Diversification Scorecard: Q1 2020
April 14, 2020
Global markets suffered in Q1 as the coronavirus outbreak worsened. The impact of the pandemic on the global economy continued to grow, wreaking havoc across financial markets. This was only exacerbated by the oil price war that was initiated after OPEC members failed to agree on production cuts. Equity markets tumbled, with most of the major indices posting negative, double-digit returns in the first quarter. The S&P 500 Index lost 19.60% in Q1, closing out both its worst quarter since 2008 and its worst first quarter in history (breaking the previous record set in 1938). In response to this unprecedented crisis, the Federal Reserve cut interest rates to near zero and launched a massive, $700 billion QE program. A historic $2 trillion stimulus package also was passed by Congress in late March (the largest emergency aid package in US history), in an effort to soften the pandemic’s blow to the American economy as we witnessed its longest expansion on record come to an end.
The US economy’s growth remained steady in the fourth quarter of 2019, as the Bureau of Economic Analysis reported its third estimate of Q4 GDP at 2.1%, in line with third-quarter growth and the prior estimate. However, the economic effects of the outbreak have begun to appear in the data, with some economists forecasting as high as a 30% contraction (annualized) in US growth in the second quarter of 2020. The adverse impact of COVID-19 on employment also has started to appear in the data. Unemployment had continued to surprise all the way through February, with the unemployment rate hitting a 50-year low at 3.5%, as employers added 273,000 jobs during the month, above the consensus expectations of 175,000. Unfortunately, we have already started to see a reversal in those numbers, with the unemployment rate rising to 4.4% in March and 701,000 jobs lost. Weekly jobless claims hit a record high of 6.6 million for the week ending April 4, bringing the total number to nearly 17 million since the pandemic shut down the American economy.
In a risk-off environment, demand for US Treasurys was high, as investors sought a safe haven when equity markets began to decline. Lower-quality debt sold off, with panicked investors bidding up Treasurys, sending their yields close to historical lows. The U.S. Treasury yield curve steepened over the quarter, with yields on the shortest-term maturities declining relative to the intermediate- and long-term portions of the curve. The yield on the benchmark 10-year US Treasury Note declined, ending the quarter at 0.67%, compared with 1.92% on December 31.
Diversification produced mixed, though mostly negative, results over the quarter. Equity markets experienced a steep sell-off, underperforming fixed income securities by a wide margin. Diversification from exposure to international developed and emerging markets equities detracted from relative returns, as both asset classes trailed domestic equities in Q1, with the Russell 3000 Index down 20.90% vs. -22.83% for the MSCI EAFE and -23.60% for the MSCI EM indices. Large cap and growth exposures were the biggest equity contributors from a high level. Diversification through small and mid cap equities detracted from returns over the quarter, as the Russell 2000 Index declined 30.61% and the Russell Mid Cap Index lost 27.07% compared with -20.22% for the Russell 1000 Index. Value lagged growth for the quarter, detracting from relative performance, with growth outperforming across large, mid, and small cap equities. Exposure to REITs and commodities generally detracted from relative performance, as they could not keep pace with large cap domestic equity. Although fixed income securities posted mixed returns, exposure, by and large, contributed to performance, as many investors flocked to the safety of Treasurys. Diversification across fixed income was generally subtractive over the quarter, as high yield bonds, international bonds, emerging market bonds, and bank loans all underperformed core bonds.
Though diversification seemingly can be viewed as detrimental over the quarter, it is important to consider it within a longer-term context as well. Many of the benefits that are not observed as easily over a quarter are much more apparent over a longer time period. It would behoove investors to remember that many of the asset classes that suffered the worst during the 2008 Global Financial Crisis bounced back the best afterward. We saw a huge decline in emerging market equities in 2008, for example, closing out the year down 53.33%, only to see that same asset class end 2009 up 78.51%. International and mid cap equities had similar stories. Within fixed income, high yield, bank loans, and emerging market bonds all followed a similar suit, posting some of the largest declines in 2008 only to post some of the best returns in 2009. It is important in times like these, in the midst of sharp market declines, for investors to remain focused on their long-term financial plan and not let short-term volatility deter them from the benefits of diversification.
- Fixed income exposure contributed to performance, as many investors flocked to the safety of Treasurys.
- Domestic equity outpaced international, and developed equity markets outperformed emerging markets.
- Growth outperformed value across all market capitalizations.
- Large cap outperformed both mid and small cap stocks.
- Investment grade bonds outpaced high yield, and domestic fixed income outpaced international.
- Information Technology, Health Care, and Consumer Staples were the strongest-performing S&P 500 Index sectors on a relative basis.
- Equity exposure detracted from performance, as equity markets experienced a sharp sell-off, underperforming fixed income securities.
- Emerging markets and international stocks mostly trailed domestic stocks.
- Value lagged growth across all market capitalizations.
- Small cap stocks were hit especially hard, followed by mid cap, as both trailed large cap.
- REITs and commodities mostly trailed equities for the quarter.
- The Energy, Financials, and Industrials sectors were the poorest relative performers.
- High yield, international bonds, emerging markets bonds, and bank loans underperformed core bonds.
|Asset Class Returns*
|Large Cap Growth
|Large Cap Value
|Mid Cap Growth
|Mid Cap Value
|Small Cap Growth
|Small Cap Value
|Int'l Developed Markets
|Emerging Market Bonds
* Data from Morningstar. Asset classes represented by (in order of table): Russell 1000 Growth TR USD, Russell 1000 Value TR USD, Russell Mid Cap Growth TR USD, Russell Mid Cap Value TR USD, Russell 2000 Growth TR USD, Russell 2000 Value TR USD, MSCI EAFE NR USD, MSCI EM NR USD, Bloomberg Commodity TR USD, DJ US Select REIT TR USD, BBgBarc US Govt/Credit Interm TR USD, BBgBarc US Govt/Credit 1-3 Yr TR USD, BBgBarc US Corporate High Yield TR USD, BBgBarc US Treasury US TIPS TR USD, BBgBarc Global Aggregate TR USD, JPM EMBI Global TR USD, S&P/LSTA Leveraged Loan TR.