Q2 2020 Market Commentary
At the end of 2019, when news of the Coronavirus first broke out, the Chinese government denied that the virus could be spread person to person and even arrested a brave doctor who spoke out. In early 2020, even the (CDC) Center for Disease Control and the World Health Organization seemed unconcerned about the virus. As we end the first quarter of 2020, we are now facing a global pandemic effecting 189 countries worldwide. The U.S. as well as other governments around the world have now reversed course and are waging a massive war against the virus. Hopefully, we might be turning the corner on the virus. On Sunday, April 12th, Dr. Fauci, Director of the National Institute of Allergy and Infectious Diseases credited the strong measures taken by the Federal government along with local and state governments in flattening the curve. Using metrics including hospitalizations, intensive-care check-ins, and intubations, the outbreak appears to be slowing. Moreover, he mentioned parts of the U.S. could start to reopen as early as May. In this commentary, we will discuss the current status of the economy, why the financial markets have begun to stabilize, and why a true economic recovery will most likely look like a “U” (longer recovery) than a “V” (short recovery).
In order to protect as much human life as possible from the Coronavirus (Covid-19), the U.S. government has caused a self-induced shutdown of the U.S. economy. The speed of the economic contraction will be of a magnitude few living people have witnessed.To put things into perspective, during the height of the 2008-2009 Financial Crisis, the worst recession since the Great Depression, weekly jobless claims hit over 629,000.During the week of March 15-21st , of this year, weekly jobless claims were over 3.3 million, with 1 million in California alone. During the first week of April, jobless claims doubled again to over 6.6 million. The Bureau of Labor Statistics reports that over 16.78 million people (roughly one in ten U.S. workers) work in the hospitality industry. That entire industry has been basically shut down. Airlines are barely flying (TSA reports airline traffic in the first week of April is off over 95% year over year), the auto industry has stopped production, restaurants- if they are not closed are only providing takeout, and countless scores of industrial, service, and gig economy jobs have been put on hold.
Pandemics are rare and different from typical recessions. Recessions are typically caused by excesses in the economy. These take time to work off. Pandemics are shorter, but much deeper in their economic cost, typically over -20% of Gross Domestic Product. Economists at Deutsche Bank note that the worst economic downturns in history were caused by pandemics. Economists at the St. Louis Fed district project employment reductions of 47 million people from the current pandemic, which would translate into a 32.1% unemployment rate in their analysis of how bad things could get.
Despite the mounting economic current crisis, the financial markets have begun to stabilize from its recent lows for several reasons. First, the government’s response to these imposed shutdowns has been massive fiscal and monetary stimulus, even greater than what we saw during the 2008-2009 Financial Crisis. The goal of the stimulus is simply to provide a bridge to both companies and workers so that they can survive until they are allowed to go back to work. Several weeks ago, as the Coronavirus news got worse, and it became clear that businesses would have to close and U.S. citizens would have to self-quarantine, we essentially had a run on Wall Street where investors sold whatever they could to raise funds in order to survive the crisis. This created a large mismatch between buyers and sellers as prices fell because there were few buyers.
The Federal Reserve Bank and U.S. government response to the crisis has provided some support for the markets. During the 2008-2009 Financial Crises, it took months for the Federal Reserve Bank to respond. During the current Coronavirus crisis, the Federal Reserve Bank has responded with blazing speed and scope. The Federal Reserve has not only dropped rates to almost zero, they have announced plans that would expand their balance sheet by over $2.3 trillion to buy a host of asset backed securities, municipal bonds, corporate bonds, and even below investment grade bonds to provide liquidity to the financial markets. Most, if not all of these assets will return to the Federal Reserve balance sheet once these loans are paid back. The Federal Reserve Bank is using “REPOs” to stabilize the fixed income market. These “Repo” (REPO- repurchase agreement is a form of short-term borrowing for dealers in government securities) operations are a leading reason why the fixed income market has begun to stabilize. During the first few weeks of March all assets were being sold and there were literally almost no buyers. So even safe assets like U.S. Treasury Bills were trading below face value as investors and business owners tried to raise cash so that they could survive the upcoming economic shutdown. Traditional market makers in bonds ran out of cash to buy back bonds so prices dropped. The Federal Reserve stepped in and loaned money to market makers at very favorable rates and then allowed the market makers to repay the Federal Reserve in Treasury bills and other securities. So, in essence, the Federal Reserve provided liquidity for market makers to continue to allow the market to function. As liquidity is being restored to the fixed income market, panic selling has begun to subside. Federal Reserve Chairman Powell has also publicly announced that the Fed would use “all of its tools” to support financial markets. Buying corporate, and below investment grade bonds by the Federal Reserve Bank has never been done before, even during the Financial Crisis of 2008-2009.
Meanwhile, in a rare show of bipartisanship, Congress passed the Cares Act in record time. This 800-page, $2 trillion stimulus, Coronavirus Aid, Relief, and Economic Security Act (Cares Act) included multiple provisions that will provide help to American workers, cities, and states. Moreover, it is widely expected this bill will be expanded in the coming weeks. Among the highlights of this bill are direct cash payments of $1,200 to individuals, $2,400 to families, plus an additional $500 per child, for individual’s earnings less than $75,000 ($150,000 for couples). The plan also extended unemployment benefits, forgives interest on student loans, cancels required minimum distributions from IRA accounts for investors for this year, provides aid to small and large businesses, aid to hospitals, as well as financial support to states and municipalities.
In addition, the financial markets have stabilized as news on the Coronavirus infection rates have gotten better and as research on Coronavirus therapies’ and vaccines have progressed faster than expected. In March, the Dow Jones (DIA) at its low dropped -38.4% from its high, and the Vanguard Extended Market Index (VXF), which looks at a broader range of stocks dropped, -44.2% from its high. One of the leading reasons for the large drop in the market was the very negative projections released by the CDC (Center for Disease Control) and other organizations which released terrifying projections on the amount of deaths and disease the country would shortly endure.
As social distancing and other mitigation efforts were put into place, those worst-case scenarios fortunately did not materialize and the major indexes have gained back almost half of their losses in April. Moreover, in the first week of April the CDC and State of New York issued dire warnings that they would expect peak deaths the following week, and the state of New York issued a warning that they would run out of ventilators starting Sunday night, April 5th, followed by running out of hospital beds by Wednesday, April 8th. Fortunately, neither happened and the rate of intubations (putting a tube down a patient’s throat and hooking them up to a ventilator) actually declined as did the hospitalization rate.Thus, the new projections for New York, which accounts for almost half of the country’s COVID-19 cases, show that New York does not need any more ventilators and will have a surplus of tens of thousands of hospitals beds.This was good news not only from a social suffering stand point, but also from giving hope to investors that the country could reopen sooner because a major reason for shutting the country down was to not overwhelm the hospital system.So, if less hospital resources are needed than originally anticipated, and hospital resources continue to expand (i.e. 100,000 new ventilators by end of summer) then the hospital system likely will not be overwhelmed. Thus, the market rallied on the news.
Source: Andrew Cuomo Governor of New York Daily Briefings
However, a true return to normal will not take place until there is a vaccine. Vaccines have typically taken years to develop. However, remaining in self isolation for up to two years would certainly destroy the economy. The financial markets have rallied as a host of pharmaceutical and bio-technology companies have developed new technologies and breakthroughs that they believe will offer therapies and vaccines in months, not years. According to Informa Pharma Intelligence, there are currently 140 Covid-19 experimental drugs and vaccines in development around the globe. As of right now, Johnson & Johnson leads the pack with a potential vaccine ready for emergency use early in 2021. The company has also stated that they believe they will be able to scale the vaccine to a billion doses by the end of January 2021. Furthermore, new therapies could potentially be game changing as well as preventing the health care system from being overloaded and providing a bridge until a vaccine is developed.
New testing technologies could also allow people to get back to work more quickly. Citibank analyst Andrew Baum and his team argue that 60% of U.S. workers could be given quick, point-of-care serology tests by the end of April, and 95% by the end of May. Positive tests could allow up to 400,000 people who have been exposed to, and recovered from Covid-19 to return to work, and up to 90 million by the end of July.
Another sign of stabilization has come from corporate insiders. Corporate insiders (officers, directors, & owners of companies) sell their stocks for a lot of reasons but they generally only buy their own stocks when they feel the stocks are cheap. Moreover, corporate insiders have a very strong understanding of a companies position and outlook in their market. In March, the ratio of corporate insider buying reached its highest level since the Financial Crisis in 2008-2009, which in retrospect was a good buying opportunity for long term investors.
As a result, we believe the rally from the financial markets lows have been justified. Moreover, we hope a quick “V” shaped recovery where things return to normal quickly takes place. However, we think the recovery will be more “U” shaped (take longer). We believe the recovery will take longer for several reasons.
After the current crisis, the Federal government will have over $25 trillion of public debt, not counting the present value of future liabilities of social security and health care. The Federal Reserve’s balance sheet will stand at over $5 trillion ($2 trillion should return to the Fed balance sheet once their loans are paid back), the highest in its history. Only after World War II were public debts higher. In a nutshell, the U.S. will have few policy bullets to deal with any future emergencies. Once the virus has been defeated, plans will need to be made to repair the nation’s balance sheet, meaning spending cuts and/or higher taxes.
In addition, we estimate many corporations will change their behavior as well, which could add another headwind to equity returns. The Harvard Business Review estimates that over $4.3 trillion were spent by companies over the last ten years on buying back their own stocks. Corporate stock buybacks have been a major driver of equity returns. Businesses are not designed to be shut down for extended periods of time, and when things do return to normal businesses will have to repair balance sheets before they return to buying back their own stocks (corporate insiders may continue to buy their own stocks, but at a much smaller level).
In conclusion, the U.S. economy has been hit with a major unforeseen shock. Historically, recessions characterized by a sharp deceleration in economic growth were often followed by sharp “V” shaped acceleration. While we hope this is the case, we believe this recovery will take longer to recover from due to the high debt load of the U.S. government, the fact that the Federal Reserve Bank has already spent most of their policy bullets, and an expected large slow-down in corporate stock buy backs which have been a major support for equity prices over the last ten years. Furthermore, we expect interest rates to remain at ultra-low levels for an extended period time. Given this backdrop, we expect that high quality companies, with strong balance sheets who are providing goods and services that people need to use on a daily basis, and who are returning cash back to investors from dividends at rates significantly higher than the yield of a ten year U.S. government bond, should perform well.
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