Market Update May 4th, 2020

The Economy now appears to have bottomed and is ever-so-gradually starting to improve, while the coming horrendous economic and earnings reports are just getting started. We expect choppy markets to continue as investors navigate this crosscurrent for a while. We think the market lows are in (March 23rd), and we do not expect a re-test, but we could certainly see more near-term weakness after the surprisingly strong April recovery rally.   

We could try to estimate the total GDP decline or where the unemployment rate ultimately bottoms out, but not only is it hard to make accurate estimates when so much is still unquantifiable, I don’t even know how useful it is trying to guess the total near term impact from a temporary economic shutdown. We already know it will be record-breaking. When the official numbers come out for April and May they will be brutal...the worst of our lifetimes. But everyone also knows this is self-inflicted and temporary.

The good news is we are starting to see some light at the end of the tunnel now that many U.S. states and foreign countries are gradually reopening. During the week ending May 2nd, airline passengers passing through TSA checkpoints were up 26% from the prior week, and up 40% from the week before that. Gasoline consumption in the U.S. has increased three weeks in a row, up 16% from three weeks ago. Hotel occupancy and railcar traffic are up from a month ago. We have a very long way to go, and rather than a “V” shape, we are expecting more of a “U” shaped recovery. It will take time.

The Chinese economy has been recovering nicely, which is good news for the global economy, since China accounts for about a third of global growth…more than the U.S., Europe and Japan combined.

While we certainly wish we had seen this market crash coming, the big declines hit so hard and so fast, even before we knew the economy would be shut down, that we felt it was too late to try to sell out without risking getting hurt. On Thursday March 12th, the market suffered its greatest single-day percentage fall since the Black Monday crash in 1987, and markets had already hit their lows by the time the broad economic shutdowns were announced.

While March was the worst month for U.S. stock markets in 46 years, April rebounded with the best month in 33 years, underscoring the risks of pulling out of the market after such a steep and rapid sell-off, even though we all knew much worse economic news was sure to come.  

Why have stocks rebounded so much when the economic and earnings news is so bad and about to get even worse? I think three reasons:

  • Investors know this is a temporary situation, so they have begun evaluating stocks based on where they should be in six months or a year, rather than where they are today.

 

  • The alternative is bonds and cash with yields near zero and no inflation protection, in an environment of a devaluing dollar.

 

  • Investors are figuring out that the government will have to continue to print more and more money in the foreseeable future, which will eventually devalue the currency/become inflationary, favoring stocks, real estate (and probably gold) over time, while being a headwind for bonds and cash.

The government has no choice but to make the economy and stock markets grow. Everything relies on it…from tax revenues and employment, to government pensions and unfunded liabilities (Medicare, Social Security, etc.). They have already printed trillions of dollars in stimulus and backstops during this shutdown, and they haven’t even gotten to state and local government bailouts yet, which will be coming.

Without the private sector, there is no public sector. Businesses pay for all government. Since we forced businesses to close, we have no choice but to plug as many of the gaps as we can by cranking up the money printing presses to keep the economy and governments afloat. Investors are starting to realize that the ultimate manifestation is a devalued currency and eventual inflation. (Not right now while the economic shutdown and collapsed commodity prices have created deflationary pressures, but eventually the inflation will surface.)  

This happened after the Great Depression and WWII, the last time we had to print massive amounts of money. Looking back, it was easy to see that it was bond and cash holders who lost wealth, as the interest rate they earned didn’t keep up with the inflation rate for decades afterward. Stocks and real estate outpaced inflation as they were able to raise their prices and rents, so their earnings, dividends and stock or real estate values climbed accordingly. (At least those who were able to stomach some substantial volatility along the way).

The path of least resistance in this situation is for the government is to print money and gradually inflate away the debt so it becomes less of a burden in the future. If you buy a 30-year treasury bond today, you get an interest rate that is well below even the current low inflation rate. Then in 30 years you get your same money back, when it is likely to buy a fraction of what it did when you invested it in the bond.

Without diving too deeply into global macroeconomic and monetary issues, there is another important development in the mechanism for funding our debt today.   

For decades foreign investors have bought our treasury bonds and basically funded our expansion. Primarily because of safety, better interest rates, and to balance capital accounts from trade surpluses. In September of 2018 that all changed when the cost of currency hedging eliminated the yield premium of U.S. treasuries. From then on more and more of our new treasury issuance has been purchased by our Federal Reserve. Today nearly all of our treasury issuance is being purchased by the Fed. They are printing money to buy the new treasury securities being issued by our Treasury to finance our deficits and debt. (And in just the last seven weeks of this economic shutdown, the Fed has purchased more U.S. treasuries than all of the purchases by foreigners in the last six years.) 

The Fed is now in a position that may be beyond the point of return. If they don’t buy the treasuries, interest rates would likely spike high enough to severely threaten the economy, and the dollar may spike high enough to plunge the global economy into recession or depression, taking us down with it. And the end result of this money printing (buying our own debt) is likely lower interest rates for longer, and eventually devaluing existing dollars and creating inflation.

Europe, Japan and others are printing bailout money during this crisis also, but not yet to the scale of the U.S. That combined with our interest rates being lowered to near zero, means the U.S. dollar should probably eventually start to weaken. Maybe not until this crisis and high fear level has eased, but that should be the eventual result. And if/when that happens, it may tilt a little more performance advantage toward foreign and emerging market stocks, commodities and probably gold for a while.   

Hang in there. We are gradually working our way through this unique and challenging economic and investment landscape. We think the worst news is already mostly factored in, and investors who can continue to grit their teeth through the economic pain should be rewarded in the years ahead.

As always, please feel free call or email me any time.

Darren