I’m happy to report that our active approach to management during the second quarter has helped dampen sudden bouts of market volatility while continuing to move accounts towards positive territory for the year.
Our newsletter this quarter focuses on the phases of the developing COVID Crisis and its economic and market impact. While we’re all sick of talking about the virus, the path of the virus and the economy remain inextricably linked. We do try our best to stay focused on the data and economic narrative.
Virus information such as cases, hospitalizations, or treatments will not be broadly covered in this note. We’re happy to share the sources we use to track those trends if you’re interested.
In the 2nd half of the year, the path of economic reopening, a potential waning appetite by fiscal authorities to continue their support, the escalation or de-escalation of trade wars, and extreme political positions will all play their part. In the face of these shifting tides, we try to stay as optimistic as possible while adhering to our risk management objectives.
As always, if you have any questions or concerns related to the market or our outlook, please let us know. We’re here to help.
The Anatomy of a Disaster
As I write this note, a thunderstorm is headed towards Kansas City. While the probability of being in the path of a tornado is relatively small, it’s unsurprisingly top of mind when a storm is upon you. Unfortunately, it just so happens that a powerful storm and a resulting disaster mesh well within the current market/economic narrative. After all, the hallmarks of a tornado are 1) they often arrive with little warning, and 2) are devastating when hit a community head-on. Sound familiar?
The first stage of any disaster is trauma. Of course, in a natural disaster, that trauma occurs in the form of lost property and lost life. Our current crisis was at the height of the trauma stage in March and April, and the breadth of damage to health and wellbeing on a global scale was previously unthinkable.
As an initial response to a traumatic event is mounted, the rescue phase begins. The rescue phase in our natural disaster example is very straightforward. Much like the healthcare and essential personnel response to the COVID crisis, the rescue phase in the natural disaster puts the best of the human spirit on full display. The added rescue efforts needed in response to the virus came on the financial front. As we outlined in our 1st Quarter Newsletter, the fiscal and monetary responses were every bit proactive and potent as the shutdown was devastating. Had the Congress and Federal Reserve not acted with such force, we’d likely now be in a situation of mass bankruptcy AND mass unemployment. Those bankruptcies would have made any attempt at returning the unemployed to work all but impossible.
The Recovery stage is where we find out if/when our situation pre-trauma will again become a reality. Often after a powerful storm, there is a window of time where insurance and charity can help to rebuild/repair physical damage. The resulting jolt of economic activity can help return the community to a positive financial trajectory. On the other hand, a city without the wherewithal for a speedy rebuild will slowly become less and less attractive to current and prospective citizens. This concept of long-term damage is a genuine threat to the recovering community in our example, just as it is for our financial system. Scars from the Great Financial Crisis persist to this very day in the form of both social and economic consequences.
Depending on where you look, there are continuing signs of all three phases of the crisis. As COVID cases and hospitalizations rise, our healthcare system remains on the brink of trauma. Our fiscal and monetary authorities continue to administer the potent medicine that has thus far kept us from financial calamity. Economic data are showing emerging signs of recovery. And financial markets seemingly pick between one of the three stages on a daily basis.
State of Play – Markets and the Data
In our previous newsletter, we lamented that the data was as shocking as it was useless. And absent a few very high-frequency datasets, that remains the case. Since this trauma/rescue/recovery cycle has only been a reality for about four months, the one month lag in most government data creates a situation where information is not descriptive of the current situation
Let’s start our chart review with the equity market. The collapse, bounce, and attempted recovery in the market has been one for the history books. Interestingly though, the participation in the rebound/recovery hasn’t been as broadly experienced as you might expect. Sectors of the market that rely on real economic activity such as Industrials, Financials, and Energy have badly lagged industries chasing secular trends such as Technology and Communications.
The market plunged 35% from Feb. 19th to Mar. 23rd and the prevailing fear was that many of the companies in the eye of the Coronavirus storm (hospitality, leisure, and transportation) would cease to exist. A cascading failure of businesses could have caused mass-unemployment and economic depression. Then came the rescues of the corporate and personal segments of the economy.
When you or I go to borrow, the interest rate we are offered is directly related to our ability to repay the debt. If it appears unlikely that we’ll be able to repay, we’ll likely be charged a higher rate (or we won’t be offered a loan at all). Companies are no different. The gauge for measuring this access/cost of financing is called a credit spread. A credit spread is simply the difference between the rate of interest a company can secure versus a very safe alternative (US Treasury Bonds). A higher spread is a sign that companies are having a tough time raising capital at preferred rates.
As credit spreads soared, the Federal Reserve decided to act in a previously unthinkable way. They provided a backstop on Mar. 23rd in the form of an implicit guarantee of the entire corporate debt market (blue dotted line). Once credit markets unfroze, even the most troubled companies were able to access the cash they desperately needed to finance their dormant operations.
The legislation in the C.A.R.E.S. Act (and companion acts) provided fiscal stimulus in the form of direct cash infusions for businesses and citizens alike. The cash injections have thus far provided a cushion in the aggregate for personal income. You’ll note that even as unemployment has skyrocketed in the past three months, personal income has expanded.
The increase in personal income is not evenly distributed and could cause distortions longer-term. For now, these distortions will be tolerated so long as income is stable or expanding in the aggregate.
The best way to foster a robust recovery is simple; we need to get people back to work quickly. The current unemployment rate of 11.x% is absurdly high and poses a significant long-term risk to our consumer-led economy. Note that the highest unemployment rate seen in the Great Financial Crisis was 10.x%. The difference in this episode, of course, is that the recession is being caused by an exogenous and (hopefully) temporary event - not financial excesses and fraud.
The Bureau of Labor Statistics (BLS) publishes a monthly report that frames the condition of the United States labor market. During recessions, jobs reports tend to show increasing unemployment, and during recoveries/expansions, they show job gains. The industry composition and status of this churn between employed/unemployed can tell us a lot about the trajectory of the overall economy.
The BLS classification of ‘Temporarily Unemployed’ refers to an unemployed person who either has a set date to return to their previous job or expects to return to their position within six months. If a person has lost their job and is actively searching for an entirely new job, they are classified as ‘Not Temporarily Unemployed.’
As you can guess, a great many American citizens who are currently unemployed view their situation as temporary. And that is a good thing. Keeping workers attached (even if loosely attached) to their former employers is a major legislative objective. Although that does assume that the companies from which they’ve departed truly intend to hire them back.
The lines above show the total number of unemployed Americans (17.7 million) as well as the current status of those people. The entirety of the roughly 7 million job gains since the peak in April has come from the pool of temporary workers. That makes perfect sense – businesses that were previously ordered to close are bringing back some of their staff.
The composition of the 17.7 million unemployed citizens is becoming a concern. The NOT temporarily unemployed classification (purple line) is continuing to rise at an accelerating rate, even as the total comes down. You’ll note that in the previous two recessions, the vast majority of the unemployed population was made up of non-temporarily unemployed, which makes perfect sense. Most ‘normal’ recessions are caused by a shock to demand that results in businesses laying off workers. The concern here is that a prolonged period of high unemployment will eventually stunt consumer confidence, spending, and business revenues. That self-defeating cycle fits into the narrative that we’ve not yet actually experienced a ‘normal’ recession. A continuation of that trend will be very troubling for many economists.
In ordinary times, consumer confidence is one of the most influential sentiment measures. After all, about two-thirds of our Gross Domestic Product (economic output of our country) comes from consumption. As I’m sure you’d guess, consumers are not feeling great right now. Whether it’s a political, health, or financial concern, there are more than enough reasons for lack of comfort. On the other hand, as people go back to work, or receive additional fiscal support, this number will be a great way to track the road to recovery.
The following charts on retail sales give us two points of discussion. First, the transformation of personal income into business revenue is the lifeblood of our capitalist system, so it’s critical to have a grip on where we stand. Second, it’s a great way to illustrate how data can be used to lie straight to your face. First, let’s look at the year over year growth rate (May 2020 versus May 2019).
As expected, retail sales fell off a cliff in April as the economy was shuttered. The year over year decline moderated substantially in May but is still showing a dramatic 6.1% contraction.
The contrast of month over month data (May 2020 versus April 2020) shows a very logical result; April printed the worst month ever, and May experienced the biggest month ever. The cumulative effect of those two outliers is that retail sales are down 6.1% y/y. These incongruent reads on the same data will provide exploitive opportunities for both sides in the upcoming election. Please consume your economic data responsibly.
The final chart in our review is the terminus of the consumer economy express – corporate earnings.S&P 500 companies will begin reporting their second-quarter results in about one week, and the numbers are expected to be dismal. However, commentary from management will likely be the main event. Analysts and investors will anxiously listen for indications of emerging trends as we enter the back half of the year. Those trends will offer hints as to when we may return to the peak index earnings level of 2019. While the spectrum of potential outcomes for the trajectory for earnings is wide, consensus estimates call for a full earnings recovery by 2022.