After nearly 11 years, the historic bull market that emerged from the ashes of the last financial crisis abruptly ended in February as the coronavirus took root in developed markets. Since then, the global pandemic has not only upended life for many households – as economic activity was put on pause – but also has sparked record levels of market volatility. After suffering a gut-wrenching sell-off earlier this year, stocks have staged a meaningful rally since markets bottomed in March. However, economic data remains challenged and many companies are simply suspending or withdrawing any near-term financial guidance amidst the increased economic uncertainty.
This comes as no great surprise to us. Over the course of four weeks alone, the U.S. economy shed as many jobs as were created over the entire prior decade. Fortunately, unlike the financial crisis of 2008-09, the Federal Reserve and Treasury acted decisively and swiftly in unleashing a torrent of stimulus and policy measures designed to hold the economy together. As such, forecasts indicate the jobless rate peaking later this year before a quick but largely temporary decline as lockdowns are eased. In general, this will likely lead to a bumpy reopening phase with slow job creation following an initial surge, as businesses adapt to changing customer behavior and depressed consumer confidence that could fall further with intermittent virus outbreaks. Fortunately, the tone in financial markets has improved due to all the new loans, grants, and bond buying, but anecdotal tales remain of dysfunctional websites for processing unemployment claims and broad confusion over how to best access government programs.
Currently, many investors and business leaders are hoping for a “V”-shaped recovery as economies reopen on a piecemeal basis through the summer months, with the thought being that things might bounce back as fast as they fell apart. The challenge is that today’s economic weakness is largely concentrated in the services sector, unlike in previous recessions where manufacturing and construction typically bore the brunt of any downturn. Unlike factories, individuals have feelings and will alter their behavior. In short, people cannot be “started up” the same way as a manufacturing plant. As such, many expect Q2 GDP to decline at the fastest quarter-to-quarter annualized rate since the 1930s, before experiencing any kind of rebound in Q3.
While the Fed is likely to remain accommodative to help offset the short-term decline to global growth, we wouldn’t be shocked to see further fiscal stimulus targeted at individual taxpayers, small businesses, and local and state municipalities that typically operate with balanced budgets. As it seeks to plug the revenue gap for the private sector, the federal government’s budget deficit is expected to explode this year to nearly 18% of GDP, the highest since World War II. Yet, despite the increased supply of debt, yields on 2- and 5-year treasury bonds remain near record lows. This brings us to our main concern.
The current rally in equities not only is being led by a narrow set of stocks (largely mega-cap and technology stocks), but also is missing confirmation by the price action one would expect in commodities, bond yields, or gold – all of which would be “behaving” differently if the economy was about to experience a sharp rebound. In fact, as global storage for oil approached full capacity for the first time ever, crude futures recently joined government debt in doing the once unthinkable: trading at negative prices. Even as the virus creates near-term deflationary headwinds, we believe the unprecedented expansion of central bank balance sheets might be sowing the seeds of next decade’s inflation. Nearer to intermediate term, however, we expect sluggish growth and low inflation over the next couple of years as companies incur additional costs and lost productivity inhibits wage growth. With each passing week that corporate earnings estimates continue to deteriorate, more bankruptcies are likely to soon be announced as corporate leverage was rising for years before the coronavirus reared its ugly head.
If bond yields remain low as the Fed seeks to provide the economy with a way to grow out of its high-debt burden, any austerity measures could further undercut economic growth. While there may be a current boom for purveyors of digital services – think online streaming, e-commerce, and the remote work-from-home trends – most businesses will likely incur lower margins due to (1) reduced demand from consumers who are rebuilding their depleted savings, and (2) higher costs for keeping more inventory on hand (to shrink what they have come to realize were overextended supply chains). We could easily see another round of layoffs as many businesses realize that demand will not return to normal or may anticipate a reduction in revenue with a second wave of the pandemic. Any exit path is expected to be difficult with nervous consumers struggling to understand new health protocols and a stop-start rhythm for businesses that crimps efficiency as well as profit margins.
In summary, while the market turmoil caused angst for many investors these past few months, it presented the JNBA Investment Committee with an opportunity to add value to client portfolios through the time-tested disciplines of rebalancing into equities (buy low, sell high) and harvesting losses to create future tax savings. However, we remain cautious as there is still a wide gap between how financial markets are performing and the widespread distress on Main Street. We believe government bonds may be less effective at providing income or diversifying equity risk and are therefore rotating into fixed income where actively managed mandates to evaluate credit risk can present flexibility to capture opportunities and manage risk. On the equity side, we continue to favor less volatile, dividend-paying securities and stocks of firms with strong balance sheets (think higher quality).
As always, you have our utmost commitment that we will continue to monitor the situation and selectively respond to new developments as new information unfolds in the months ahead.
Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from JNBA Financial Advisors, LLC.
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