There has been a lot of talk about a significant market correction – mostly due to the apparent disconnect between the performance of U.S. stocks (as measure by the S&P 500 Composite Index) against the glaring shortcomings of the broader U.S. economy; not to mention the fact that the COVID 19 virus continues to rage unabated. These twin concerns imply that U.S. stock market has gotten ahead of itself.
It is a valid concern, but a serious correction is far from certain. Consider the facts or, should we say, numbers! A correction normally occurs when overvaluation across a broad swath of the market is unsustainable. Creating a situation where a market takes down all stocks is much like lowering ships while draining water from a lake. However, in this case, not all stocks have participated in the recovery. In fact, it is the narrowest recovery on record.
What we are witnessing is a major dislocation where five companies (see chart) represent 27.77% of the market capitalization of the S&P 500 composite index. More importantly, those five companies have collectively generated a 15.90% weighted year-to-date return within the S&P 500. Considering the S&P 500 is up about 8.66% year to date, that means the collective weighted return of the five tech giants accounted for 185% of the total return accredited to the S&P 500. Put another way, the bulk of the remaining 495 companies have collectively dragged down the performance of the index. Many of these companies represent the broader economy – i.e. services, financials, travel and leisure, brick and mortar retail – which means, overall, the S&P 500 index is not as far removed from the performance of the broader economy.
That is not what one would expect to see as a precursor to a market sell-off. Especially when you consider the monetary stimulus that has been floated by the U.S. government and the massive expansion of the U.S. Federal Reserve’s (FED) balance sheet. Which is to say, the FED has been running their printing press at full capacity adding more than U.S. $1.5 trillion to the M1 money supply (see chart) since March.
At the same time the FED cut interest rates to near zero adding additional stimulus to the recovery. That is important information when we understand the impact lower rates have on asset prices. Think about the average Canadian detached home valued at, say, $500,000. Further assume you borrowed 80% of the value of the home at a 3% interest rate, which is about where rates were pre-pandemic. The interest cost for a $400,000 loan would be approximately $12,000 per year.
Today the five-year mortgage interest rate is 2%, which represents $8,000 in annual interest payments for the same $400,000 mortgage. Assuming you were comfortable paying $12,000 in annual interest, you could now afford to borrow $600,000 at 2% interest rate. In other words, house prices could rise just because the cost of carry has been reduced.
Obviously, home buyers are impacted by other considerations, notably job security, which is front and center on the minds of prospective purchasers. Which brings us back to the broader economy. As we wean the economy off government support programs we will have a better picture as to the damage caused by COVID. In the same way that a stable job market is another leg underpinning housing prices, the same can be said for equity values.
If we accept the distortions to value caused by economic stimulus and low interest rates, a case can be made that stocks could have some ways to run. We have just reached the previous pre-COVID highs but at these levels we are functioning in an environment where consumers have disposable income (because of government stimulus) and are spending it in ways that were not evident before the onset of COVID. For example, buying online as opposed to shopping at brick and mortar retail. In fact, online shopping now represents 13% of all retail spending up from just 6.5% pre-pandemic. We think that change in consumer behavior will continue post-pandemic even if somewhat less than the current numbers suggest.
At this stage we suspect that equity prices are not as overvalued as they might look on the surface. We have ample liquidity in the system, much more than we had pre-pandemic, but we still face challenges as the economy re-opens. There also remains the risk that the economy will have to shut down again if we get a second-wave surge in COVID cases.
The financial markets are betting that a vaccine will be available by the end of the year or, at worst, in the first quarter of 2021. If we get a successful vaccine, that will remove the risk of another economic lockdown. What we will likely see is a game of whack-a-mole where governments and related health agencies tamp down pockets of community spread. In time, we believe the fears of a lockdown will abate and global economies will return to some version of normalcy.
We are applying the greatest weight to this scenario: a successful fast-tracked vaccine, mid- and long-term plans for re-opening, and a return to the low unemployment levels that existed pre-pandemic. In this scenario, those economically sensitive stocks could perk up dramatically. And the degree to which pandemic-altered consumer behavior endures post-COVID will determine whether the five tech giants will continue to lead through 2021.
There is also the question about where interest rates go from here. Conventional wisdom tells us that interest rates will move higher in line with the ebb and flow of the business cycle. An expanding economy leads to excesses, giving rise to higher prices and wages that eventually spark an inflationary spike. To temper inflation expectations the FED raises interest rates, which sets in motion a new rate cycle.
Here is the problem! The FED is not following conventional wisdom. Last week Chairman Jerome Powell provided some insight into the FED’s mandate. Where FED policy has historically been guided by the twin objectives of maximum employment and moderate inflation, the new strategy will pay less attention to inflation and focus instead on maximum employment. You could argue that this is politically motivated, but it will likely stick because it comes from both sides of the aisle.
The Democrats want the FED to be pro-active in helping the disenfranchised get their share of the American Dream. The best way to do that is to ensure an abundance of jobs that allow individuals of all ethnicity to get a foot in the door and begin to build a life for themselves.
What we need to know is that the FED will begin to measure inflation based on a longer-term average rather than the quarter-to-quarter calibration of the consumer price index. More importantly, this change in policy was unanimous and non-partisan as all members of the FED’s open market committee signed off on this new approach to inflation management.
This means that interest rates will remain low for a long period of time. So even if we see the FED cut back on their monetary expansion – not at all a forgone conclusion – we will continue to live in a low interest rate environment. And that brings us back to my previous report where I talked about T.I.N.A. (i.e., There Is No Alternative) which means that equities may be the only game in town.
So, what are the risks? The main concern is the impact such a strategy will have on one’s currency. But that is only a problem if the strategy is being applied in one country, which is different from how it is being applied across the globe. At this stage, every major industrial country is following the same theme and at this point many countries find themselves in a negative interest rate environment. Do not be surprised if negative interest rates come to the U.S. and Canada over the next 12 to 24 months.
One of the beneficiaries of this strategy will be gold and silver, either through physical ownership of the precious metals or via ownership of mining companies. Since holding gold and silver bullion does not pay dividends, one of the main risk factors is the cost of carry. With ultra-low interest rates, that is less of a concern.
At the other side of the ledger, we will continue to see challenges for money center banks (i.e., banks located in major cities like New York, London and Hong Kong). Already we are seeing banks like J P Morgan Chase trading at or near book value. Canadian banks have additional challenges as their shares continue to trade well above book, which is likely the result of Canadian bank policy and Federal government comfort with above average dividend payouts.
GLOBAL OUTLOOK
After the severe pandemic-induced contraction we are starting to see some green shoots. The double-digit decline in economic activity that occurred in the first and second quarter is starting to abate. On average, global economic growth is forecast to contract by an unprecedented 4.1% in 2020. Major industrial powers are expected to decline by -5.3% while emerging markets should come in around -3.4%. The exception is China, which is expected to recover more than most, sustaining an -2.5% decline overall during 2020.
The average forecasts assume that a second wave of the pandemic will not result in another broad-based shutdown. One could argue that this assumption is, to some extent, grounded in science as we now have better protocols and an abundance of personal protective equipment. Moreover, another major shutdown would be economically catastrophic and lead to a widespread long-term depression. Plus, of course, these forecasts assume the release of a viable vaccine in time to dampen the risk of a second wave.
If these assumptions hold, then the worst of the damage among major industrialized economies occurred in April. Further, that damage was limited by major fiscal (government stimulus) and monetary policy (central bank policy) intervention. Thanks to substantial labor market interventions and large-scale monetary and fiscal measures by some countries, we are seeing improved financial conditions, a pickup in global demand and better business and consumer sentiment, which seem to be resulting in a sustained pickup in consumer confidence and global demand.
Second tier emerging markets have been supported by the liquidity provided by global central banks. What has been clear is that the lockdowns that occurred within major industrialized economies were and are not sustainable within emerging economies, which have less access to government support programs. Instead, the advantage of emerging markets is a much younger labor force, which can more readily survive exposure to the pandemic.
The exception is China. The initial lockdowns across China served to limit exposure to the pandemic but did nothing to support seamless supply chains, which will be China’s long-term challenge. What we do know is that the objectives of the U.S. / China trade pact are no longer feasible. With so many missed targets look for additional de-coupling of U.S. / China initiatives regardless who wins the U.S. presidency.
Make no mistake, the post-pandemic global economy will look very different from what we saw pre-pandemic. The base case among economists is that normalized global growth will be lower than pre-pandemic levels owing to questions about supply chain disruptions. We suspect countries will begin to focus on building infrastructure to ensure stable supply lines that rely less on foreign dictates.
The other major concern is how to deal with the surge in debt for all economies. One response would be higher taxes, which would cause widespread fiscal damage, especially to emerging economies. And have an unwelcomed long-term impact on global growth.
U.S. OUTLOOK
The U.S. responded quickly to the pandemic. The stay-at-home orders helped slow the virus, government stimulus and loan forbearances helped keep consumers above water, and FED intervention provided much needed liquidity to financial markets.
You can look at this as a glass half full or half empty. I suppose it depends on whether you watch FOX or CNN. The fact remains, the U.S. economy tanked from March to mid-May and is just now beginning its road to recovery. There will be continuing pain among sectors within the economy, and many may never recover. We’re thinking about retail brick and mortar stores, restaurants and some of the weaker links in the energy patch. All will become casualties of a system where the strong survive and the weak perish.
Perhaps the biggest challenge facing America is the uncertainty surrounding the Presidential election. Trump trails in the polls but among swing states the margins are tight. And make no mistake, this election like past encounters will be determined by swing-state suburban voters. Wisconsin is a key battleground, which Trump won in 2016 by less than 1%. The other major swing State is Florida and if Trump loses there it is game over.
There are key differences in the platforms espoused by the candidates. Biden will do more to unite the country, but he will also raise taxes. Trump, on the other hand, will continue his strategy of divide and conquer but will maintain lower taxes, which should be good for business.
We suspect a Biden win would likely spark and sell-off – perhaps a 5% correction – as investors factor higher corporate tax rates when they recalibrate corporate earnings. That said, beyond the initial recalibration, we doubt a win by either candidate will have a significant effect on equity valuations longer term.
CANADA OUTLOOK
The Canadian economy was hit with a double whammy exacerbated by a pre-existing high debt-to-equity ratio among Canadian consumers. Not only was the country battered by COVID it also suffered from lower oil prices. Alberta has been hit particularly hard and there is a train of thought that energy prices may never recover to pre-pandemic levels. Lest we forget oil prices were above U.S. $107 per barrel less than a year ago and, today, WTI oil is changing hands at U.S. $43 per barrel.
Real Canadian GDP fell by more than -8% in the first quarter and greater than -38% (annualized) in the second quarter. The main damage was confined to April and there has already a significantly rebound in June and July, and the International Monetary Fund projects Canadian GDP to decline -8.4% by year end. It would have been much worse had policymakers not stepped up with income support, wage subsidies and business loan measures.
Following the FED strategy, the Bank of Canada slashed interest rates to near zero (i.e. 25 basis points for overnight rates) and began numerous asset purchase programs that include Provincial, Municipal and corporate bonds.
More importantly, Canada has been more controlled in its re-opening stance. Unlike the U.S. approach of opening the economy at all costs, Canada has engaged in a slow and steady approach with consistent messaging. We think that will benefit the economy longer term as it reduces the possibility of a second shutdown and thereby set the stage of a bounce-back recovery in the second quarter of next year.
SUMMARY – COVID SCARS
Getting back to a ‘new normal’ will depend largely on the delivery of a viable vaccine. The question is what will the new normal look like? We expect to see long term a fractured post-pandemic recovery. Whereas other recessions created havoc in all segments of the economy, the pandemic induced recession had an outsized impact on the service sector.
Government enforced social distancing measures disproportionately impacted restaurants, gyms, and retail shopping venues, which by extension led to lop-sided economic hardship for younger service workers who make up the bulk of this labor cohort. This will also have a lasting impact because even with re-opening, consumers have been slow to adapt to pre-pandemic norms.
Office workers face many of the same obstacles. The new work-from-home norm should have a positive impact on housing prices (bolstered by ultra-low interest rates) but could have a meaningful negative impact on office leasing.
We are already witnessing, in our opinion, a disproportionate short-term surge in housing prices for detached homes in communities outside major urban centers. We suspect the trend to move outside major metropolitan centers will be short lived as individuals weigh the benefits of health care, entertainment venues and eventually a staggered return to work. To that point, we think the new workplace norm will combine staggered social distancing attendance at the office augmented by a work-from-home strategy supported by improved technologies.
Richard Croft, Chairman & CIO