Top Weekly Themes
- The longest economic expansion on record in the United States hit a wall during the first quarter of 2020. Economic conditions deteriorated during the second half of March, after the number of coronavirus cases started to accelerate, and U.S. government-mandated shutdowns and social distancing measures took effect. The abrupt halt of economic activity for a little more than two weeks in March was enough to cause a -4.8% contraction in real GDP for the first quarter, which was the worst GDP figure since the Great Recession of 2008/2009. We believe economic data will likely look much worse in the second quarter as multiple weeks of quarantines and a complete cessation of business activity in many industries takes its toll. In fact, economists from several prominent investment firms are forecasting GDP to decline in excess of -25%, coupled with a double-digit unemployment rate. Equity markets are looking past the economic swoon triggered by the pandemic, given the 30% gains registered off the March 23 low. There have been some favorable developments in terms of medical treatments (e.g., Gilead’s Remdesivir drug), and a modest slowdown in the number of daily infections; however, we think the market may be overly optimistic about the path to economic stability, future recovery in corporate profits, and the lasting effects this pandemic may inflict on consumer and business confidence. Although efforts by the Federal Reserve and federal government may have taken the worst-case scenario off the table, our view is that at current prices, near-term equity market risk is asymmetric to the downside.
- The Federal Reserve (“Fed”) took a breather and announced no new policy actions during this past week’s Federal Open Market Committee Meeting (“FOMC”). Given the unprecedented level of monetary stimulus recently imposed by the Fed, which dwarfed measures taken during the Great Recession, it’s somewhat surprising to hear that there were no new announcements. It’s becoming challenging to keep track of the numerous programs/facilities that have been unveiled. The Fed’s balance sheet is now close to 30% of U.S. GDP, and there are no signs that this figure will be reined in anytime soon. In fact, Fed Chair, Jerome Powell, used the word “medium-term,” to describe the duration in terms of the elevated risks stemming from the pandemic. The Fed’s actions over the past several weeks were successful in helping financial markets stabilize, and afforded us the opportunity to increase our exposure to corporate credits modestly. In our view, the Fed’s efforts to stabilize financial markets are likely to be more effective than any attempt to boost economic activity.
- China’s economy has started to recover as quarantines have been lifted, and businesses have gradually started to recover. PMI survey data, which measure business conditions for the services and manufacturing sectors, has crossed into expansion territory from deeply depressed levels. However, business and consumer confidence levels are still well below pre-coronavirus levels. So why should we care about what is happening with China’s economy? The health and economic crisis caused by the coronavirus first surfaced in China, before reaching U.S. shores. China is much further ahead in terms of recovering from the aftermath of the pandemic. The recovery in China has not been V-shaped, but more of a slow, steady grind to normal. In our opinion, a similar economic trajectory seems likely in the U.S., where the effects of the pandemic have been more severe.
|Week (%)||YTD (%)||1-Year (%)||3-Year (%)||5-Year (%)||Div Yield (%)|
|Russell 1000 Value||4.4||(18.5)||(11.0)||4.3||21.1||2.96|
|Russell 1000 Growth||4.3||(1.4)||10.8||54.8||87.0||1.13|
|Bloomberg/Barc US Aggregate||0.0||5.0||10.8||16.3||20.5||1.31|
|Bloomberg/Barc US High Yield||0.5||(8.8)||(4.1)||5.7||18.4||8.05|
|Bloomberg/Barc Muni Bond||(1.0)||(1.9)||2.2||10.1||16.1||2.25|
|Bloomberg/Barc Global Agg. Ex U.S.||1.7||(0.5)||3.9||9.2||11.6||0.83|
|Crude Oil (WTI) ($/bbl)||14.2||(69.1||(70.5)||(61.8)||(68.4)||18.8|
|Natural Gas ($/mmbtu)||0.4||(11.0)||(24.3)||(40.5)||(29.2)||1.9|
|1 Week Ago||YTD||1-Year Ago||3-Years Ago||5-Years Ago||Current Level|
As of April 30, 2020 (close)
*Dividend Yield For MSCI EAFE and MSCI EM are from 3/31/2020.
Chart of the Week
- The volatility levels we’ve seen have not been limited to equities or riskier credits. Oil prices, as measured by WTI Crude Oil, were in the low 60s at the beginning of 2020 and fell into negative territory (that’s not a typo) over a week ago —which seems surreal. So, if you owned a barrel of oil, you would have had to pay someone to take it off your hands.
- Several factors have caused such a precipitous drop. Storage capacity for oil was limited before the onset of the coronavirus, meaning there was plenty of supply. The abrupt decline of global economic activity as the coronavirus pandemic spread caused a demand shock, which exacerbated the excess supply situation.
- Falling commodity prices signify deflation, which concerns global central banks. The extreme levels of fiscal and monetary policy were put in place to stem the deflationary tide.
- The challenging environment for the energy complex has not caused us to increase our allocation to energy-related equities, despite many companies trading at extremely “cheap” valuations. The energy complex is capital-intensive, and many operators have a considerable amount of debt. We think bankruptcy risk is quite high, and we would prefer to invest in more stable businesses that are not leveraged to commodity prices, which we don’t believe we have an edge forecasting. Within the energy sector, we prefer exposure to integrated energy companies versus more commodity-sensitive exploration and production businesses.
Will Current Monetary and Fiscal Policy Ignite an Inflation Bomb?
In short, no. While “money printing” and excessive government spending can be a precursor to inflation, we don’t believe that runaway inflation is the most likely outcome in this case.
The economic fallout caused by the coronavirus is massive. Over the past 6 weeks, nearly 30 million workers have filed initial unemployment insurance claims. At the end of January, the entire U.S. civilian workforce consisted of approximately 165 million employees. The number of jobs lost relative to the size of the workforce is staggering. While the CARES Act passed by Congress is mitigating the impact associated with the considerable decline in consumer spending, we don’t envision it supercharging economic growth. High nominal GDP, along with a spike in wage growth, and rising input costs are often a warning sign of potential inflation. For now, it does not seem that any of these typical inflation drivers are present. In fact, inflation levels have trended downward for 40 years. There are a lot of theories (more services vs. manufacturing, globalization – an abundance of cheap labor, technological innovations, rising dependency ratio, etc.) as to why this has occurred.
Regarding central bank intervention and monetary stimulus: the Fed’s Quantitative Easing (“QE”) program enables owners of financial assets to, in simple terms, swap assets for cash. Simply stated, the Fed “prints money” and “un-prints” the bonds they are purchasing. When that happens, the private sector has a similarly safe financial asset (cash) and lower income. In other words, the private sector has more money but, in aggregate, it actually has less overall value (the principal and interest of the bond). This is marginally deflationary, in our view. Further, if that cash is not spent at a rampant rate, it won’t trigger inflation. Japan has engaged in some form of QE for more than 20 years, and The Bank of Japan is still fighting a deflationary battle. Whether QE is a viable tool over the long-run is a separate debate, but we don’t think its use is necessarily a precursor to higher inflation.
Large fiscal and monetary stimulus over the past couple of decades – although this one is on a different level – has caused the money supply to rise sharply at different times, as seen by the chart below. M1, M2, and MZM are different methodologies used by the Federal Reserve to measure the amount of financial assets in circulation.
This has not caused an inflationary spike, which was predicted by many economists. One reason is that M2 Velocity (Total Value of Nominal GDP/M2), meaning the frequency that one unit of currency is used for transactions, has been trending downward since the late 1990s (see chart below). Central banks can inject a tremendous amount of liquidity into the system, but if it doesn’t change hands, inflation will not pose a threat.