July Investment Comments
The U.S. has officially tipped into recession, defined as two straight quarters of negative economic growth. Q1 GDP contracted at a 5% annualized rate. Q2 will feel the full brunt of lockdown. Trading Economics reports consensus Q2 GDP growth estimates as -17%. Continuing jobless claims are hovering in the 21 million range, more than ten times their pre-pandemic level. Supplementary unemployment benefits of $600 per week are scheduled to cease at the end of July, unless lawmakers negotiate some kind of modified extension. It won’t be easy to spur a broad-based return to work. The jobs have to be there, and people have to be incentivized to accept them.
The stock market, meanwhile, is anticipating a robust recovery. After a jarring 35% March plunge, the market’s subsequent recovery has been just as stunning. The S&P 500 is currently down just 4% on the year. The Nasdaq 100, burgeoning with beloved, recession-resistant software companies, is up 13%. Japan’s Nikkei 225 has performed similarly to the S&P. European stock averages have been a little weaker, mostly down low-double digits so far this year. Valuations were not exactly cheap before the pandemic started. So what happens next?
The money pot is boiling, and it’s not clear whether the lid will stay down. The Federal Reserve responded to a budding financial crisis by pumping about $3 trillion into the financial system. Two-thirds of that increase went to Treasury security purchases. Coincidentally, that $2 trillion accounts for most of the increase in our national debt during the past six months, an ominous statistic.
The remaining $1 trillion of liquidity injections was split about equally between shorter-term banking system relief—repurchase agreements and foreign currency swaps—and direct purchases of private mortgages, business and consumer loans, and corporate bonds. This last category of business and consumer obligations is controversial because it has traditionally been the private market’s exclusive territory, with one major exception. The Fed previously responded to the 2008-2009 financial crisis with the Troubled Asset Relief Program (TARP). TARP focused heavily on acquiring mortgages and real estate loans due to the nature of that crisis. In the current case, it is not as easy to locate the epicenter of the crisis. The Federal Reserve is taking more of a shotgun approach.
It makes sense for the Fed to help thaw consumer lending markets during times of great uncertainty, although the Fed must take care not to promote irresponsible lending. Its corporate bond purchases are harder to justify. In an editorial entitled “The Resurrection Board” on June 14, the Wall Street Journal’s Editorial Board accused the Fed’s market interventions of propping up shares of hopeless companies, including bankrupt Hertz Global Holdings. This criticism seems like a stretch. We blame day traders succumbing to speculative fever and, perhaps, institutional money trying to anticipate them.
So what is the Fed trying to do if not support insolvent companies? A recent press release blandly announces the Fed’s intention to “support market liquidity.” Corporate bonds are normally pretty liquid—at the right yield. It is not much of a stretch to say the Federal Reserve is supporting liquidity at below-market rates. That is to say, it is suppressing the yield curve rather than accept a free-market consensus.
It might get away with it too. Concerns about lenders’ incentives aside, the main penalty for money-printing is inflation. Seemingly as ever, inflation remains tame. As the Federal Reserve started injecting liquidity in March and April, gold rallied near to its 2011 highs of $1,800, extending its 20% gains from 2019. However, the rally has not continued in May or June. The U.S. dollar has been a little weak during the past month but is an average performer over the past six and twelve months compared to other major currencies. Surging prices for gold and a weakening dollar would suggest an outlook for rising inflation, but neither have been significant.
May’s Consumer Price Index showed a decline for the third straight month. Energy and apparel showed the biggest declines, with nowhere to go and nobody to impress. Food and medical care, as important as ever, increased steadily. With oil prices rebounding in May and June, inflation seems likely to pick up again in the second half of the year. Consumers have the cash to meet it head-on. In April, the household savings rate skyrocketed from a long-term average of under 8% to 33%. That’s what happens when people can’t shop. We will see what happens when, suddenly, they can again.
On the other hand, the sudden shock of forced lockdown has accelerated some powerful deflationary forces as well, especially in travel and commercial real estate. We have heard countless instances of companies cutting back on travel budgets with no intention to restore them to previous levels. Technology companies supporting remote work have described the lockdown period as a boon that accelerates adoption by something like two years. A shift to working from home has also caused companies to reduce their projected office space requirements, a negative for commercial real estate. It will take time for these reduced needs to filter into lower rents. In good times, the real estate market tends to drift up steadily. In a downturn, it simply freezes.
Residential housing is another story. The more time people spend at home, the more they value that home. Hardware and home improvement stores are reporting record sales. Sheryl Palmer, CEO of Taylor Morrison Home, told Jack Hough of Barron’s (June 15) “How we can go from peak to trough back to peak again, all in about 10, 12 weeks, is unlike anything I’ve seen.” Glenn Kelman, CEO of realtor Redfin says, “We’re set up this summer for the mother of all bidding-war seasons…emboldened by the stock market and low rates.” Consumers might be dressed in old rags, but they are feathering their nests finely.
The market may look vulnerable at these levels, and a volatile ride is almost a certainty, but investors need to realize that holding cash is not riskless either. Stocks are real assets that rise with inflation and also benefit from long-term economic growth. With the Federal Reserve working overtime to spur both, it’s still easy to make a case for a portfolio of leading companies. Other assets are not as certain.
Miles Putnam, CFA