The recent wave of sobering economic data is painting a bleak picture for our nation’s post-pandemic future. While pundits pontificate on whether the recovery will be V-shaped, U-shaped or W-shaped, there’s one important fact that many are missing: the market fallout from COVID-19 will likely forever change how investors structure their portfolios.
So-called Modern Portfolio Theory, which contends that a well-balanced portfolio is composed of 60% stocks and 40% bonds, is just not going to hold water going forward. Investors seeking long-term capital appreciation are not going to be able to rely on exposure to just two asset classes.
Even before the COVID-19 crisis ravaged the U.S. economy, the combination of rising debt levels and unsustainable central banking policies had begun to cut the legs out from under fixed-income markets.
Congress has now reached well over $2.5 trillion in coronavirus-related stimulus spending, with the nearly $500 billion “Phase 3.5” bill adding on to the unprecedented $2.2 trillion relief package passed in late March. It is hard to see how adding trillions of dollars to the already heaping federal debt is sustainable at a time when corporate tax collection and household income will decrease sharply.
Massive debt also exists at the state level. Distressed states like Illinois, which has been grappling with budget deficits, high pension costs and a shrinking population even before the pandemic hit, recently announced its plan to issue massive short-term and long-term debt facilities. As a result, its borrowing costs have soared. Illinois 10-year bonds have more than doubled since January and are trading at yields comparable to emerging-market levels.
The unsustainable levels of debt at both the federal and state levels will only lead to distress and eventually the need for debt forgiveness or default related to government bonds.
Secondly, the Federal Reserve’s decision to pour even more capital into the markets will lead to even lower yield on Treasury bonds and correlated fixed income investments in the future. The Fed’s balance sheet has ballooned to nearly $6.6 trillion, growing 54% in less than two months. As interest rates dip toward zero, or become negative, it’s clearer than ever that bonds simply cannot replicate the historic levels of income investors need, especially those in retirement. Meanwhile, in pursuit of yield, investors have poured into corporate bonds, nearly one third of which are high yield or leveraged loans.
Lastly, the inevitable softening of the economy coming out of the COVID-19 crisis will put pressure on corporate earnings, and in turn make corporate equity investments and corporate bonds riskier. As consumer spending continues to diminish, many companies will be dramatically impacted.
During this recession, all asset classes are going to take a beating.
Prior to the 2008 financial crisis, the financial industry touted “diversification” among different asset classes as the preferred risk-mitigation technique. However, in the aftermath of the crisis, many claimed that diversification had “failed.” The more likely case is that diversification’s “failure” was due to poor implementation.