The Weekly Economic & Market Recap
December 4, 2020
The U.S. economy is beginning to show signs of fragility as the recent surge of Covid-19 cases causes some states reimpose certain restrictions in order to attempt to mitigate the spread of the disease. High frequency data shows that while consumer credit and debit card transactions are on par with last year, the number of U.S. seated diners, as well as travel and navigation app usage, are trending down over the last month and are roughly 50% lower on an annual basis. With that being said, it was not surprising that some market participants were dismayed when it was announced that the Treasury Department would terminate some of the Fed’s liquidity facilities by the end of year and take back the massive amount of capital that the Fed had received. The leaders at the Fed have been very vocal about the need for additional fiscal and monetary stimulus and the previously mentioned action removes key capital market backstops. Luckily, the market’s reaction to the early removal of the credit facilities has been muted thus far, which shows how much market confidence has been restored since the dislocations experienced back in March. It is also important to note that only a small fraction of the credit facilities were utilized as the Fed was able to restore proper market stability by the sheer announcement of the programs back in early spring. Credit spreads are currently very tight from a historic perspective and the need for additional monetary policy stimulus may not be apparent right now, however, the Fed should have all the necessary tools available to respond to potential hardships moving forward. With Janet Yellen selected as the new Treasury Secretary (it is probable that she will be confirmed by the Senate), the relationship between the Treasury Department and Fed is projected to be quite strong moving forward. Yellen’s incredible experience at the Fed coupled with her extraordinary communication skills should comfort market participants to a degree and assist greatly in the rebuilding of the economy.
November 20, 2020
Positive developments regarding a vaccine from both Moderna and Pfizer over the last couple of weeks have driven a strong equity market rally. Investors are cheering the prospect of a widely available vaccine by the middle of next year, which should greatly diminish the risk to the current cyclical recovery. With the potential for consumer behavior to gradually return to a semblance of normalcy toward the end of 2021, equity investors can feel more confident that the robust earnings rebound which is already underway can continue. Most companies in the S&P 500 have reported third quarter earnings with 84% reporting a positive surprise. Expectations going into the quarter were admittedly very low and blended earnings are still likely down 6.3% year-over-year for the quarter. However, the positive tone of the earnings reports has driven the twelve-month consensus forward earnings estimate up over 7% to $166 over the last two months. Robust economic growth next year should provide for solid earnings growth. Many economists expect the domestic economy to grow well above 4% next year with the global economy growing even faster at a rate above 6%. Strong economic growth, supported by remarkably accommodative monetary policy and a huge fiscal deficit of 8.6% of GDP, should allow for significant revenue growth and margin expansion. Additionally, low borrowing costs due to extremely low interest rates will also lift earnings and cash flows. The strong move in the equity market in November, although somewhat startling, is logical. The brighter prospects ahead do not diminish the short-term concerns that could make financial markets uncomfortable as we close out the year. The coronavirus’s spread has accelerated across the country and we are now recording the highest-ever number of new reported cases. Fourth quarter estimates for GDP growth are being lowered due to rolling lockdowns. There are several reasons that suggest the economic impact of a second lockdown will be less severe. Both individuals and corporations are better positioned to handle the disruption. Despite the potential for increased volatility, investors need to remain focused on the cyclical recovery ahead
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November 13, 2020
Risk markets began the week on a rather euphoric note based primarily on the news that major progress is being made on the development and approval of a vaccine, which could eventually resolve the health crisis caused by Covid-19. Moreover, the MSCI All Country World Index increased in market capitalization by roughly $1 trillion on Monday alone and was led primarily by the cyclical sectors of the economy that have suffered the most throughout the pandemic. The press release by Pfizer showed that the new vaccine it is developing with BioNTech SE helped prevent greater than 90% of symptomatic infections, which comes at an opportune time now that Covid-19 cases are making a massive resurgence globally. With roughly 200 vaccine development projects in over 30 countries taking place at the current juncture, a tremendous amount of resources is being dedicated to this extremely important cause. The pace at which the vaccine is progressing is quite impressive as historically it has taken an average of 11 years for a vaccine to reach the finish line with a failure rate of roughly 94%. Just this week the Fed released its Financial Stability Report, which stated that uncertainty remains elevated and “given the generally high level of leverage in the non-financial business sector, prolonged weak profits could trigger financial stress and defaults.” The last thing the Fed wants is for the health crisis to evolve into a financial crisis and therefore, the approval of a vaccine is the most important factor driving markets currently. Even with the encouraging vaccine news released this week, a resumption to pre-pandemic life will still take time. Moreover, Pfizer and BioNTech’s phase three trials are not yet complete and it is unknown how long immunity will last and whether it can be utilized by all segments of the population. Also, storage may become an issue as gene-based vaccines require storage at extremely cold temperatures, which could preclude its usage in certain areas. At this point if everything continues in a positive direction, a large-scale rollout of the above-mentioned vaccine might come in the first half of 2021 and although the light is brighter at the end of the tunnel, caution is still warranted.
November 6, 2020
The political uncertainty of the last few weeks has been overhanging the financial markets and is partially the reason why the equity markets have been on a roller coaster ride. The week, heading into the election equity, markets were preoccupied by the diminishing prospects for a fiscal stimulus deal, rising coronavirus case counts and talk of a contested election. Stocks experienced their worst weekly decline since March. Despite the lack of a clear election outcome and the lack of a blue wave that many anticipated, the equity market rallied anyway this week and reversed the recent selloff. The likely election result is for divided government with the Republicans retaining control of the Senate assuming the Georgia runoffs break their way. Assuming divided government holds, the next round of stimulus will probably be less robust, and it may take longer to arrive than if the Democrats had total control as a result of last Tuesday’s election. We should expect a continuation of our structural deficits of approximately $1.1 trillion over the next few years. It also means that we will not see a significant change to tax rates over the near term, which removes a significant near-term concern for many investors. With a large structural deficit as the core fiscal policy element and the Federal Reserve intent on remaining stimulative until the unemployment rate falls below full employment, it seems the die is cast for economic reflation over the next few years. The Fed has been quite clear that it only intends to tighten monetary policy when it forecasts inflation to average greater than 2% over the medium term. The coronavirus and the government’s response will impact the slope of the recovery over the next year, but as the cycle extends out into 2022 it would not be a surprise to see inflation approaching conditions that would warrant a normalizing response from the Fed. In the short-term, investors need to deal with this period of electoral uncertainty and stay focused on long-term investment objectives.
October 30, 2020
Elevated volatility resurfaced this week and it was primarily predicated on the resurgence of Covid-19 cases around the globe, the lack of progress on additional fiscal stimulus and the increased probability of a contested U.S. presidential election outcome. Financial conditions have tightened recently, but are nowhere near the levels reached approximately 7 months ago thanks to the prompt and aggressive actions of the Fed. Beyond bringing frontend rates down close to zero, implementing numerous liquidity facilities and purchasing a sizable amount of assets (the Fed’s balance sheet is now over $7 trillion), the Fed has demonstrated its ability to innovate and further expand its tool set. What has been amazing is the incredibly tight range that U.S. Treasury yields have moved in the recent past. More specifically, the 10-year U.S. Treasury yield has fluctuated just 23.7 basis points (bps) over the past two months, which is the tightest range since 2018. But, the shape of the yield curve has been changing to a degree as of late with the long end of the U.S. Treasury curve beginning to lift off. There are numerous forces pushing the most interest rate sensitive portion of the yield curve higher including the prospect of additional fiscal stimulus, the reorientation of global supply chains and the development of additional medical solutions to fight Covid-19. The Fed is acutely aware of the economically beneficial nature of low interest rates and how they help reduce the slack within the labor market. The Fed is currently purchasing approximately $80 billion dollars of U.S. Treasuries a month and the September Fed Minutes indicated that they are examining the current purchase program and could shift purchases to the long end of the curve to create downward pressure on rates if need be. A further step would be to introduce a yield curve control program and explicitly set a yield target range at a specific tenor, similar to what is being implemented currently in Japan and Australia. With rates so low currently, it may seem premature to discuss ways to suppress them, but given the existing headwinds facing the economy, all options must be available in order to sustain the recovery.
October 23 , 2020
questionable, or at the very least less impactful, it is highly likely that we will see additional fiscal stimulus once the fog of the election dissipates. Fiscal stimulus will help ensure that the economy stays on a sustainable growth path. Additionally, several secular disruptors will remain in place. First, the prospect of heightened friction between the U.S. and China as the fight for global economic and political primacy between the two superpowers heats up. Second, the rise of populism has not yet peaked. Populism is the creation of higher levels of economic inequality and the sense that many people have been left behind, which have only been amplified by the impacts of the coronavirus driven recession. Protectionism and rising nationalistic sentiments will likely have a detrimental effect on trade and global supply chains for many years to come. Finally, technology is an essential aspect of productivity growth, but it also is a major disruptive force that shifts work and business processes. Technology, and the ongoing digitization of our daily lives, generally lifts the economy (and our standard of living), but it creates winners and losers. Regardless of who is in power in Washington, these factors will remain critical aspects of the investment landscape.
October 16, 2020
October 9, 2020
The equity market has rallied roughly six percent over the last two weeks largely on continuing optimism regarding an additional stimulus package from Congress. Stocks have regained two-thirds of the early September correction. The correction seemed very orderly and without panic, which has allowed market sentiment to more easily shift directions. It is not unusual for the equity market to experience a retrenchment in the early fall, especially in an election year. With the election less than a month away, investors are focused on the policy ramifications of various election outcomes and the potential frightful implications of a contested election. Although most statisticians would argue that the number of observations is too limited to draw meaningful conclusions, we contend that from an aggregate equity market perspective, elections in the past have had a negligible effect over a full market cycle. Therefore, most investors should focus on their long-term investment and financial goals and financial market fundamentals. Before this year’s election, many companies will have released third-quarter earnings along with forward guidance on the
current quarter and the outlook for 2021. By early November, we should have a reasonable sample to assess the slope of earnings growth over the near term. According to FactSet, estimates for the S&P 500 for the third quarter are expected to be down 20.9% year-over-year (YoY), which is a clear improvement relative to the drop of 31.7% in the second quarter. Despite the large drop in earnings YoY in the second quarter, it was apparent that analysts’ estimates were too pessimistic. So, the better than expected results helped the equity market firm. Unlike the second quarter
where analysts’ expectations for earnings were falling heading into earnings season, estimates for Q3 have been improving. Recent economic indicators have been on balance a little softer than anticipated. For example, improvement in unemployment claims has slowed, which is perhaps signaling that the overall economic recovery will be more deliberate. Notwithstanding a contested election, earnings and forward guidance are likely to be more important drivers of near-term market sentiment than the election.
October 2, 2020
For many years, the relationship between the U.S. and China had been evolving in a positive direction. With China’s transformation into a global manufacturing powerhouse and the U.S. consumers’ desire for cost effective consumption, the two countries had become the largest global trading partners by 2014. However, major issues between the two nations, which had been developing for years, hit a boiling point in 2018 with the start of the trade war. More specifically, U.S. leaders had accused the Chinese of unfair trading practices which included, forced technology transfer, intellectual property theft and subsidies to domestic companies. China denied the accusations, but that did not stop the Trump administration from imposing tariffs on close to $500 billion of goods by
2019, which Bloomberg Economics estimates could lower global GDP by roughly 0.6% by 2021 (the estimate was made prior to the pandemic). Trade tensions did dissipate with the signing of the “phase one” trade deal, in which China agreed to address some of the abovementioned unfair trading practices and purchase a substantial amount of U.S. goods. Unfortunately, China has fallen behind on its purchase commitments, but the two countries still remain committed to the deal. On a different note, the Trump administration has designated numerous Chinese technology companies as national security threats. The Chinese have responded by saying the designation is an attempt to suppress the development of Chinese companies. On another front, the U.S. has also revoked Hong Kong’s special trading status, that had helped it develop into an international financial center after China imposed a new national security law in response to pro-democracy protests. An additional pain point between the U.S. and China pertains to the rerouting of supply chains out of China. The pandemic has made it abundantly clear how important diversified routes of production can be during times of crisis. It is not surprising that the relationship between the U.S. and China has deteriorated to its lowest point in approximately four decades and regardless of the upcoming election outcome, tensions between the two largest economies in the world will continue to simmer for the foreseeable future.
September 25, 2020
stores. Despite stores reopening, foot traffic is down substantially, which reduces the economic value of having a physical presence. For a majority of retailers with an extensive footprint, many of their individual locations
are no longer able to provide a return sufficient to make them economically viable. The largest fixed cost for most retailers is rent and many of these rental agreements were negotiated many years ago. The rental costs that retailers had agreed to do not reflect the reality of the current economic environment. Many retailers are looking for concessions or to renegotiate deals with landlords. According to the National Retail Federation, only 65% of retailers in July were paying 75% to 100% of their rent commitment. Obviously, the struggles retailers are facing will cause a
ripple effect on landlords and banks. This is just one industry specific example, and there are more industries that are troubled, but the more concerning impact is on the labor market. Millions of middle-class workers have lost jobs during the pandemic in industries like retail, restaurants, and leisure. Unemployment benefits have certainly helped but cannot
supplant a good paying job, especially for families with debt. Prior to this year, Americans had amassed $4.2 trillion in consumer debt along with $10 trillion in mortgage debt and for those without a job, making debt payments will be difficult. These structural issues are likely to be a drag on the recovery and will take years to resolve.
September 18, 2020
At this week’s FOMC meeting, the Fed further solidified its flexible average inflation target by explicitly adopting inflation-linked guidance in its policy statement. More specifically, the FOMC expects to keep rates unchanged “until labor market conditions have reached levels consistent with the Committee’s assessment of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.” In the past the FOMC had targeted a symmetric inflation objective around 2%, but after a decade of consistently missing the target to the downside, the goal now is clearly to exceed it to the upside for a period of time. With that being said, the FOMC now projects the Fed Funds rate to reside between 0% and 0.25% through at least the end of 2023 because of the illusive nature of inflation, which has numerous contributing factors. First, even though the money supply has expanded dramatically since the financial crisis, the velocity of money (frequency of money changing hands) has collapsed. Second, the uncertainty created by the pandemic has caused consumers to pull back on spending and in turn increased the savings rate. Moreover, the average savings rate over the past 30 years in the U.S. has been approximately 6.7%, but the most recent figure as of July was a staggering 17.8%. Third, there is a tremendous amount of slack in the labor market that is limiting the average workers’ bargaining position for wage increases. As of August, the unemployment rate in the U.S. stood at 8.4%, which is well above the FOMC’s longer run projection of 4.1%. Lastly, there are the secular deflationary forces of aging demographics and advances in technology weighing on prices. On a different note, the Fed has proven in the past that it clearly has the tools to combat inflation, but a disinflationary environment has been a more difficult problem to solve. The Fed is committed to boosting inflation and inflation expectations, but the road forward will be unpredictable and filled with surprises.
September 11, 2020
September 4, 2020
A tremendous amount of fiscal stimulus has been instituted to help battle the hardships caused by the pandemic. Moreover, the Congressional Budget Office projects the 2020 Federal deficit will total $3.3 trillion or approximately 16% of GDP, which would be the largest figure since 1945. But, even with the previously mentioned government support, many are still suffering and in severe economic danger with minimal financial resources. More specifically, approximately 19 to 23 million renters in the U.S. are at risk of eviction by the end of September, according to the Aspen Institute, which vastly exceeds the recent annual eviction trend of roughly 1 million people. Much has been done thus far to keep people from facing eviction. For example, the CARES Act, which was passed in March, placed a ban on evictions in apartments backed by federal financing that lasted until July 25th and protected approximately 28% of tenants. Also, landlords have worked with tenants on modified rental payment plans to avoid eviction and keep some form of income in place. Just recently, the Centers for Disease Control and Prevention (CDC) announced a plan to temporarily halt evictions of renters earning less than $99,000 a year ($198,000 for couples) to help mitigate the spread of Covid-19. However, those seeking eviction relief will have to provide evidence that they are unable to afford their full rental payment and instead pay what they are able to. The CDC’s initiative will most likely face legal challenges from landlords, but keeping people in their homes should be a priority during these trying times. It is also true that landlords need adequate income to cover property expenses, capital improvements and debt service otherwise they are at risk of foreclosure, which could negatively impact the nation’s affordable housing stock. With the underemployment rate still residing at an elevated level of 14.2%, the eviction situation will be an issue for the foreseeable future. Congress desperately needs to pass an additional stimulus bill in the near term and some form of need-based rental assistance should undoubtedly be included.
August 28, 2020
The Federal Reserve Bank of Kansas City sponsors a symposium on important economic and policy issues facing the global economy every August in Jackson Hole, Wyoming. The symposium is closely watched because it attracts prominent central bankers, government finance ministers, and notable academics. This year the Jackson Hole symposium’s title is “Navigating the Decade Ahead: Implications for Monetary Policy”. Fed Chair Jerome Powell’s address at Jackson Hole on Thursday spoke directly to the theme of the conference. Mr. Powell announced a major policy shift to “average inflation targeting,” which essentially means that the Fed will allow inflation to run modestly above its 2% goal for a period after being below its target. The Federal Reserve will actively pursue monetary policy that will lift inflation above its target to offset periods of inflation persistently below its goal. The reasoning is that inflation will occasionally be driven below the target by recessions. Therefore, it needs to be above target during periods of expanding economic environments to average the Fed’s long-term target. The central bank does not want inflation expectations to be embedded persistently below target due to all the attending problems that arise from weak inflation expectations. The practical implication of the Fed’s policy shift, given the long period of inflation undershoot, is that the Fed is likely to keep short rates pinned to zero for many years. Despite the prospect of additional stimulus from Washington and the possibility of a short-term rekindling of inflation as prices firm with the service side of the economy reopening, the Fed is paving the way for potentially more monetary stimulus regardless of the short-term direction of the consumer price index. The Fed may feel the need to ramp up its current quantitative easing program from the current $20 billion per week rate. Also, the new policy seems sufficiently vague to provide for significant latitude before the Fed is compelled to normalize policy.
August 21, 2020
Minutes from the most recent FOMC policy meeting, which was held in late July, showed officials are extremely concerned that the current health crisis will hinder economic growth, inflation and employment in the near term and cause substantial uncertainties over the medium term. Since the pandemic began, the Fed has effectively implemented a multitude of monetary policy tools and successfully stabilized financial conditions. However, there still remains a disconnect between the markets and the economy and the Fed is far from achieving its dual mandate of full employment and price stability. Fed officials continue to reiterate the need for additional fiscal support from Congress, but they also acknowledge the danger of the massive amount of public debt that has been accumulated over the years, which now stands at $26.6 trillion and has grown approximately $3 trillion since the end of March. Holding back additional fiscal support during recessionary times poses a major headwind to the burgeoning economic recovery unless a medical solution is developed.
August 14, 2020
There are many aspects of ordinary life that have been made surreal by the coronavirus. Playoff hockey in August and major league baseball games being played in empty stadiums are two prime examples. Other elements may not necessarily be surreal, but they are not what they appear. For example, core Consumer Price Index (CPI) in July had the largest monthly rebound since 1991, and the YoY reading jumped from 1.2% to 1.6%. The pickup in core CPI was driven by a rebound in spending categories that were especially hard hit in the second quarter. The dis-inflationary impact of the demand destruction from the self-imposed economic shutdown is starting to unwind, but prices remain well below their pre-pandemic levels. We would expect inflation readings to settle down soon. Recent changes in Disposable Personal income (DPI) can, however, be classified as both surreal and not what it appears. DPI is a vital driver of consumer spending, which is roughly 70% of the U.S. economy. Generally, DPI is a function of the size of the labor market and job growth. So, even though we lost 22.2 million jobs from February to April, with the massive collapse of the economy (GDP -32.9% in Q2), DPI exploded higher in the second quarter. DPI averaged $1.39 trillion per month in Q1 but averaged almost $1.5 trillion per month in Q2. It was the largest increase ever and was the result of a $258 billion increase in support payments from the Federal government. With the additional $600 weekly Federal unemployment benefits expiring at the end of July, short of new transfer payments from Washington, continuing the current pace of the economic recovery will be challenging given the income cliff faced by some consumers. Also, small businesses will perhaps be laying off some workers whose jobs were temporarily saved by PPP loans, as the mandate which requires employers to maintain staffing levels for loan forgiveness is lapsing. This will slow the recovery of the labor market and will be a drag on disposable personal income.
August 7, 2020
2020 has thus far been a year filled with economic, social and emotional turbulence and hardship. Fear and uncertainty regarding the forward path of Covid-19 has left numerous corporate income statements devoid of much needed revenue after a decade of indulging on cheap debt, which altered the financial health of many companies. Moreover, bankruptcy filings of companies with liabilities of at least $50 million are on pace to be the most since the recession that followed the financial crisis back in 2008. But the situation would have been much worse had the Fed not instituted an enormous open-ended bond purchasing program, along with numerous liquidity facilities targeted at corporate bonds among other asset classes. Moreover, short-term funding costs as measured by the spread between 90-day commercial paper and Treasury bills has compressed to an extremely low 7 basis points (bps) after spiking on March 24th to over 205 bps. Also, credit spreads have dropped precipitously since their March highs. Furthermore, U.S. high yield bonds experienced tremendous demand during the month of July as yields fell the most during any single month on record. Historically, when bankruptcy filings and defaults pick up, credit spreads tend to widen in order to compensate investors for the increased probability of potential losses. Right now, the high yield market is being distorted to a degree as many troubled companies work to outlast the downturn by deferring rent payments, obtaining temporary reprieves from suppliers, furloughing workers and applying for government aid. The previously mentioned tactics along with extremely accommodative monetary policy has undoubtedly kept companies in business longer than what would have been imaginable. However, the pace of the economic recovery will ultimately decide the severity of the credit cycle and given the current unknowns and the diminished upside potential in the high yield market, we feel this asset class should be approached with caution.
July 31, 2020
The news flow and trading activity generally slow as we get deeper into the summer. That was not the case this week as investors had a myriad of new data points to analyze. The Federal Reserve’s Open Market Committee (FOMC), which sets the rate on the Fed funds, concluded its July meeting and, as expected, did not change its policy. Notably, the Fed also reiterated its commitment to using all tools necessary to support the economy. On the economic front, the Commerce Department reported second-quarter GDP, and it too was consistent with expectations. The economy posted its sharpest downturn on record, which was broad base, and can only be characterized as horrendous. Consumer spending was especially weak as services consumption fell 43.5% during the period. However, there was nothing in the report to dissuade us of our opinion that the halting economic restart will lead to a meaningful rebound in the consumer side of the economy in the third quarter. The surprise for investors seems to be stronger than expected earnings. With 185 companies reporting second-quarter earnings this past week, now over 62% of companies in the S&P 500 have reported with over 80% exceeding analyst’s expectations. The number of companies beating expectations in percentage terms is comfortably above historical norms, but it seems stronger since several large bellwether companies had blowout quarters (AAPL, AMZN, PYPL, GOOG, FB). According to FactSet, 2Q earnings for the S&P 500 are estimated to decline by 43.4%, with revenue dropping 10.0%. Earnings will be at the worst level since 4Q 2010. The apparent stabilization of economic activity and the surprising earnings season leads us to believe that the earnings picture should brighten from here. Investors need to remember, however, that the magnitude of the earnings bounce next year is dependent on the virus’ impact on the strength and shape of the economic recovery.
July 24, 2020
The U.S. fiscal response to the Covid-19 pandemic was expansive and impactful during a time of enormous human suffering and uncertainty. The main component of the domestic fiscal response is the CARES Act, which was passed on March 27th with overwhelming support by Congress and amounted to approximately $2.2 trillion. Unfortunately, some provisions of the CARES Act are set to expire soon and without an additional fiscal package, the nascent economic recovery will be in jeopardy. One of the more effective but controversial provisions of the CARES Act is the additional $600 per week unemployment benefit, which layers onto existing state unemployment benefits and will expire at the end of the month. Moreover, the additional $600 per week equates to approximately $65 billion in monthly income and studies have shown that a vast majority of this additional income is spent. Furthermore, overall retail sales in June showed that spending was down just 60 basis points compared to the pre-pandemic level. On the other hand, it has been noted that the additional unemployment benefit is so generous that some individuals are making more money unemployed than they did while working. The obvious solution is to continue the additional unemployment benefit but at a somewhat reduced level to create an incentive for all individuals to reenter the workforce. Another area where additional federal funding is needed is at the state and local government levels. The CARES Act did make $150 billion available to state and local governments but only for the specific purpose of fighting Covid-19 and not for general budgetary purposes. Due to the massive sales and income tax short falls caused by the lockdowns, state and local governments have eliminated roughly 1.5 million workers in three months, which far exceeds the state and municipal job losses experienced after the financial crisis. The near-term economic outlook will dim without additional fiscal stimulus. Right now, Congress is not in agreement on what the next fiscal stimulus package will look like, but it is our belief that given what is at stake, a resolution to partially alleviate a portion of the suffering due to Covid-19 will be found.
July 17, 2020
The Federal Reserve has taken unprecedented steps, most notably expanding its balance sheet by over $3 trillion, to stave off an economic crisis in the wake of the Covid-19 pandemic. The Fed has vowed to maintain short-term interest rates at the zero-bound through 2021 and to purchase securities as required to provide liquidity to the capital markets. As with any liberally administered prescriptive measure, there are unintended side effects. Long term, the impact may be a secular deterioration of the dollar and higher inflation, but this risk seems to be too far in the future to worry investors today. The more immediate concern has been the dramatic impact of the Fed on asset prices. Although most of the Fed’s bond buying has been in U.S. Treasuries and mortgage-backed securities, the Fed’s pledge to intervene in the market for corporate debt has given financial markets confidence to bid up risk assets. It seems to us that in some cases prices have become unmoored from the near-term fundamentals and risks are not being properly priced. Although there has been significant issuance of new debt offerings, the premiums demanded on corporate bonds relative to Treasuries has narrowed sharply. Credit spreads in the high-yield segment of the bond market have been cut in half since March, and the investment grade spreads are almost back to pre-pandemic levels. Distortions and risk-taking can be found in the equity side as well. The forward price-to-earnings multiple on Growth stocks (Russell 1000 Growth Index) is 31.2x and over 13 multiple points higher than Value stocks. Companies that are perceived to be beneficiaries of current pandemic have seen their stocks rally sharply. Netflix is a case in point. After soaring 60% this year on the realization of a blowout first quarter, the stock sold off today as investors realized that despite a great first quarter earnings, subscriber and revenue growth were simply pulled forward. With abundant liquidity and highly accommodative monetary policy, investors need to stay focused on long-term investment opportunities and be mindful of the valuation distortions present in the current market environment.
July 10, 2020
Virus resurgence is a major risk right now with roughly half of the U.S. population experiencing a halt or rollback in reopening plans indicating that the path forward to fully revive the economy will be anything but smooth. Covid-19 case counts in the U.S. are rising rapidly at over 50,000 new cases per day, which easily surpasses the previous peak reached back in April. High frequency data, which had turned the corner once the reopening process commenced now shows signs of stalling. Economic data indicates that consumers are still cautious as they battle an invisible enemy. Moreover, roughly one third to half of Covid-19 transmissions occur from asymptomatic carriers according to research from the University of Oxford. Additionally, with an incredibly long incubation period (roughly five days) the disease can travel silently around a community before being detected. The previously mentioned points highlight a few of the reasons why this disease is so difficult to contain. But hope should not be lost as progress is being made on the medical front and the capacities of human ingenuity should never be underestimated. One factor that has been buttressing risk-on assets is that even though the case count is rising dramatically, it has not been associated with a rapid increase in new deaths due in large part to improved medical treatments. Moreover, there are more than 160 different programs that have been launched to develop and test new treatments including vaccines, antivirals, antibody treatments and anti-inflammatories. Back in 2015 the median time for U.S. regulators to approve a new drug was 333 days; however, given the current circumstances the approval process has been expedited. There is a high probability that numerous medical solutions will exist to combat Covid-19 at some point in the future, but the current situation is unquestionably having an enormous social and economic toll. Congress and the Fed have worked hard to help the U.S. population through this difficult time, but their work is far from over and it is our belief that additional fiscal and monetary stimulus will have to be rolled out in the coming months.
June 26, 2020
The performance divergence between the major equity market indexes during the stock market’s recovery has continued. The discrepancy between many indexes is at levels we have not seen in many decades. For example, the Dow Jones Industrial Average is down roughly 10% from the beginning of the year, yet the tech-laden Nasdaq Composite has rallied almost 12%. Large-cap stocks have decisively outperformed small-cap stocks with a performance differential of 10.7% on a year-to-date basis and 12.8% over the last 12 months. The divergence between growth and value has been even more staggering as large-cap growth stocks (Russell 1000 Growth) have outpaced large-cap value (Russell 1000 Value) by more than 24% in 2020. We have highlighted market divergences in the past as they are often reconciled in a market downdraft causing a change in market leadership. Many strategists consider significant market divergences as a warning sign for volatility ahead.
Another type of divergence that we are also becoming concerned with is the disparate impact the recession is having on personal income and savings. Across the major industrialized countries, according to Capital Economics, employment has fallen by over 55 million, and another 35 million have been furloughed. In the U.S. alone more than 20 million workers have already lost their jobs. The pandemic has devastated workers in some industries such as restaurants, travel, leisure, and retail. Workers in other industries have been largely unaffected from an employment and income perspective. Shuttered retail shops and businesses have not allowed those who have retained their jobs to spend their earnings as they ordinarily would. These workers have experienced an involuntary rise in their savings. Because a disproportionate number of people in lower-wage service jobs have been negatively affected by the recession, the underlying problem of income inequality and the growing economic chasm between the wealthy and the middle class will only get worse due to the economic downturn. The structural causes of income and wealth in-equality have been in place for decades, but the issue seems to be coming to ahead and is likely to be a major subject in the November election.
June 19, 2020
During the twelve bear markets since World War II, equity markets have declined on average over 30% and taken roughly 14 months to go from peak-to-trough. The recovery from those bear markets has averaged two years. The S&P 500 is still 8% off old highs reached in February, but the speed of the 40% recovery in the price of the index is unprecedented. The dramatic equity market drawdown and rapid recovery has, as of today, only taken four months. The breathtaking pace has left many investors uncertain. Yet other investors still embrace the prior bull market’s mantra of buy the dip. We are seeing an elevated level of market speculation, especially from retail investors. The Hertz saga, a significant rally in the stock price after declaring bankruptcy and the suggestion of a secondary offering, is a clear indication of how speculation has crept into markets. Hopefulness regarding a quick economic rebound is not just in the financial markets. The small business optimism index bounced from April’s seven-year low of 90.4 to 94.4 in May. Small business owners are optimistic about future business conditions and expect the recession to be short-lived. That is consistent with the 80% of unemployed who expect to have their jobs back soon. There is some justification for the positive sentiment. The high-frequency economic data suggests the worst is behind the U.S. economy. More importantly, economic indicators such as retail sales and housing starts are indicating that the consumer side of the economy is experiencing a strong rebound. However, our experience has been when markets seem to be running ahead of the fundamentals and speculation ramps up, financial markets tend to experience a period of heightened volatility. The coronavirus case counts and hospitalizations have improved in some areas of the country but have deteriorated in others. The coronavirus remains a threat to the economy. After the initial bounce in economic activity off extreme lows, the economic recovery is likely to be somewhat uneven. The uncertainty will create periodic spikes in volatility as we transition to a more sustainable growth phase.
June 12, 2020
Volatility made a comeback this week as indications of a second wave of COVID-19 infections coupled with the Fed’s bleak summary of economic projections weighed heavily on risk assets. Moreover, the VIX Index, which is derived from price inputs based upon S&P 500 index options, surged 66% through the first four trading days of the week. Progress toward easing lockdowns across the U.S. is encountering headwinds as national health officials are warning about a second wave of infections popping up outside of the previous hot spots of New York and New Jersey. Furthermore, Texas, which has been pushing to ease the lockdowns imposed during the first round of infections, now finds itself experiencing a surge in COVID-19 cases. Unless a vaccine is developed or herd immunity is established, fully reopening the economy is going to be a long and iterative process. Historically it has taken on average nearly 11 years to bring a vaccine to market and the success rate is rather low, with only 6% of experimental vaccines making it to the finish line. It is refreshing to see that the medical community is already making great strides to combat COVID-19. Moreover, according to the World Health Organization, there are roughly 100 experimental vaccines under development. With that being said, the Director of the U.S. National Institute of Allergy and Infectious Diseases is optimistic that a vaccine could be available by the end of this year for use by healthcare professionals and those most vulnerable. There are various COVID-19 vaccine candidates in different phases of clinical trials and medical professionals are doing their best to balance the speed of development versus human safety. The lockdowns that were instituted due to the lack of a medical solution to COVID-19 caused an extraordinarily deep economic recession. High frequency economic data, like electricity consumption and restaurant reservation bookings, are slowly starting to turn the corner but they still have a long way to go. A medical solution is the key to a quicker recovery and it is evident that progress is being made.
June 5, 2020
This year has proven to be a period of shocking events and surprises. The coronavirus seemingly, out of nowhere, has caused a devastating and costly loss of life, with 108,000 Americans having already died due to the pandemic. It has also created the deepest recession since the Great Depression and a breathtakingly rapid bear market. We have seen truly unprecedented efforts by the Federal Reserve, as well as other central banks, to provide liquidity to the economy through direct intervention in credit markets. The fiscal and monetary support has been the driving force allowing financial markets to stabilize and for the dramatic recovery in equity markets. Perhaps just as astonishing as the virus and its economic impact has been the tremendous resiliency of the equity market. Despite all the social and economic carnage related to the coronavirus, investors in U.S. large-cap stocks have been seemingly unscathed as major indexes have largely recovered to beginning of the year levels. Even for most equity bulls, it has been difficult to be comfortable with the equity market rally due to the wide divergences that have developed. The Russell 2000 index, a standard index used to represent small-cap stocks, under-performed the S&P 500 index on a year-to-date basis by 22% through mid-April. Another example has been the massive gulf in relative performance between growth and value stocks, which by early May was over 23%when comparing the Russell 1000 Growth versus the Russell 1000 Value. Additionally, the fixed income market was not confirming the equity market's strength as bond yields remained stubbornly compressed and yield spreads elevated. Over the last few weeks, all these divergences have begun to resolve as the equity rally broadened into small caps and value stocks, and bond yields have started to rise. The equity market, based on technical and fundamental factors, seems to be overbought. But the stock market’s strength is born out of investor optimism that the economy is on the mend. Today’s employment report is reinforcing that narrative and perhaps suggesting that the U.S. economy will prove to be resilient.
May 29, 2020
There are 158 days until the United States presidential election with many additional national offices and governorships at stake. Given the proximity to such an important election, most issues that rise to the level of national interest will be seen from a political framework. This will certainly occur regarding the state of the economy and the government's response to the coronavirus. The rhetoric and tension between the U.S. and China have risen recently due to the Covid-19 pandemic. As the death toll in the U.S. from the coronavirus passed 100,000 this week, many in Washington are blaming the Chinese for making the situation worse by not being transparent when the health crisis began. No candidate wants to be seen as “politically soft” on China. With this as a back-drop, the Chinese approved a controversial national security law that bans secession, subversion, terrorism, foreign intervention, and would allow China’s state security agencies to operate openly in Hong Kong. Secretary of State Mike Pompeo announced that the U.S. State Department no longer considers Hong Kong to have any significant autonomy. The Trump administration will take countermeasures that will continue to amplify the tension. The financial markets need to be concerned that the back-and-forth between the U.S. and China will devolve into a mutually destructive effort to punish each other and will prove damaging to the nascent economic recovery. Leaders in both countries are unlikely to publicly backdown due to the internal political ramifications, but they also understand the economic realities and consequences of rekindling the trade war. The global economy is fragile and the two largest, most dynamic major economies in the world need to lead the path forward. We expect harsh language from both sides, and sanctions that will allow political leaders on both sides to display “toughness.” But whatever measures are ultimately implemented, we do not believe they will be economically significant. The political and economic stakes are too high. The tension may however be sufficient reason for the market to consolidate recent gains.
May 22, 2020
With cases of COVID- 19 totaling more than 5,000,000 around the world, the entire global economy has been devastated by this horrific disease. According to the International Monetary Fund, real global GDP is expected to wither by 3% in 2020, which would surpass the economic contraction caused by the global financial crisis between mid-2007 to 2009. Regional growth projections for 2020 range from positive 1.5% in South Asia to negative 7.3% in Western Europe. Unfortunately, economic momentum in Western Europe was already deteriorating heading into this year as the trade war of 2019 weighed heavily on the region’s exports. Moreover, the past decade has been tenuous for the European Union (EU) as it has dealt with a sovereign debt crisis, an immigration wave and Brexit. However, the lockdown recession caused by the coronavirus represents the greatest challenge the EU has faced since World War II. The European Central Bank has been aggressively implementing accommodative monetary policies for over 8 years through low to negative interest rates and a massive expansion of its balance sheet, but more undoubtedly needs to be done. Eurobonds and the mutualization of debt have been proposed in the past but has not gained traction as the more solvent nations within the EU have not wanted to burden their taxpayers with the debts of less frugal nations. Difficulties have also arisen in the EU since there is no common treasury to direct funds to where they are needed the most. The nations that have been heavily impacted by the pandemic unfortunately have less capacity from a fiscal perspective to stimulate their economies. Also, European countries in the currency bloc are precluded from devaluing their currency during times of economic hardship, which can prolong their recoveries. But, with the recent agreement between Germany and France to support a €500 billion recovery fund, there is hope on the horizon. If the recovery fund is approved by the EU members, the proceeds would flow to the areas in greatest need in the form of grants. At this point, not all EU members are behind the recovery fund; however, France and Germany have made tangible progress towards creating EU debt and alleviating, to a degree, some of the economic imbalances that have evolved in Europe over the years.
May 15, 2020
The economic indicators released this week continue to reflect the dramatic impact the economic lockdown caused by Covid-19 virus has inflicted on the economy. The record drop in retail sales was especially awful, but very predictable given that more than 30 million people have filed for unemployment assistance since February and the massive disruption to retailers caused by forced store closings. The statistics are suggesting that this economic contraction will be extremely severe, perhaps matching the recessions seen in the 1920’s and 1930’s. Federal Reserve Chairman Jerome Powell spoke this week (virtually) at the Peterson Institute taking a somber tone regarding the economy and making the case for more fiscal support. He suggests that now is not the time for deficit hawks to allow debt concerns to restrict fiscal stimulus as long-term structural economic damage can be minimized by more federal spending. Although we are concerned about the implications of government deficits and effects of debt in the long run, in our view, it seems prudent to do whatever is necessary to avoid the tail risk associated with a prolonged recession. Additional support, especially if it is well targeted, will also lessen the duration of the downturn. The length of the recession is an important factor because there is a strong correlation between the length of the recession and the required amount of time needed for the economy to fully recovery. Research suggests that actual depth of the contraction does not have a large impact on the time to recovery. It makes sense when you consider the longer the recession, the greater the impact on supply chains, job skills, cash cycles, etc. The goal for fiscal and monetary authorities should be to make sure this is an average recession from a duration perspective. This would limit the corrosive structural financial damage caused by a protracted economic downturn and lessen the human cost as well.
May 8, 2020
With economies gradually embarking on the long and uneven road to reopening, people around the world are wondering what the future may hold given the dramatic lifestyle changes that have come about to combat the pandemic. The recent risk-on sentiment in the equity market, which was largely induced by massive amounts of fiscal and monetary policy accommodation, may be masking the fact that the journey to a full recovery could be years from now. The best case study available to gauge what the path forward might resemble may come from China. With the corona-virus originating in the city of Wuhan back in the later stages of 2019, China was the first country to confront the virus. China moved rapidly to suppress the outbreak by locking down cities in late January of this year. The lockdown had a tremendous impact on economic activity with the Chinese Composite PMI dropping precipitously from 53.0 in January (anything above 50 signifies expansion) to a dismal 28.9 in February. However, with lockdown measures easing in certain parts of China in March, the Composite PMI re-bounded back to 53.0. At a surface level, it appears that China successfully contained the coronavirus within the first quarter of this year, but many believe their numbers are misstated. Moreover, it is certainly suspect that China’s population is four times the size of the U.S. but they reported one-fifteenth the amount of coronavirus cases. Therefore, a better indication of the true health of the Chinese economy is commentary of Chinese operations through first quarter U.S. company earning reports. Generally speaking, consumer-oriented companies have reopened a majority of their stores, but capacity has been limited, store hours have been reduced and consumers have been cautious to spend. In order to incentivize consumer spending, the Chinese government has expanded unemployment benefits and issued spending vouchers to many of its citizens, but the Chinese consumer is showing signs of trepidation and may not resume their previous spending patterns anytime soon. The abrupt evolution of the global recession does not fore-tell a rapid recovery at this point, but progress is certainly being made.
May 1, 2020
Despite horrible economic data last month, April proved to be a stellar month for equity investors. The rally off the March 23rd lows has been almost as breathtaking in speed as the roughly four-week bear market that preceded it. The equity market has rallied over 30% from the March lows through the end of April, and the S&P 500 was down only 9.9% on a year-to-date basis. Equity investors have been able to look beyond the output contraction of 4.8% in the first quarter as indicated by the GDP report released this week, and a second quarter that will be demonstrably worse. The equity market seems to be anticipating a V-shaped economic recovery with a sharp and strong economic lift in the second half of 2020. The massive liquidity that has been provided by both the Federal Reserve and the federal government is a logical justification for this optimism. On top of the CARES Act, which will provide $2.3 trillion in fiscal stimulus, the Federal Reserve has expanded its balance sheet by $2.4 trillion to over $6 trillion in only a few months. With current Congressional mandates, the Fed has the capacity to expand its balance sheet to $10 trillion if it feels the need to do so. To provide perspective on a $10 trillion Fed balance sheet, the entire U.S. economy is only slightly larger than $20 trillion. The Fed has traditionally acted as a “lender of last resort” and would provide liquidity to banks to encourage the extension of credit to the financial system. With the creation of the Primary Market Credit Facility and the Secondary Market Corporate Credit Facility, the Fed has the potential to act as a direct “lender of last resort,” which extends its mandate not just to the problem of market liquidity, but to providing support for insolvent companies. The Fed cannot generally solve a solvency problem caused by a lack of revenues, at least not for any extended length of time. The massive fiscal and monetary stimulus will not resolve all the economic difficulties that lay ahead. There will be residual economic damage, and it is doubtful that the recovery will be V-shaped.
April 24, 2020
The emotional, physical and economic hardship that Covid-19 has inflicted on people around the world has been immense to say the least. The disease has now infected roughly to 2.8 million individuals globally, which is presumably an understatement due to asymptomatic carriers and a lack of adequate testing in certain portions of the globe. With the absence of a medical solution to Covid-19, social distancing and lockdowns have been implemented in an effort to slow the spread of the disease and flatten the curve. Here in the United States the economic impact has been devastating even with the massive fiscal and monetary stimulus that has been enacted thus far. Furthermore, working Americans have a bleak outlook at this point with 25% believing they are likely or fairly likely to lose their jobs in the next 12 months according to a Gallup poll. The previously mentioned statistic is not surprising given the total number of people filing for unemployment insurance over the last five weeks has climbed to a staggering 26.5 million. The only way to truly heal the economy is to open it back up, but to do so without herd immunity poses significant challenges. Therefore, the guidelines for reopening the American economy are based upon data driven criteria at the state and regional level, preparedness to meet the medical needs if the virus reemerges and phased guidelines that will be followed at the local level. The reopening process will not be immediate, nor will it be linear, but it will take time and encounter numerous hurdles along the way. A key to the reopening process will be mass testing and tracking to identify, isolate and monitor any new Covid-19 outbreaks. The good news is that the daily growth rate of Covid-19 cases appears to have peaked in the U.S. and there is some light at the end of the tunnel. Also, with approximately 83 Covid-19 vaccines currently in development globally, a medical solution is becoming more probable and could add a well needed tailwind to reopening the economy.
April 17, 2020
The reality of the recession is starting to bleed through into the economic data. High-frequency data series such as unemployment claims reflected the significant and sudden impact the coronavirus has inflicted on the economy. This week another 5.25 million people filed for unemployment benefits. Over the last four weeks, 22 million new claims have been filed implying that the unemployment rate is currently a staggering 16%. A few March economic reports came out recently indicating how widespread the economic damage has become. Industrial production plunged 5.4%m/m, which was the sharpest contraction since 1946. Several regional Fed surveys (Empire and Philly) suggest that the collapse of the industrial economy will continue through the second quarter. The U.S. economy at its core is led by consumer activity, and with the job destruction over the last month, consumer demand will inevitably be severely affected. Real consumption fell by approximately 5% annualized in the first quarter, and in March, headline retail sales saw their sharpest monthly drop on record. We expect the economic data to continue to worsen as the recession deepens. The scope of the economic damage and potential residual risks to the economy are not lost on the Federal Reserve and federal government officials, who have combined to commit more than $6 trillion to arrest the economic recession caused by the pandemic. To understand the magnitude of the government’s response, consider that it is larger than the entire GDP of the U.S. economy in the fourth quarter. The nonpartisan Committee for a Responsible Federal Budget projects that the combination of the stimulus spending and the recessions' effect on federal revenues will cause a budget deficit of $3.8 trillion this year. The response, particularly by the Fed, has been unprecedented in both the size and scope. The government initiatives and a seemingly flattening of the coronavirus case curve have provided temporary relief to markets allowing for a powerful rally. Opening the economy will take time and will be difficult given the uncertainty created by the virus. The prospects for the equity market’s continuing recovery depend on a medical solution limiting the fear of the virus and a fully functioning economy.
April 10, 2020
Risk assets performed extremely well this week as markets became encouraged by signs that the spread of COVID-19 may be decelerating. Lockdowns and social distancing appear to be working; however, the economic impact has been devastating. As of April 4th, weekly initial jobless claims rose by 6.6 million to bring the total over the past three weeks to just shy of 17 million. With respect to the service sector, Markit U.S. Services PMI, which was in expansionary territory back in January dropped precipitously to 39.8 in March. Also, the University of Michigan Consumer Sentiment Index declined dramatically to 71.0 in April from 89.1 one month prior and was the largest monthly drop on record. Although it has not been formally announced, it is quite apparent that an economic recession has begun. According to Bloomberg research, the duration of a recession matters more than its depth regarding equity market declines. Moreover, history suggests that the current sharp economic downturn can be contained to a degree if it is short lived. Unfortunately, we are dealing with a pandemic that has a forward path plagued with uncertainty. The U.S. government and central bank realized the severity of the situation and reacted rapidly. On top of all the fiscal and monetary measures taken to date, the Fed recently announced a new $2.3 trillion lending program that will target cities and states along with small to midsized businesses. The goal of the recently enacted monetary stimulus is to stabilize the financial system, muffle volatility and keep municipalities and businesses solvent during the lockdown phase. On a different note, it is important from a portfolio perspective to keep a long-term focus. A study of monthly observations since 1950 shows that a portfolio’s risk profile tends to decrease as the holding period increases. During periods of volatility like the one most recently experienced, it can be difficult to hold the course and not deviate from the targeted asset allocation. But if liquidity needs, time horizon, tax situation, return expectations and risk tolerance have not changed, then staying the course from an investment perspective is the prudent thing to do.
April 3, 2020
Last Friday, the House of Representatives approved the Coronavirus Aid, Relief, and Economic Security (CARES) Act by a voice vote and the President signed it into law. The CARES Act is a massive $2.2 trillion bill in response to the economic damage caused by the Covid-19 pandemic. One of the major components of this financial-support package is the Small Business Administration’s Paycheck Protection Program (PPP). The PPP would provide SBA lenders up to $350 billion in government-guaranteed loans to cover up to eight weeks of payroll and other expenses, and importantly, if businesses keep their workforce intact the loans would be forgiven. The SBA expects that business owners will be able to apply for loans as soon as today, but many details of the program remain unclear, and banks are pushing back on the start date until important parameters are more well defined. Lenders want to participate in the program to support local businesses in their communities, but lack of clarity regarding the program details and the program’s questionable economics for banks has created a hesitancy for some banks. Interest rates for PPP loans were initially set at 0.5%, which is too small to cover the financing and cost of administering the loans. At the request of community banks, Treasury Secretary Mnuchin said on Thursday night that the interest rate would be raised to 1% to entice banks to participate in the program. A well-functioning support program that can provide the needed financial assistance to small businesses to bridge them to the economic recovery is vitally important. Small businesses employ 59 million people in the U.S., which makes up 47.5% of the country’s workforce. Last year, in the SBA’s signature 7(a) and 504 programs, the SBA approved 58,000 loans totaling$28 billion. The PPP is a massive escalation in lending activity that will require millions of loans and it needs to scale very quickly to provide the desired safety net. Undoubtedly, there will be trials getting out of the gate and there will be unintended consequences. CARES Act programs will require midcourse corrections, but implementing these important pro-grams are critical to limiting the economic damage of the pandemic and setting the stage for a recovery sometime in the second half.
March 27, 2020
Due to the lack of an immediate medical solution to Covid-19, governments around the world have resorted to social distancing and lockdown measures in order to mitigate the spread of the virus. Moreover, approximately 50% of the U.S. population is now subjected to some form of governmental restraint, which is substantially impacting the economy. The first glimpse of the economic damage arrived when initial jobless claims for the week ending March 21st skyrocketed to 3.28 million and easily surpassed the previous record of 695,000 back in 1982. Both the Fed and the government officials are cognizant that economic data is going to deteriorate further and they have been extremely active this week. In terms of monetary stimulus, the Fed expanded its quantitative easing program by removing the cap and making it open ended while adding agency CMBS to its pool of eligible assets. The Fed also established two facilities to purchase investment grade corporate debt on both the primary and secondary markets, resurrected the Term Asset-Backed Securities Loan Facility and created the money market mutual fund and commercial paper funding facilities. On fiscal front, both sides of Congress passed a $2 trillion stimulus bill that will be broad reaching and help individuals, businesses, states and local governments as well as other entities cope with the economic hardships to come. With that being said, the level of fiscal and monetary stimulus is monumental in terms of its breadth and size. But there is little doubt that the true recovery will come when the rate of new Covid-19 cases begins to meaningfully fall which means we must rely heavily on the medical community in the weeks and months to come. The Milken Institute currently estimates that there are 58 institutions working on Covid-19 treatment therapies and 43 are embarking on the development of a vaccine. Thus, the amount of resources and talent devoted to addressing Covid-19 is sizable and even though successful results are not right around the corner, the medical field should be able to provide some much-needed relief in the near future. In the meantime, the dramatic and timely monetary and fiscal measures taken thus far can help ease the pain of the pandemic.
March 20, 2020
On Thursday this week, the market finally broke an unprecedented string of nine consecutive trading days with swings up or down of greater than 4% in the equity market. The selling pressure has been extreme due to uncertainty caused by the coronavirus outbreak and undefined economic consequences. As a society, we have decided to prioritize containment of the virus over the economic impact. Travel bans and the shutdown of businesses deemed nonessential, coupled with consumer demand destruction has wreaked havoc across the entire country and has created a tremendous economic shock. The slope of the yield curve and the level of rates suggested that the market was already nervous about an aging bull market. The conditions were ripe for a correction of some magnitude, but obviously, a global pandemic was not expected to be the catalyst for a potential global recession and the end to the longest bull market in history. The speed of the market drawdown and the change in market expectations have been breathtaking. So, where do we go from here?Timing is always very difficult, but history can provide us with an idea of the sequencing of events to follow. After an event-driven crisis, the central banks act first and aggressively to provide liquidity and confidence in the durability of the financial system. That has already occurred, and we are likely to see additional action if necessary. This is followed by a painful period of indecision by governmental authorities that causes additional financial market turmoil; ultimately, corrective fiscal measures are taken that helps boost demand and confidence. We are still waiting for a comprehensive, cohesive set of fiscal policy steps to stabilize the economy and lift growth on the other side of the containment efforts. These fiscal policy tools will come. Typically, financial markets bottom soon after authorities have put in place sufficient economic safeguards. Investors need to maintain a long-term orientation and use normalized earnings to get comfortable with valuations. Smoothing out the cyclicality of earnings and applying an average multiple suggest there is more reward than risk for investors with a reasonable time horizon.
March 13, 2020
Since 1945, the S&P 500 has experienced 10 bear markets, (a peak to trough decline of 20% or more) which equates to one occurring every 7.5 years. On average, the peak to trough has taken approximately 17.5 months; however, the unforeseen and rapidly evolving nature of COVID-19 caused the current bear market to occur in just 16 trading sessions. The market turmoil of recent weeks even caused a dislocation in the U.S. Treasury market. Typically, during times of market stress, investors sell assets and buy Treasuries for their safety and liquidity, but during times of times of panic liquidity can dry up in most asset classes and investors are forced to sell Treasuries in order to obtain cash. This was evident a few times this week when Treasury yields escalated while equities sold off. The Fed took action on Thursday to support the Treasury market by modifying its Treasury reinvestment and $60 billion monthly purchase program to include Treasuries across all maturities. The previously mentioned action may open the door to additional quantitative easing when the FOMC meets next week, which will help less liquid corners of the market clear in a more orderly fashion. The markets will need more than ultra-accommodative monetary policy to combat the supply chain disruptions and reduce consumer demand caused by COVID-19. With that being said, President Trump declared a national emergency and announced a range of actions to help soften the economic impacts from the outbreak. An additional hint of good news is that, market and economic support is coming from all over the globe in the form of mortgage forbearance in Italy, 0% interest rate loans in Sweden, bond purchases in Japan and the reduction of required reserve ratios for some banks in China. According to Bloomberg, COVID-19 cases total 80,813 in China, however, the number of new cases have declined to the point where there were no new cases reported today. China took drastic measures to stop the spread of the virus and as their economy gradually returns to normal, they provide hope that COVID-19 can be contained.
March 6, 2020
Extreme volatility continued to grip financial markets last week. Apart from the ongoing spread of the Covid-19 virus, the most notable development was that the Fed cut interest rates in between FOMC meetings for the first time since the financial crisis. The timing of the cut was surprising, but the fact that the Fed felt the situation warranted a 50-basis point cut was striking as well. The Fed cut its key Fed Funds rate to a range of 1% to 1.25%. It was highly unusual for the Fed to take such bold action, but it is not unprecedented. The Fed also moved aggressively after the 9/11 attacks, the 2001 tech stock bubble, the Russian financial crisis and the collapse of Long Term Capital in 1998. The pre-emptive rate cut is intended to provide insurance against future economic weakness. Economic data continues to be relatively strong as evidenced by February’s non-farm payroll report. The domestic economy’s current momentum and the Fed’s aggressive rate move failed to have much impact on the long end of the yield curve. In fact, as investors attempted to lower portfolio risk in the face of economic uncertainty caused by the coronavirus’ impact, the 10-year U.S. Treasury reached an all-time low yield of 0.66% this week. Perhaps more astoundingly the two-year Treasury yield was 1.3% just two weeks ago, but fell to 0.39% with the decline in yields over the last two weeks. The bond market is suggesting additional rate cuts and more financial market volatility ahead. The Fed Fund futures is predicting another 50-basis point cut at the March FOMC meeting. Since much of the expected economic softness caused by the virus is due to a supply shock, the Fed’s rate cut will be providing only a modest economic lift. Fiscal stimulus in the form of a credit facility for businesses affected by the transitory impact of the virus would be more efficacious and would bring confidence to financial markets.
February 28, 2020
The financial markets this week focused on the potential economic impact of the coronavirus (Covid-19). With 83,694 confirmed cases (62 in the United States) and 2,809 deaths globally, the virus has now spread to 50 countries. Its estimated fatality rate is 2.3% and is highest among older adults with pre-existing medical conditions (fatality rate is well under 0.5% for patients under 50 years old). For comparison’s sake, in 2003, the SARS pathogen had 8,096 total cases and 774 deaths with a similar transmission rate profile (just as contagious).
The economic impact from Covid-19 will take several quarters to work through the global economy. Absent another exogenous shock it could take over a full year from the initial recognition of the virus in early December 2019 for its economic effects to be fully realized. The virus will affect the economy as people are unable to pursue economic interests due to illness or from containment efforts to control the virus’ spread. Consumer spending is also likely to be reduced as consumer behavior adjusts, while individuals avoid situations that potentially expose them to the virus (for example, people stop dining out and taking cruises). Finally, supply chain issues can reduce activity as manufacturers cannot produce products without input sources.
The magnitude of the Covid-19 triggered downdraft is uncertain given the unpredictability of the virus’ progression and economic impact. After a 30% plus year in 2019, we had expected the equity market to provide modest returns in 2020. The weakening domestic economy and the supply chain disruptions could meaningfully impact earnings growth. New earnings estimates for 2020 will likely be flat or up only modestly. Equity price levels and valuations are in the process of incorporating revised earnings expectations. The S&P 500 is down over 10% and has entered correction territory since reaching a new all-time closing high of 3386 only last Wednesday (02/19/2020). The blended 12-month forward price to earnings ratio was 19.0x last week and is now approximately 16.8x – its median going back to 1990 is 15.1x. Historically, 5% to 10% corrections occur a few times per year. In previous equity corrections, dating back to 1945, the average peak to trough has taken 4.1 months and the average peak-to-peak lasted just under 8 months. With today’s advances in technology coupled with algorithmic trading, however, markets move much faster than in the past.
February 21, 2020
One of the main questions vexing markets, is the degree to which the coronavirus will weigh on growth in the world’s second largest economy. With a fraction of the Chinese economy functioning at this point, certain businesses are finding it increasingly difficult to meet their financial obligations. Back in 2016, President Xi Jinping embarked on a deleveraging campaign that led to a crackdown on shadow banking. Since then, the credit cycle has accelerated and defaults have increased dramatically. Moreover, both investment grade and high yield borrowers have seen credit spreads over government debt escalate to the highest figures since November of 2019. Even though the Chinese government has responded with easier liquidity policies, the funding is not finding its way to smaller private companies, which accounted for more than 80% of the defaults in 2019. With domestic market bond defaults totaling a record 137.6 billion yuan ($19.7 billion) last year, the impacts of the coronavirus will only exacerbate the credit cycle. But, based on 5-year Chinese sovereign credit default swaps, which are trading at 35 basis points (bps) and is well below the 17-year average of 70 bps, the market is confident that the central government has the financial means to absorb the economic impacts from this epidemic. An additional headwind to growth facing China pertains to the country’s aging demographic profile. Back in 1979, China enacted the one-child policy due to food and housing shortages the nation was facing at the time. In 2016, however, China revised the policy to allow for up to two children, but it has not helped increase birthrates. Furthermore, there were only 14.6 million births in China in 2019, which was the lowest figure since 1961. It is projected that by the year 2030, China’s population will peak at 1.45 billion people and in 2040 24% of the population will be 65 or older. There is no question that China is facing a demographic headwind and even though it has the capacity to handle the issue now, it could unfortunately become progressively more difficult.
February 14, 2020
Growth stocks have dramatically outperformed value stocks in 2020. Year-to-date, the Russell 1000 Growth index has risen 8.4% versus only 1.1% for the Russell 1000 Value index. That is a stunning divergence in a relatively short period. The top five companies in the growth index also happen to be the top five in the S&P 500. From a market cap weight perspective, these stocks account for roughly 29.7% of the Russell 1000 Growth index and 16.8% of the S&P 500. The performance of these top five companies has contributed almost 60% of the year-to-date return for both indexes. The top five companies are Apple, Microsoft, Alphabet, Amazon, and Facebook. The weighted average return of these companies is over 12% in 2020 and has driven the S&P 500 index up 4.6%. In contrast, the equally weighted S&P 500 index is up only 2.5%. The concentrated nature of this equity market has been a concern for many investors. There have been several reasons that have resulted in investment dollars flowing disproportionately into relatively few names. Better organic revenue growth is a major reason but share buybacks have also been a significant driver of out-performance for these top companies. The tax reform initiated in 2018 unlocked foreign cash holdings with the hopes that the repatriated dollars would go into capital investment, but far more money has gone into enhancing shareholder returns through share repurchases and dividend increases. Share repurchases have been a huge source of liquidity for the equity market, with repurchases totaling $700 billion in 2019. The buybacks have also been highly concentrated, with just 25 companies accounting for over half of the total. According to DataStream, Apple, Microsoft, and Alphabet collectively repurchased $116.7 billion worth of stock. Share buybacks are likely to slow and be less supportive of equities over the next few years. First, for at least two-thirds of top 25 companies, the amount of the buybacks are greater than net cash flow after capital expenditures and dividend payments and therefore are not sustainable. Second, it becomes harder to make a compelling case that share repurchases are an effective use of capital as PE multiples rise.
February 7, 2020
Global economic growth, which increased last year at the weakest pace since 2009, is going to again be pressured by the duration and severity of the coronavirus. With several Chinese provinces extending the Lunar New Year holiday to help contain the spread of the coronavirus, roughly two-thirds of China’s economy remained closed this week. Confirmed cases escalated past 31,000 and some fear that the figure is much higher as hard-hit provinces like Wuhan and Hubei are overwhelmed and lack a sufficient supply of tests. The Chinese government is taking the threat extremely seriously and has instituted a travel ban that encompasses over 50 million people. China’s central bank (PBOC) has also taken action by flooding banks with short-term liquidity and reducing the interest rate charged for money. It is also believed that the PBOC will decrease the loan prime rate and reduce the reserve requirement ratio for banks in the near future. At this point, the impact to China’s first quarter GDP is difficult to forecast; however, Bloomberg Economics predicts that growth could slow to 4.5%. If the steps taken thus far to contain the virus prove successful, then the loss of global GDP growth should be limited, which is what global equity markets are currently suggesting. On a different note, a long-term theme that has been weighing on global GDP pertains to the slowdown in population growth. Here in the U.S., the population grew by just 50 basis points annualized through July of 2019. The previously mentioned figure is estimated to be the slowest rate of growth over the past 100 years. There are extensive implications to a decline in population growth due to the fact that it tends to limit overall demand as well as the ability to satisfy demand. With U.S. GDP growth hovering just above 2% as of the fourth quarter of 2019, maintaining that growth rate in the face of declining population growth will undoubtedly be an uphill battle.
January 31, 2020
Equity markets were under pressure last week as investors try to assess the effect of the coronavirus on the global economy. The growing global contagion has created uncertainty and will likely cause earnings expectations to be reduced. Although fourth quarter earnings reports have generally been in line with forecasts, investors are concerned about forward earnings. Historically, the economic and market related impact for global contagions have tended to be relatively contained and short lived. From a longer perspective, the bipartisan Congressional Budget Office (CBO) released their latest baseline budget projections. The CBO forecast federal deficits will exceed $1 trillion each year over the next ten years. Over the period from 2021 to 2030, the U.S. will amass another $13 trillion in debt, adding to the $23 trillion that we currently owe. More worrisome is that the forecasts expect that the annual deficits will be accelerating over time. Net debt-to-GDP at the end of 2019 was 79% and is projected to be 98% by the end of the forecast period. The only other time the debt/GDP ratio was this high was due to WWII. The U.S. is producing a large debt burden during a time of economic stability. The deficit issue is being driven by rapid growth in spending caused by an aging population, rising healthcare costs, and interest costs. In fact, the fastest growing portion of the budget over the forecast period is net interest costs that will grow from $383 billion per year in 2019 to an estimated $819 billion in 2030. As the debt burden increases, it could lead to less public and private investment, reduced fiscal flexibility and slower overall economic growth. Financial markets are not concerned about debt levels at this point. The sooner the legislators in Washington address the nation’s fiscal situation, the easier the solution will be and the more acceptable the societal cost.
January 24, 2020
The European Central Bank left policy unchanged this week which was widely expected. The deposit rate remained at -0.50% and QE at E20B per month. What struck us was the ECB’s announcement that the central bank would conduct its first strategic review of policy since 2003. The review will address a range of relevant topics but will center on inflation. Despite aggressive stimulus for many years, the ECB has failed to lift inflation to its inflation target just below 2%. Some analysts have cynically suggested that it was not a failure of monetary policy, but rather measurement error and that inflation is running hotter than indicated. Lower than expected inflation, as predicted by classic econometric models such as the Phillips Curve, is not unique to Europe. Inflation is running stubbornly below the Federal Reserve’s desired level as measured by the core PCE index. Additionally, wage growth disappointed in December growing at a tepid pace of only 2.9% year-over-year. Employment growth has been strong with the U.S. economy on average producing 160,000 new jobs per month over the last year, which should be sufficient in a late-cycle environment to provide support for additional wage and consumption growth. Financial markets are not pricing in any inflation risk. The real existential threat to the bull market is inflation and rising inflation expectations. Equity indexes will experience drawdowns and corrections related to geopolitical tensions, the outbreak of viruses and political uncertainty. Generally, these types of issues will not cause economic dislocations sufficient to drive the economy into a recession. Rising inflation can force a significant enough change in interest rates and Federal Reserve policy to imperil the economy, and in turn the bull market. We are a long way from inflation sparking the next recession. There are other reasons for equities to correct, such as earnings disappointments. The market will be focused on forward guidance from the earnings’ reports.
January 17, 2020
Since 2018, the global economy has been hindered by the expansive ramifications of the trade war between the U.S. and China. Over the previously mentioned timeframe, global trade has declined, tariffs have been implemented, supply chains have been rerouted, manufacturing has suffered, business confidence has plummeted and monetary policy has eased. A nascent resolution to the trade war became official this week when Phase One of the deal was signed. As part of the agreement, the U.S. has arranged to cut in half the 15% tariff rate on $120 billon of Chinese imports and not place a 15% tariff on $150 billion of primarily consumer goods, which was scheduled to go into effect last month. The U.S. will still enforce the 25% tariff on $250 billion of Chinese imports.
January 10, 2020
January 3, 2020