Highlights:
· Equity market returns continued to outpace economic growth despite the ongoing COVID-19 pandemic and a divisive U.S. presidential election approaching.
· Monetary and fiscal policy continue to be generally accommodative in the face of the ongoing pandemic, although U.S. pandemic unemployment assistance payments ceased on July 31st and no further fiscal support is likely to be provided until after the election.
· The investment policy we embrace keeps the long term in mind and believes there is value in consistency, caution and patience in both good times and bad.
Commentary:
The recovery in the equity markets continued to outpace actual economic recovery during the third quarter. The COVID-19 pandemic continues to influence nearly every facet of our lives, but investors are betting on what the world and economy will look like over the next year or two, not what they look like today. In this regard, the consensus seems to be that a vaccine will be discovered sooner rather than later, the virus will simply disappear on its own due to herd immunity, or this strain of coronavirus will join the many viruses that are already part of the annual flu season cycle. None of these outcomes is guaranteed, certainly not in the near term. The only positive aspect may be that we may potentially have a more rapid, effective and less disruptive response for the next virus to come down the road.
Likewise, investors are counting that central banks will be accommodating for the near future by keeping interest rates low and making equities more attractive relative to cash or bonds. Of course, there remains numerous risks bubbling below, or even on the surface, that threaten to derail the current momentum in the equity markets. These include another virus-driven lockdown, the outcome of the U.S. presidential election, runaway inflation, the prospect of higher taxes to pay for all the recent stimulus, and an escalation in the trade war with China and other trading partners. These known and understood risks are presumably largely factored into current equity prices. Typically, however, it is the proverbial piano falling from the sky that causes the most severe market corrections or, even worse, crashes. Of course, there is nothing typical about the current situation.
The biggest fear lingering in the back of many of our minds, from both a personal and financial perspective, is a return to widespread national lockdowns. Even if there is a second wave of COVID-19 infections this winter as many experts are predicting, we believe widespread lockdowns are unlikely. For starters, the reason lockdowns were put in place in March was to prevent healthcare systems from being overwhelmed. While positive cases are rising in many countries, the percentage of those testing positive who require hospitalization is much lower now and more rapid testing is more widely available. Second, many countries, including the U.S. and China, were successful this summer in putting in place localized restrictions that contained the virus and limited the overall economic impact. The first half of 2020 experienced the worst global recession since the Great Depression so the economic and human toll of national lockdowns is now irrefutably known to be severe. Our best guess is that localized restrictions continue to be the norm until the virus is under control, with service providers such as travel, hospitality and retail trade companies continuing to bear the brunt of the economic impact.
If a return to widespread national lockdowns is the biggest fear, the biggest question might be whether consumer spending will hold up throughout the winter. Pent-up demand from the spring lockdown led to a resurgence in consumer spending during the summer as lockdowns were lifted. Historically low interest rates attracted auto and homebuyers who typically have higher incomes and more job security than lower-wage, service sector workers that were hit the hardest during the coronavirus-driven recession. Unemployment improved over the summer, but remains elevated, and even with the summer resurgence, consumer spending still lags behind levels from before COVID-19 hit. There is likely to be a significant correlation between the level of coronavirus infections, restrictions and/or lockdowns, and consumer spending.
Central banks and government leaders do not seem to be anticipating a return to pre-coronavirus economic activity anytime soon based on actions taken during the quarter. The U.S. Federal Reserve (Fed) announced it would start tolerating periods when inflation runs higher than 2%, shifting course from its policy of more than 70 years of preemptively raising interest rates whenever the unemployment rate ran too low to contain inflation. Considering that inflation remains quite low and unemployment high, this policy shift seems to indicate that the Fed’s primary goal is achieving full employment, and that the Fed believes it is unlikely that runaway inflation, like experienced during the 1970s, will be an issue any time soon. Accordingly, the Fed’s policy change could keep interest rates below reported inflation for longer periods. This policy shift also seems to be an acknowledgement that lower levels of unemployment and expanded monetary policy have not led to higher inflation during the lengthy bull market cycle that began in 2009 after the great recession, as they had in previous years.
Many Fed officials now believe that more fiscal relief, in addition to an extended period of ultra-low rates, is necessary to boost growth, employment and inflation. Fed Chair Jerome Powell himself might have said it best – “The Fed can lend, but it can’t spend.” Translation: the Fed can lower rates and make it easy to borrow, but can’t provide direct subsidies to keep small business afloat, grants to struggling municipalities or unemployment compensation to those who have lost their jobs because of the coronavirus pandemic. Due to election year politics, congress did not act to extend the $600 weekly pandemic unemployment assistance benefit that expired on July 31st and at this point democrats and republicans seem unlikely to compromise on an additional relief package prior to the U.S. presidential election on November 3rd.
Lack of ongoing fiscal support was not an issue in Europe, where European Union (EU) leaders agreed on a $2.06 trillion spending package built around the EU’s first-ever issuance of common debt on a large scale to fund grants and loans for countries hit hardest by the coronavirus pandemic. In the near term, the recovery plan is intended to boost Europe’s economic recovery from the coronavirus, while allowing Italy, Spain, Greece and other struggling countries to increase government spending now without having to fear that already high national debt will rise to unsustainable levels. In essence, the wealthier northern countries, such as Germany and France, determined it was preferable to help the more depressed economies of the southern countries now rather than face a currency crisis in the future. Longer term, there is hope that this bond issuance represents a significant step in the EU’s move toward a more genuine economic integration and perhaps finally provide a European equivalent to U.S. Treasuries, which have long been considered one of the safest assets for investors to hold. Elsewhere, in an effort to support its region’s companies, the European Central Bank (ECB) stepped up its corporate bond purchases in response to weaker economic data that weighed on credit markets. ECB President Christine Lagarde also recently stated that she believes the world’s central banks will likely need to continue to provide stimulus to support government spending for several years. In the case of the ECB, this could include cutting its key interest rate further below zero.
Government debt has soared to levels last seen during World War II in an effort to combat the economic impact of COVID-19. Longer-term implications might include higher taxes and larger government, but for now, most economists agree that governments should not worry about mounting debt and instead continue to focus on bringing the virus under control and muting the economic fallout as much as possible.
Likewise, corporate America is more indebted today than ever before after tapping the bond market at record-shattering levels over the last few months. Some companies were simply taking advantage of record low borrowing rates, but for many companies this influx of cash was necessary to stay afloat during the pandemic lockdown. If the pandemic lingers longer than many investors are anticipating, this could cause earnings to sink at the same time as interest and debt repayments are due. This scenario has the potential to be a significant headwind for hiring, employee wages and capital spending.
With COVID-19 persisting and a divisive U.S. presidential election looming, the near-term outlook for the economy and equity markets remains as unpredictable as ever. This should be expected to result in increased levels of volatility. The investment policy we advocate is intended to protect investors to the greatest extent possible from a future that we acknowledge we cannot predict. This investment policy further concedes that corrections, and sometimes crashes, in the equity markets are equally unpredictable and also inevitable, but emphasizes that a willingness to weather sudden market drops is a critical, if not the most critical, part of long-term investing.
Investors who attempt to buy and sell based on the latest economic data tend to give more weight to the most recent information than long-term data. Accurately predicting future events and then timing the market accordingly is difficult at best. This is why we believe investors with a short-term focus are more likely to underperform long-term investors. We may not be able to predict the market’s next move, but we believe that if you stay the course with a financial-planning driven, long-term investment policy, your portfolio and financial plan can survive these inevitable, and unpredictable, turbulent periods. This sentiment was summed up perfectly by Peter Kunhardt, director of the HBO documentary Becoming Warren Buffet, who said in a 2017 interview that Buffet understands that “you don’t have to trade things all the time; you can sit on things, too. You don’t have to make many decisions in life to make a lot of money.” Or as Buffet himself said, “Someone’s sitting in the shade today because someone planted a tree a long time ago.”
Urban Financial Advisory Corporation – October 2020