Clients have asked us how the stock market could rally from a near 40% drop in March of last year, when the country has gone from the lowest level of unemployment in fifty years pre-pandemic, to the highest level of unemployment since 1939 during the pandemic. In this commentary, we will talk about why the financial markets have rallied, and what we see as the biggest financial impacts from the pandemic as we move into 2021 as well as our outlook for the year ahead.
The primary reason why the financial markets rallied off their lows in March 2020 was because of massive monetary and fiscal stimulus. Monetary stimulus is when the Federal Reserve Bank expands its balance sheet and purchases securities in the open market (usually U.S. Treasuries and mortgage backed securities) by printing money to pay for the assets. During the early months of the pandemic the Fed deployed more monetary stimulus in the financial markets than during the entire Financial Crisis of 2008-2009. Moreover, the Fed continues to purchase roughly $120 billion per month of financial assets. By purchasing securities, the Fed is driving down yields on fixed income investments. This in turn makes financing big ticket items (i.e. buying a home or car) easier, which helps the economy. It also helps the stock market move higher because by driving yields lower, the dividend yields on stocks become more attractive in comparison. For example, an investor can buy a ten-year U.S. government bond paying 1% per year (short term bonds pay even less), with no potential for income growth, or they can buy a basket of stocks such as the S&P 500 (SPY) or Dow Jones (DIA) which yield 1.5% and 1.8% respectively where the underlying dividend grows over time.
On top of monetary stimulus, the Federal Government also deployed massive amounts of fiscal stimulus, over $3.5 trillion. Fiscal stimulus is the use of government collected tax dollars and borrowed money to aid the economy. The medical war against COVID-19 cost as much as any physical war. These payments included a wide range of stimulus covering health care cost, protective equipment, medical research, loans to businesses, and even direct payments to citizens. These payments have jump started economic activity and are intended to provide a financial bridge until COVID-19 has been defeated.
In addition to stimulus, major financial market benchmarks such as the S&P 500 have rallied although they increasingly do not reflect the underlying economy that they were originally designed to track. In fact, the Standard and Poor’s S&P 500 index is now composed of 38% technology companies, even though as of November 2020 the technology sector only employed 2% of the workers in the country and generated 6% of all economic activity in the country (See Chart Below).
Moreover, the U.S. Bureau of Labor Statistics reports that nearly 10% of the U.S. workforce (16.78 million people) is employed in the hospitality industry (airlines, hotels, restaurants, etc.). However, these sectors are hardly represented in the S&P 500. So, when people seem confused why the stock market can rally when so many people are unemployed, it is because the sectors of the economy that are doing well right now (e-commerce, digital products that allow working from home, social media, etc.) are greatly over-represented in the S&P 500, while the sectors that are being hurt are greatly under-represented in the S&P 500. According to William O’Neil + Co., benchmarks such as the Ishares Dividend Index (DVY) and the Vanguard Real Estate Index (VNQ), which have a broader representation of the overall economy, were actually down last year -8.97% and -8.47% respectively.
While we agree that monetary and fiscal stimulus were needed to aid people affected by the pandemic, it will have an impact on the country going forward. The biggest impact will be the financial cost of COVID-19 and the huge debt load the country has added by waging war against the pandemic. Similar to World War II, American debt held by the public now equals close to 100% of GDP. After World War II, the United States underwent considerable belt tightening and fiscal restraint, running only small deficits (and some surpluses). As the world’s superpower after WWII, the U.S. economy continued to grow and in combination with fiscal discipline the country’s debt to GDP level returned to more manageable levels by the 1960’s.
Today, the situation is much different. The baby boomer generation (born after WWII) is retiring in large numbers (over 10,000 baby boomers turn 65 every day), and they are drawing down Social Security funds, while at the same time driving up health care cost. The baby boomer financial cost of retirement was expected, yet the country has done a poor job preparing for those expenses. What was not expected has been the $3.5 trillion in spending the U.S. Federal government has authorized to shore up the economic recovery since the start of the pandemic.Meanwhile, the Federal Reserve Bank has also been actively using its tools and expanding its balance sheet.This is important because given the size of the U.S. public debt, now $27 trillion (US debt clock.org), any increase in interest rates would wreak havoc on the nation’s yearly deficit.Given the above spending requirements, the Congressional Budget Office (CBO) expects the U.S. to continue to run high deficits for the foreseeable future, which will further increase the size of the national debt. Therefore, it is hard to determine when we will get out of our debt problem while we are still adding to the size of the debt.
We believe these high debt loads are a problem for several reasons. First, it leaves the country in a weakened condition to respond to any future crises. The reality is that the country still has not repaired its balance sheet from the Financial Crisis of 2008-2009, and now the situation is worse. Next, plenty of empirical data shows large debt loads slow economic growth. This is a problem because a sustained period of strong economic growth will be needed to bring the country’s debt to GDP ratio back down to more manageable levels. In addition, the higher our debt becomes, the more likely the Federal Reserve will feel pressure to keep rates low in order to fund the government. This will make it harder on retirees to generate retirement income because financial assets are priced off the risk-free rates. Today, one million dollars invested in a ten-year U.S. Treasury bond will generate roughly $10,000 in annual income. Fifteen years ago, that same amount of money would have generated as much as $50,000 in annual income. So, even though prices have gone up during that time, the amount you can purchase from risk- free annual income has gone down. This will force investors into riskier assets in order to compensate for the lower risk-free rate.
While debt caused by the pandemic will be a problem, productivity growth could be a silver lining. Productivity growth is perhaps one of the most important measurements in all of economics, as it measures how fast an economy can grow without triggering inflation. Productivity in the U.S. has been stagnant for over a decade. However, the pandemic has caused structural changes to the economy that have unleashed a productivity boom. Since the pandemic began, the Bureau of Labor Statistics reports that productivity growth in the U.S. has grown at an 8% yearly rate, the fastest growth since the 1960’s. During the pandemic, Americans have been consuming roughly 7% more goods online than before the pandemic, even as the number of people distributing those goods have fallen by over 2% (Barron’s Magazine January 10, 2021). Turns out, selling goods online is far more efficient for many retailers, requiring less people and less land to generate the same amount of revenue. Moreover, an even bigger change has been in how Americans work. In 2019, 5.7% of Americans worked full time from home. In December of 2020, Barron’s estimated 33 million Americans (roughly 26% of all full-time workers) were working from home. Before the pandemic, about 40% of Americans who did not work at home spent at least an hour commuting each day, with at least 10% spending at least two hours commuting to and from work each day. This new found time, along with incredible advancements in cloud-based software platforms and connectivity systems, have allowed the same amount of workers to get more done in the same amount of time. As the economy continues its move towards further digitalization, we look for continued productivity growth in the years ahead.
Another silver lining of the pandemic has been that a lot of the fiscal stimulus money remains unspent. The majority of consumers still have jobs, and many consumers are flush with cash and are eager to spend it. Thanks to a combination of one-time economic payments, loan forgiveness, low interest rates, and forbearance programs, average personal wealth levels are actually higher now than in 2019. At the same time, consumer spending has been depressed due to COVID-19. The result is U.S. households have saved $1.5 trillion since February of last year, which is equal to about 10% of total household spending in 2019. In addition, since the end of 2019, American consumers have paid down $150 billion dollars in revolving debt. (Barron’s Magazine 12-27-20). Debt repayment, combined with lower interest rates have actually dramatically improved household finances. Indeed, interest payments as a percent of household disposable income is now the lowest in 40 years (See chart below).
This bodes well for near term growth, because once the economy opens back up, we believe consumers (70% of the U.S. economy is driven by consumers) will be eager to get back out, and they have cash in their pockets to spend.
In conclusion, we believe that the market has rallied primarily due to massive monetary and fiscal stimulus. Moreover, major market benchmark rebalancing has also masked many parts of the economy most affected by the pandemic, which in turn has inflated the financial markets when compared to the real economy. In the long term, we remain very concerned about the massive build-up of public debt. In the short term, we believe the market can continue to grind higher as the economy opens back up and the remaining stimulus funds are spent. Thus, we continue to feel the best way to invest in the financial markets are in large capitalization, brand name companies, with strong balance sheets who are returning cash back to investors from either dividends or stock buy-backs who are providing goods and services that consumers need to use on a daily basis.
We thank you for your continued support. Sincerely,
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