications of these actions. While the massive and immediate contraction in economic output is obvious, our inability to estimate the duration of the shut-down leaves great uncertainty about the economy’s ability to bounce back.
The hope is that the $2 trillion of Federal economic stimulus can quickly make its way into the hands of companies and workers to float the economy for the next two months. How bad will the bottlenecks be in getting this money distributed? Execution is critical. Time is critical. What happens in the next three to four weeks will determine the severity of this crisis in terms of the financial and societal fallout. The global economy is like the heavyweight champion of the world, flattened on the mat by a sucker punch from a rookie, upstart boxer. The referee is on his knees beside our champ, slapping the mat with the count, “One … two … three …!” If the ref gets to the count of ten, our champ, the global economy, will suffer a mighty loss. But if, as is our hope and expectation, the champ stirs, rises to a knee, shakes his head and leaps powerfully to his feet, we can avoid a severe recession or worse.
The economic news in the weeks and months ahead will look horrible. The economy is in recession. As Matt DeVries describes in his Market & Economy article below, in the weeks and months ahead, the reported declines in employment, economic output and corporate earnings will be some of the worst we have ever seen. The headlines will be filled with these reports as well as disturbing reports of the spread of the virus and the associated human suffering and death. Many of us have thus far learned of infections and deaths from afar. If, as projected, the virus continues to spread, many of us will be affected personally. We will know people who are infected, and we may know people who don’t survive. This will be difficult and will add to the emotional toll of this period of our lives. We know this is coming.
We’ll learn how resilient the US economy truly is. The Great Recession, which began in December 2007 and ended in June 2009, was the longest and most severe in terms of US GDP contraction since World War II. Unemployment doubled from 5% to 10%, home prices fell 30%, the stock market declined 57% and household net worth fell 20%. And yet, cumulative real GDP only declined 5.1% during this period. Once the economy began expanding again in June 2009, each of these negative trends reversed. Over the next decade, unemployment fell to a fifty-year low while household net worth, home prices and the stock market reached new highs. Our economy is amazingly resilient; today it faces a test that is seemingly unlike those of the past. How will it respond to this scenario where we have intentionally sidelined its dynamic energy? Time will tell. The pessimistic view is that the losses will be too severe and that the economy can’t bounce back in time to avoid a years-long slump. Optimists call for a better scenario. Based on the past resilience of our economy we remain optimistic that we will avoid a deep and lengthy recession.
Humans will do a better job with the next pandemic. Airline hijackings became rare after 9/11. But it required a tragedy for that to be the case. Experts have warned for years that humans were unprepared for a pandemic. The world now believes. As we did on 9/11, today we are paying a steep price for our unpreparedness. This won’t happen next time. Next time we’ll have stockpiles of supplies and equipment, we’ll likely each have a box of masks at home, we’ll understand social distancing, we’ll have rapid testing capabilities, we’ll understand how to isolate and protect the vulnerable and we’ll make use of the amazing technologies now being created at a feverish pace. Most important, we’ll know how to deal with a virus while not shutting down the economy.
Will the world be different after the virus? Many are predicting that the world will be completely changed by this crisis. You’ve heard the questions: “Who will fly on a plane, go on a cruise, go to a restaurant or bar or attend a basketball game?” My answer is that I will. And you probably will too. Actually, a cruise has never been on my bucket list but maybe that will change as I “mature.” We humans tend to be a risk-taking lot and the passage of time tends to heal the wounds of the past. The further we get from a period of great pain, fear and uncertainty, the more we discount its significance. We explain away what happened with the benefit of hindsight. We readily accept higher levels of risk and we project the more recent past far into the future. In some ways we should be thankful for this human characteristic; as we’ve written before, without our risk-taking tendencies, early man likely wouldn’t have emerged from the cave after his first brutal fight with the mighty mastodon. Needing to eat, he embraced risk and he emerged. And just look at the remarkable progress he has made since.
In some ways we will see a different world. Activities like remote working, online shopping, distance learning, video/telemedicine, the pace of our embracing new technologies, and many more trends will greatly accelerate. This will create new opportunities and will also be destructive. Capitalism is often referred to as creative destruction and COVID-19 is accelerating this phenomenon. Some have written that the virus crisis will harden borders, reduce world trade (globalism) and accelerate the nationalism trend that has emerged in the last decade. Others have pointed out that like never before, the countries of the world will be required to come together in cooperation to defeat a menace like this pandemic. It will be interesting. Life always is, isn’t it?
In closing, I’ll return to the words of Steve Scruggs with which I opened. Things are never as good or as bad as they seem. In mid-February, it appeared that the US economy was firing on all cylinders. Economists were expecting 275,000 new jobs for the month as China trade tensions eased, unemployment was at a record low and the stock market was at a record high. The virus has revealed our fragility. In just six weeks our reality has changed; things weren’t as good as they seemed. We face a time of great challenge in the months ahead. It will be sad and it will be scary. But we’ll get through it. At some point in the future we’ll be in a much better place. We’ll look back and marvel at this strange time. We’ll agree then that it wasn’t as bad as our worst fears today. For now, we’ll buckle in and grind it out, knowing that a brighter future awaits.
We join you in thinking about and praying for those who have been affected by the coronavirus including those who are ill, the families and friends of those who have died, the thousands of individuals around the world who are showing leadership during this time, and especially those on the front lines—doctors, nurses, other healthcare workers, first responders and anyone else putting their health at risk in order to help others.
We hope this has been helpful to you. Thank you for choosing Queens Road for your clients. ■
Market and Economy
The new year started with so much promise. The US economy had grown, albeit slowly, for eleven consecutive years and was expected to continue doing so in 2020. Trade talks between the US and China were progressing. Stocks were rising in January—until the first reports out of China of an outbreak of a new coronavirus.
As COVID-19 grew into a pandemic and spread quickly across the world, global stock markets plummeted. In the US, the longest duration bull market in history ended with the fastest decline in history. It took just 20 days for the S&P 500 to fall over 20% from an all-time high on February 19th—even faster than the market crashes of 1929 and 1987. Unfortunately, it fell further than 20%. By the market close on March 23rd, the S&P was down 34% from its high. Then, responding to the passage of the $2 trillion Coronavirus Aid, Relief, and Economic Security Act (CARES Act), the S&P rallied by 20% in just three trading days ending March 26 before trending down somewhat to end the quarter down 23.7% from its February peak. For the full quarter, the S&P was off 19.6%.
Small-cap stocks (-30.6%) and mid-cap stocks (-27.1%), which typically have weaker balance sheets and less diversified revenue sources, were hit harder. Foreign stock markets were down more than US large-cap stocks, possibly because the virus cycle started earlier in Asia and Europe.
If you merely look at the Barclays US Aggregate Bond Index’s return of 3.1% through March you might conclude that bonds were a safe haven throughout the storm that rocked stock markets. In fact, in mid-March, the selloff even spread to bonds as the Barclays bond index fell nearly 10% over a week and a half as investors sold securities of all types in a desperate effort to raise cash. After bottoming on March 19th, bond prices recovered most of their losses, primarily as a result of actions taken by the Fed to stabilize trading and provide liquidity. Compared to taxable bonds, volatility in the municipal bond market was more severe. While the Barclays Municipal Bond Index ended the quarter down only slightly at -0.6%, the index fell more than 14% in mid-March for the liquidity reasons mentioned above but also because investors are worried about the negative impact on municipalities from lower tax revenues.
Market Index Returns as of March 31, 2020
|Index||1st Quarter||1 Year||3 Years||5 Years||10 Years|
|S&P 500 (US Large Cap)||-19.6%||-7.0%||5.1%||6.7%||10.5%|
|Russell Midcap (US Mid Cap)||-27.1%||-18.3%||-0.8%||1.9%||8.8%|
|Russell 2000 (US Small Cap)||-30.6%||-24.0%||-4.6%||-0.3%||6.9%|
|MSCI ACWI X-US IMI Net (Foreign Equity)||-24.1%||-16.3%||-2.3%||-0.7%||2.1%|
|MSCI EM (Foreign Emerging)||-23.6%||-17.7%||-1.6%||-0.4%||0.7%|
|Barclays Aggregate Bond||3.2%||8.9%||4.8%||3.4%||3.9%|
|Barclays Muni Bond||-0.6%||3.9%||4.0%||3.2%||4.1%|
|Past performance is not an indication of future performance.|
The Cost of Social Distancing
To “flatten the curve” of the number of coronavirus infections, “non-essential” businesses have been closed while much of the still-employed workforce is working from home. The solution to halting the spread of the virus has halted the global economy as well. Even without official GDP measurements that will take time to be released, we can say with certainty that the economy is in recession.
As a frame of reference, let’s look at the past recessions. When the DotCom bubble burst in 2001, a fairly shallow recession followed as US GDP fell 0.3% and unemployment rose to 6.3%. The financial crisis just over ten years ago was much worse as US GDP fell 5.1% and unemployment jumped to 10.0%. During the Great Depression, the deepest contraction in the past century, GDP fell 24.9% and unemployment rose to 26.7%.
|Recession||Period Range||Duration (months)||Peak Unemployment||GDP decline (peak to trough)|
|Great Depression||Aug 1929–Mar 1933||43||24.9%||−26.7%|
|Recession of 1937–1938||May 1937–June 1938||13||17.8%||−18.2%|
|Post WWII Recession||Feb 1945–Oct 1945||8||5.2%||−12.7%|
|WWII-Bond Recession||Nov 1948-Oct 1949||11||7.9%||-1.7|
|Post Korean War Recession||Jul 1953-May 1954||10||6.1%||-2.6|
|Eisenhower Recession||Aug 1957-Apr 1958||8||7.5%||-3.7|
|Monetary Recession||Apr 1960-Feb 1961||10||7.1%||-1.6|
|Vietnam War Recession||Dec 1969-Nov 1970||11||6.1%||-0.6|
|Oil Crisis||Nov 1973–Mar 1975||16||9.0%||−3.2%|
|First Volcker Recession||Jan 1980–July 1980||6||7.8%||−2.2%|
|Second Volcker Recession||July 1981–Nov 1982||16||10.8%||−2.7%|
|Gulf War Recession||July 1990–Mar 1991||8||7.8%||−1.4%|
|DotCom Bubble||Mar 2001–Nov 2001||8||6.3%||−0.3%|
|Global Financial Crisis||Dec 2007–June 2009||18||10.0%||−5.1%|
Sources: US Bureau of Labor Statistics, National Bureau of Economic Research
Estimates for first-quarter GDP declines range up to as much as 10% but forecasts for the second quarter are truly shocking. Here are some of the estimates for year-over-year GDP declines for the second quarter: Goldman Sachs -24%, JPMorgan -25%, and Morgan Stanley -30%.
The effects of shelter in place and social distancing are already showing in new claims for unemployment as layoffs and furloughs have begun. After averaging roughly 200,000 to 225,000 new claims per week in the US for the past several years, a record 3.28 million people filed for unemployment in the week ended March 21. The following week, another record was set as new claims doubled to 6.6 million.
In just two weeks’ time, almost 10 million Americans are either temporarily or permanently out of a job. Hovering around five-decade lows at 3.6% in February, the US unemployment rate spiked to 4.4% in March—the largest one-month jump since 1975—and will certainly jump by more next month.
Plummeting oil prices have not helped matters. After Russia balked at cutting production along with the rest of OPEC, Saudi Arabia responded by flooding the market with even more oil. This massive increase in oil supply coinciding with an equally large collapse in oil demand due to the coronavirus has crushed the energy sector and pushed oil prices down by more than half to 18-year lows. While the energy sector makes up just 2.6% of the S&P 500 as of March 31st, oil and gas make up a larger portion of US GDP and has wider reach when you consider ancillary businesses and lending from banks and other financial entities.
In the face of such dire forecasts, the Federal Reserve acted swiftly by cutting the Fed Funds rate a full 1% to zero, along with announcing its fourth quantitative easing (QE) program. Initially, the Fed vowed to buy up to $700 billion in Treasuries and agency bonds to ensure liquidity but the cap was quickly lifted and purchases are also being expanded to municipal and corporate bonds. With what is being called “QE Infinity,” the Fed has vowed to do whatever it takes to ensure liquidity in the credit markets.
The Fed also announced several new lending facilities such as directly offering dollars for Treasuries held by foreign central banks to prevent them from selling in the open market. It took over six years for the Fed balance sheet to grow by $3.6 trillion coming out of the financial crisis. We may see it grow by a larger amount in just a couple of months.
Not to be outdone, Congress moved quickly to pass legislation that was signed into law by President Trump on March 27, creating its massive $2 trillion stimulus package. The CARES Act will help provide medical care resources and financial relief to help keep the country afloat while we deal with COVID-19. The Act will result in increased unemployment benefits as well as direct cash payments to millions of individuals and loans to potentially thousands of small businesses.
The CARES Act also provides loans to specific large companies in many of the hardest-hit industries, but with some strings attached. For example, US airlines accepting money cannot lay off or furlough employees or reduce their pay. These companies also cannot pay dividends or buy back company stock for over a year.
The Act devotes $349 billion in grants and loans to small businesses and nonprofits. Loan payments will start after six months and any part of the loan used for employee pay, rent, utilities, and mortgage interest will be forgiven. The amount forgiven will be reduced if any employees are laid off. These business loans will be crucial considering a study by the JPMorgan Chase Institute that found that half of small businesses have cash on hand to cover just 27 days or fewer of expenses.
Asia and Europe Ahead of US in the Virus Cycle
The financial story is similar all across the world, though most other large economies are ahead of the US in terms of the virus cycle. Foreign central banks and governments have enacted large stimulus packages as countries deal with widespread shutdowns. For comparison to the US, JPMorgan is projecting -15% and -22% contractions in economic output for the Eurozone in the first and second quarters.
Emerging markets may lead the world out of this recession. China, which was the first country to deal with COVID-19 and which took possibly the most draconian steps to halt its spread, likely took most of its economic hit in the first quarter and will start seeing a rebound in the second quarter. South Korea should look very similar.
So Are Stocks Cheap?
That is a tough question to answer right now. We know that prices, as measured by the broad market indices, are down more than 20% from recent highs. The prices of some companies (energy, travel, lodging, financials, restaurants) are down far more while other companies (consumer staples, healthcare, grocery, technology) have fared significantly better. We know what the prices are; we simply have very little visibility as to what earnings will be. Current price to earnings (P/E) ratios are of little value because stock prices tumbled much faster than earnings expectations have fallen. According to FactSet, analysts are now projecting declines in 2020 quarterly earnings for the S&P 500 in the first quarter (-5.2%), second quarter (-10.0%), and third quarter (-1.1%). These estimates are likely still too high and we expect to see further downward revisions. Even with the earnings rebound expected in the fourth quarter, we will likely see the first double-digit decline in annual earnings in over a decade. As investors, we hesitate to say if stocks are cheap at any given time; history has shown that this exercise has rarely proven to be of value. We don’t know exactly how much earnings will fall or how long major portions of the economy will be locked down. We do know that there is a lot of uncertainty in the market right now and we sense that many investors are sitting tight waiting to see if the CARES Act stimulus and the aggressive actions of the Federal Reserve will support the economy long enough to get business moving again. We take comfort in knowing we have significant liquidity in our portfolios and that we have relatively small exposure to energy, travel, and retail stocks.
Life after Corona
I heard once that in life there are good times and there are times you will get through. This is a time we will get through. Social distancing, mass testing and other actions will eventually stem the tide of the virus as we have seen in China and South Korea, each of which has seen its number of new cases slow to fewer than 100 per day. As shown in the chart below, we are seeing a slowing in the growth rate of new infections in Italy, Germany, France and other parts of the world that have been hit hard.
On Sunday, April 5, Dr. Deborah Birx, White House Coronavirus Response Coordinator, said that several U.S. hotspots such as the Detroit area, New York and Louisiana could reach their mortality peaks during the next week. She cited models created by the Institute for Health Metrics and Evaluation (IHME) at the University of Washington. These models allow you to research projected peak infection and mortality statistics by state. For example, according to the website, NY will see its mortality rate peak on April 10 while NC will see its mortality rate peak on April 28. The researchers maintaining the website models update their data and projections regularly.
Obviously, the sooner we return to normal the better. It is just a question of how bad things will get first. While the depth of this recession may be deeper than what we’ve seen in recent decades, it may also be shorter because the Federal Reserve and CARES Act have given the US economy a strong foundation to return to growth quickly. There remains a chance that we may see a significantly faster than average economic recovery as a bookend to the fastest ever economic contraction.
As always, we recommend maintaining a long-term investment approach. Below are charts from the last nine recessions. The price action of the S&P 500 (shown in green) and the movement of the unemployment rate (purple) are shown during each recession (shaded in gray). In eight out of nine cases, stocks bottomed and started rising before the recessions ended or unemployment peaked. Markets are forward-looking. In this case, the market is looking past the crisis, trying to determine the depth of the recession and the level of earnings expected in the future. This doesn’t mean that markets won’t fall from here. Stocks may retest the lows of March or go even lower. We simply think it’s important to remember that trying to call the bottom will be very difficult. ■
The thoughts expressed in this piece concerning recent market movements and future prospects for small company stocks are solely the opinion of Queens Road Funds at April 14, 2020, and, of course, historical market trends are not necessarily indicative of future market movements. Statements regarding the future prospects for particular securities held in the Funds’ portfolios and Queens Road Funds’ investment intentions with respect to those securities reflect the portfolio manager’s opinions as of April 14, 2020, and are subject to change at any time without notice. There can be no assurance that securities mentioned above will be included in any Queens Road Fund-managed portfolio in the future.
This material is not authorized for distribution unless preceded or accompanied by a current prospectus. The prospectus contains important information on the Fund’s investment objectives, risks, and charges and expenses. Please read the prospectus carefully before investing or sending money. The Fund invests primarily in small-cap stocks which may involve considerably more risk than investing in larger-cap stocks. (Please see “Primary Risks for Fund Investors” in the prospectus.) As of 03/31/2020, the Fund held a limited number of stocks, which may involve considerably more risk than a less concentrated portfolio because a decline in the value of any one of these stocks would cause the Fund’s overall value to decline to a greater degree.