3rd Quarter, 2020
Invest only in assets that generate net liquidity.
THE MARKETS
The last quarter saw major markets bob and weave through a path strewn with COVID-19 confusion and related short-term financial aberrations. Equity markets have been well supported by aggressive monetary policy designed to keep the financial system sufficiently lubricated during bouts of stress. The Federal Reserve’s well-articulated interest rate policy of “lower for longer” has on balance fueled the investment strategy known as TINA, “There is no alternative” to stocks as many dividend yields exceed those on investment grade fixed income securities. Fiscal stimulus unleashed during the onslaught of COVID-19 has provided additional support to markets by supporting employment and personal consumption expenditures.
While markets have had the benefit of massive global fiscal and monetary stimulus, the overall performance has been driven by a handful of technology related stocks known as the FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) plus Microsoft. Apple and Microsoft pay only modest dividends, the others none. These stocks, which comprise nearly 30% of the S&P 500, are valued for their future growth in an environment of ultralow interest rates. Year-to-date, the FAANGs plus Microsoft have returned an average of 39.8% while the remaining 494 stocks have posted a decline of about 6%. Yet it is the latter group that has returned cash to investors in the form of steady and, in some cases, growing dividends while curbing share repurchases. This anomaly is at risk to any change in investors’ perceptions that interest rates may begin to move upwards, which would more highly value upfront cash returns vs. future growth.
Present cash returns on the S&P 500 (dividend yield of 1.8%) are nearly equivalent to the rate of inflation thus the equity markets appear to be keeping investors whole as it relates to domestic purchasing power. That cannot be said for the 2 Year U.S. Treasury, which yields only 0.13%. Markets are likely to maintain these negative real fixed income returns for the duration of the pandemic.
However, movement towards a vision of light at the end of the COVID-19 tunnel will likely refocus heavily on recovery and the fallout on the new norms and the winners and losers, thus setting the stage for what could be a reordering of investment returns.
In the meantime, we can expect continued bouts of volatility as investors grapple with uncertainty. We must not lose sight of the fact that the pandemic will eventually pass and as with all global calamities, we must prepare for and accept the post order norms.
THE ECONOMY
Although the third quarter has shown a rebound from the depths of the second quarter, the global economy continues to be strongly impacted by the COVID-19 pandemic. Physical barriers to trade and travel enacted in March and April only exacerbated existing nationalistic trends disaggregating worldwide economic growth. As a result, output has fallen, unemployment has risen and near-term productivity has declined in many sectors leading to elevated credit risk. It is well to remember that a good portion of present economic activity remains sustained only by massive fiscal and monetary policy.
Until we have definitive evidence that the pandemic has been choked off by broadly available, effective vaccine therapies, attempts to forecast near-term economic activity on a country-by-country basis are likely to remain unreliable at best. Here in the US, recent 2020 forecasts by four leading investment banks range from -2.7% to -4.2% with an average of -3.5%. Similar forecast spreads exist in other G20 nations, with only China likely to have year-over-year economic growth.
Looking ahead to next year, stronger green shoots of economic activity should appear. We will be watching the following factors for evidence those green shoots will thrive:
The impact of this year’s credit risk on long-term solvency
The rebound in unlevered corporate cash flows
The ability of employment growth to more than offset jobs that have been permanently lost
The magnitude of ongoing monetary and fiscal stimulus
The level and direction of business and consumer confidence indices
Although we look to economic factors with the hope 2021 will be a year of positive transition for global economic growth, real success cannot be achieved without a meaningful degree of global traction in preventing COVID-19. Prospects will certainly be enhanced with the effective global identification and distribution of vaccines. The scientific community suggests that a 500 to 1,000 day term to the end of COVID-19 is not an unreasonable expectation, a sobering perspective that must continue to be a factor in our outlook.
At present, the domestic economy is largely influenced by inconsistent and uncoordinated responses to COVID-19 by the federal, state, and local governments, where political agendas differ markedly and scientific evidence is often ignored. While the fiscal and monetary responses to date have been most supportive for the population and business in general, the political response has not been stellar and has sown a great deal of confusion into an otherwise restive public. Nonetheless, the economy is moving forward and shows signs of genuine buoyancy.
The greatest challenge to most advanced economies has been the impact on both domestic and global supply chains, disrupting the heretofore relatively smooth movement of goods and services. Fresh food supplies, construction and building materials, social services and education are prime examples.
Air travel and the entertainment industry have experienced even greater disruption, as consumers and businesses have adapted to the danger of close contact and crowds through virtual interaction and home-centric activities. While the negative effect on airlines, hotels, theme parks, etc. is clear, there is a positive effect: the adaptation has unleashed a substantial number of new business formations, made possible by the current digital age. This in turn should create strong demand for capital through both equity financing and credit and contribute positively to next year’s nascent recovery.
The well-coordinated liquidity actions by central banks have taken accommodative monetary policy to new highs and while preventing a pandemic-induced depression, it ultimately will beget the challenge of balance sheet shrinkage, normalizing interest rates and shepherding a new policy of full employment. As investors, we ignore these challenges at our peril. The Federal government will face enormous challenges in relation to reconciling the pandemic fiscal stimulus measures taken. At present, austerity appears to have been removed from our lexicon. Dealing with these issues will have a profound effect on how our economy unfolds once the recovery gains traction.
INVESTMENT STRATEGY
We continue to pursue our quest for well-managed global companies that focus on sustainable growth, innovation and pricing power. The ability of some of these companies to adjust quickly and accurately to new norms should be rewarding to investors. Looking beyond the pandemic and eventual global recovery, we must prepare now to face the challenges of fiscal and monetary policy reverting to more normal conditions. The impact of any changes, particularly those that are not well telegraphed, hold the propensity to rattle markets thus increasing both stress and volatility. As such, and with markets and other assets supported by cheap money, increased liquidity should be kept in client portfolios, particularly if there are forthcoming needs in the next year.
A FEW THOUGHTS ABOUT LONG-TERM RISKS THAT COULD BECOME NEAR-TERM
The present recession was not financially or cyclically induced but rather thrust on us by a pandemic. This fact should not be taken to mean that we are immune from financial or business cycle shocks in the future. The global financial system has been well shored up to date by the transfer of central bank liquidity and massive government stimulus injections. A significant part of the economic rescue effort has been the widespread use of near-zero and negative interest rates. Easily available cheap money has in turn set the stage, encouraging misallocation of credit. The purpose of crisis funding was to keep businesses operating and employees working, not to provide hedge funds with capital pools for leveraged trading strategies. Unfortunately, it seems to have done both.
As an example, last March early in the pandemic rescue, the Fed was forced to intervene in the U.S. Treasury market to avoid a freeze-up exacerbated by the exploitation (by unregulated traders) of a minimal basis point arbitrage between government bond market prices and futures contracts. The Fed had not expected this type of intervention, but acted to ensure appropriate global functioning of the U.S. Treasury market in the face of the COVID-based demands for safety and liquidity. Although necessary, their action raises a question as to the adequacy of regulators’ knowledge of the leverage inherent in strategies pursued by hedge funds, non-bank financial institutions and other dark capital pools. Following the 2008 financial crisis, Congress and regulators took remedial action to establish much higher standards for capital in the banking sector so that public funds would not be used to bail out self-inflicted damage in the future. However, there is a large amount of capital beyond the clear reach of their remedial action, thus creating opportunity for a “financial accident.” This bears close watching, particularly in the context of the current late-stage credit cycle. Perhaps the regulators are taking this into account with their announcement that the prohibition of bank buybacks is being extended.
As always, your comments and questions are welcome. We want to assure you that we are doing our part in protecting our community and ourselves from further outbreaks of COVID-19.