It has been a difficult year on many levels. Given the past few months I want to catch up in several areas… with what has transpired since the spring, where things currently stand in the economy, and what I foresee going into the second half of the year and beyond. This may take a while…
As a reminder, the current economic downturn did not occur spontaneously due to COVID. In September of 2019 Repo rates indicated problems in lending markets. For several year’s companies have been borrowing extensively, especially at lower levels of credit quality. In the Fall of 2019 Morgan Stanley noted that over 20% of corporate borrowers were “zombie companies”; companies with no positive cashflow, excessive debt, and borrowing to stay afloat. This was the situation when the economy was “healthy”.
Why does Repo matter? “The repo market allows financial institutions that own lots of securities (e.g. banks, broker-dealers, hedge funds) to borrow cheaply and allows parties with lots of spare cash (e.g. money market mutual funds) to earn a small return on that cash without much risk, because securities, often U.S. Treasury securities.” (1) Without such liquidity, lending slows and rates quickly rise.
In response to the Repo crisis the Fed initiated another round of quantitative easing, or QE; in response markets rose through the end of the year. However, even as markets rose the overall economy was weakening. By December the PMIs (Purchasing Managers Index) had rolled over to negative territory indicating the economy was contracting. It was my expectation that by the end of the first quarter of 2020 the US would be in a recession. This was before COVID.
In January I became aware of the COVID virus in Wuhan, China. By February the virus had migrated to Europe and the United States and markets began to tumble. Prior to the decline trading volume was light and volatility was low.
As the stock market decline accelerated in March the Fed initiated several programs to bring stability to markets. These programs covered treasuries, muni debt, corporate debt (especially high yield debt), mortgages and commercial debt. By mid-March, the S&P500 was down nearly 30%. By early April, unemployment had risen to 17 million. (2) Restaurants and retail were closed nationwide to stop the spread of the virus. The consumer makes up over 70% of the economy and in the space of a few weeks was completely sidelined. (3)
Many of the companies most negatively impacted were those carrying the most debt and with the weakest cash flow.
Even as unemployment rose and economic data points worsened the market reversed and moved higher. Over the next few months market indexes rose on hopes of a “V-shaped recovery”. However, this seeming strength was mainly supported by 5 tech stocks. Those 5 stocks made up 20% of the value of the S&P500. (4) In 2000 at the market peak the top 5 stocks made up 18% of the index so this was a historic concentration. In an economy of 160 million workers, these 5 companies employ 1.2 million people. As of late July, these 5 stocks were up 20% YTD; the remaining 495 stocks in the index were collectively down 8% YTD.
In addition to the Fed acting quickly to support the economy, Congress responded quickly as well with PPP loans to businesses and additional unemployment compensation. This is scheduled to end in July and Congress is currently negotiating additional economic aid.
Over the past few months there has been broad discussion about how quickly the economy would rebound… a “V” shaped recovery, “U” shaped, “Swoosh” shaped… several factors are driving what the recovery will look like.
One factor is the spread of the virus and its continuing impact on the economy. The recent acceleration of cases in Arizona, Texas, and Florida due to a refusal to wear masks has been negative. Economies that opened early are now in the process of being closed-down again.
A second factor determining the rebound is corporate outlook. A Deloitte June survey of CFOs showed “60 percent of CFOs do not expect to return to a pre-crisis level of operations in 2020”, and 39% do not expect a return to normal till Q2 2021. “Accordingly, growth expectations for revenue, earnings, capital spending, and hiring have fallen to by far their lowest levels in the survey’s 10-year history.” Most CFOs expect more automation, more work-from-home, and a smaller real estate footprint. Many corporations have announced massive layoffs as a result. (5)
A third factor driving the shape of the recovery is unemployment. By Early April, 20 million were unemployed. The PPP loans brought back some of those temporarily laid off. While weekly unemployment numbers have been trending lower in the past month to 1.3 million new claims last week, this week (July 24, 2020) the new claims turned higher at 1.4 million. This reflects a worsening corporate outlook. In addition, many of the businesses that were temporarily closed are now closed permanently.
Reviewing your portfolio, how have you done during the worst recession since 1930?
Equally important to being successful in the current environment has been avoiding specific areas of risk such as fossil fuels and banks, which I purposely exclude from portfolios as an expression of Socially Responsible Investing. As of late July, the KBW bank index is down 33% YTD (6) and the S&P500 energy index is down 38% YTD (7).
So, what do I expect going forward?
I do expect the market to move lower based on increased selling, reduced earnings, worsening virus outbreak and increasing unemployment. Selling is likely to come from many sources. In the past month there have been a record number of corporate insiders selling their shares. (8) In addition, due to reduced tax revenues it seems likely that states will have to sell some pension assets to pay for ongoing obligations. (9) Universities and colleges are in a similar situation where reduced tuition and room and board will squeeze budgets and they will need to draw from endowments. (10) One of the primary reasons for equity appreciation in the past 10 years has been due to corporate buybacks… fewer available shares leads to higher share prices. Given the current recession and reduced corporate cash flow, companies are unlikely to engage in stock buybacks to drive equity prices higher. (11)
The reality of economic weakness may catch up with overextended valuations.
That said, I do expect markets to move higher over the long term. Due to the impact on the consumer, the loss of small businesses and restaurants, continuing virus outbreaks, and the accelerated move toward automation my expectation is that this recession will last for a number of years.
Because of the support programs implemented by the Fed I do expect the market to be supported and trade within a range. However, there is no clarity about the virus, the consumer, or the political situation. Without more clarity it is impossible to project earnings or valuations. Many companies have withdrawn earnings outlooks for 2020 and 2021.
One of the long-term worries is the rapid expansion of debt in the past few months taken out by companies, both strong and weak, which the Fed has committed to support. It has yet to become clear if companies will be able to support this expanded debt load. Its also unclear how the Fed will react to bonds or debt that it has purchased but the company defaults on, or files bankruptcy. By law the Fed is not permitted to experience losses.
A second long-term worry is the excessive Federal debt being generated and the impact it has on the role of the dollar. Since March the value of the dollar has fallen 7%. This money printing is one of the forces driving the price of gold and silver.
One last long-term worry is stagflation… stagnating growth with inflating prices. While inflation is viewed by most economists as a sign of growth and an overheating economy, prices can also inflate due to shrinking supplies as factories close or supply chains break down. As inflation increases bond yields tend to move higher; as bond yields move up, bond prices move down. This sets up a dangerous situation for the Fed down the road which currently holds over $6 trillion in bonds on its balance sheet.
It has taken months of observation, data collection, and analysis to put these thoughts together for you. I will continue to do so in the weeks, and months, and years to come.
If you have any questions regarding the information above, I am happy to set up a time to chat and go into more detail. Let me know your thoughts by email at email@example.com .
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2020-106049 exp 8/22
S&P500 index is a market index generally considered representative of the stock market as a whole. The index focuses on the large-cap segment of the US equities market.
Indices are unmanaged, and one cannot invest directly in an index. Past performance is not a guarantee of future results.