The COVID-19 pandemic is causing tremendous human and economic hardships both domestically and globally. The measures taken to protect public health have induced a sharp decline in economic activity and a surge in job losses, which directly impacts consumer spending. The lowest unemployment rate in a half a century soared to a postwar high of 14.7% in April. The disruptions to economic activity materially tightened financial conditions and impaired the flow of credit to households and businesses. The Federal Reserve, in response to tightening financial conditions, quickly lowered its policy interest rate to near zero in March and took extraordinary measures to bolster the flow of credit to households, businesses, and communities. As a result of this monetary policy response, financial conditions have improved considerably alongside the flow of capital within the economy.
The scale and breadth of the fiscal policy response to the pandemic is equally critical. The costs of doing too little include lost wages, fewer jobs, and deteriorating job skills. The people most vulnerable to the adverse effects of a recession are those who already faced barriers to economic opportunity, including low-income workers. While the recession caused significant dislocations in the labor market, the degree to which these disruptions are permanent or temporary largely hinges on the appropriate fiscal response. Fortunately, the U.S. has the fiscal capacity to undertake large scale spending. While there are naturally times to be concerned about growing the national debt, as the former chairman of President George W. Bush’s Council of Economic Advisers, Gregory Mankiw, recently quipped, “This is not one of them.”
Thus far, the unprecedented monetary and fiscal response to the pandemic has been sufficient to bolster investor confidence that the recession is likely to be as brief as it is deep. This optimistic investor outlook is evident in the 20.5% appreciation in the Standard & Poor’s 500 Index in the second quarter. However, it is difficult to recall a time when the general level of uncertainty has been as great as it is today. This uncertainty is clearly evident in the wide range of economic forecasts across public and private sector economists. The breadth of potential outcomes is driven by the record speed of economic change and policy responses. Additionally, the pandemic is undermining the reliability of certain economic data, particularly survey-based data of businesses and households as noted by the Bureau of Labor Statistics. Finally, epidemiological outcomes will significantly influence the rate of business reopening, which has a profound impact on economic output. With the lack of visibility into these fundamental assumptions in economic models, there remains high dispersion and low confidence in traditional economic forecasts.
The enormity of the fiscal and monetary policy response to the unfolding financial crisis was critical to stabilizing the economy and mitigating the financial toll for consumers. Policymakers have thus far been successful in preventing a liquidity crisis from becoming a solvency crisis, which should temper the longer-term economic damage caused by the pandemic. In a liquidity crisis, otherwise healthy firms collapse because they do not have access to credit to meet current obligations. A solvency crisis, on the other hand, is when a firm’s liabilities are greater than its assets; such as the collapse of Lehman Brothers in 2008. The immediate risk to the economy is that a liquidity crisis can precipitate a solvency crisis if left unaddressed.
Fortunately, the Federal Reserve quickly recognized the impending need for businesses, households, and communities to have readily available access to credit. The central bank launched a series of nine initiatives ranging from purchasing corporate bonds to providing payroll loans to small businesses to supporting municipalities through a special lending program. While the Federal Reserve’s actions have thus far been successful in preventing an initial rash of insolvencies, there will inevitably be a rise in the number of bankruptcies during the second half of the year. Small businesses, which employ nearly one half of the American workforce, will likely be disproportionately impacted by bankruptcies.
The severity of the current economic contraction guarantees that there will initially be one or two quarters of very strong economic data when business operations resume. This is indeed what many recent economic data series, such as manufacturing, new business orders, and improvement in jobless claims, reflect. However, beyond the initial sharp rebound in business activity, the pace of the recovery will likely become more fraught.
Economies expand at their potential in the long-run, which is dictated by the growth in labor force and productivity. Therefore, the character of job losses is important as it has implications for potential economic growth. Job losses that prove to be only temporary will enable workers to more quickly reengage with the labor force. If, however, a large portion of the job losses are permanent, potential economic growth over the long-term is diminished. A window into this labor force dynamic is the participation rate which measures the percentage of the population aged 16 and over that are employed or actively seeking work, and this measure has plunged as a result of the recent unprecedented job losses. If job losses are permanent in nature, this should lead to a rise in discouraged workers who give up seeking new employment and leave the work force, depressing both the labor force participation rate and potentially economic growth rates.
Source: Bureau of Labor Statistics
The Southern part of the U.S. now battles with record high new COVID-19 cases in response to easing social restrictions to enable businesses, including restaurants and bars, to reopen in some fashion. If more businesses are able to reopen in the second half of the year, consumers have ample cash to spend. The personal savings rate rocketed from 8.2% during February to a record high of 33.0% during April as savings jumped $1.4 trillion to $6.1 trillion, which includes transfer payments from the federal government such as the supplemental $600/week in unemployment benefits. Whether consumers received paychecks or government support, their purchases were severely limited by the lockdowns, contributing to the amassing of formidable cash reserves. The financial aid has allowed households to pay their rent and service their debt, shielding landlords, banks, and many specialty lenders from pressure. There is the potential for consumer savings to translate into pent-up demand as the economy continues to reopen for business.
Source: Bureau of Economic Analysis
We believe a sustained economic recovery is unfolding as the result of massive monetary and fiscal stimulus, the healing in the credit markets, and improvement in long-term growth drivers such as housing and technology spending. The pace of the economic recovery will largely depend on the ability to safely reopen the doors for commerce. Fortunately, biomedical research is marshalling resources on an unprecedented scale in the pursuit of both therapeutics and a vaccine which will clearly have an impact on the future trajectory of the economy.
The immediate collapse in economic activity short-circuited the normal business cycle. Fluctuations in the business cycle are distinct changes in the rate of growth in economic activity, particularly changes in three key cycles – the corporate profits cycle, the credit cycle, and the inventory cycle – as well as changes in monetary and fiscal policy. Charted over time, these distinct cycles appear as a series of long waves. Driven by the influence of the business cycle on employment, historic employment data is emblematic of the familiar wave pattern of the business cycle. As the chart on the following page illustrates, the economy traversed the gap from mid-cycle expansion to recession in a matter of weeks rather than the more traditional multi-quarter timeline as measured by the labor market.
Source: Bureau of Economic Analysis
In response to the end of the business cycle, the equity market fell 34.0% in twenty-three trading days during February and March, marking the quickest bear market entry in the postwar period. Although the equity market was quick to enter a bear market, generally defined as a greater than 20% decline, it only stayed in bear market territory for seven trading days. By June 3rd, the Standard & Poor’s 500 Index had appreciated 37.7% over 50 trade days, marking the greatest 50-day rally for the benchmark index since 1957 when the index was expanded from 90 constituents to 500. Interestingly, the previous seven largest 50-day rallies each saw the benchmark higher one year later.
Much of the responsibility for the sharp reversal in equity prices beginning in late March was the result of what transpired in the credit market. In many international markets, particularly in Europe, credit flows to large corporations primarily through the banks. In contrast, large domestic corporations primarily access credit through the issuance of bonds. The interest rate corporations must pay to entice investors to hold their debt is often measured against a Treasury yield with a comparable maturity. The credit spread is the difference between these two rates and is very sensitive to investors’ perception of default risk, among other factors. Credit spreads are elemental for equity investors for two primary reasons. First, credit spreads directly impact the availability and cost of debt capital for firms. Second, credit spreads are a proxy for the appropriate discount rate for calculating the present value of future corporate cash flows, which is in our opinion the cornerstone of equity valuation. As credit spreads widen, and the discount rate rises, the present value of future corporate cash flows falls. The chart below illustrates the link between credit spreads, in this case a benchmark of high yield corporate bond spreads, and the equity market as represented by the Standard & Poor’s 500 Index.
Note: Credit Spread Index is the Bloomberg Barclays U.S. Corporate High Yield Average Option Adjusted Spread
Based in part on lessons learned from the Great Financial Crisis, the Federal Reserve understands that sufficiently large liquidity and credit support can materially stem the widening of credit spreads. The central bank even launched several novel measures among the nine initiatives it announced on March 23rd to support liquidity and credit availability. Among the extensive new measures was the establishment of two facilities to support credit to large employers – the Primary Market Corporate Credit Facility (PMCCF) for new bond and loan issuance and the Secondary Market Corporate Credit Facility (SMCCF) to provide liquidity for outstanding corporate bonds. The Federal Reserve, for the first time in its history, committed to purchasing corporate bonds up to a total of $750 billion. On June 28th, the central bank released a list of 794 companies whose newly issued corporate bonds it will purchase as the sole investor in the coming months as an effort to keep borrowing costs low and availability of capital flowing. Among the companies on the list were Apple, Coca-Cola, ExxonMobil, IBM, McDonald’s, and Walmart.
Prior to the Federal Reserve’s announcement of its extraordinary measures to maintain the flow of credit to households, corporations, and communities in late March, it had already lowered its key benchmark interest rate to near zero. Further, the Federal Reserve expanded its balance sheet by $2.8 trillion since March 2nd largely through the purchase of Treasury securities in order to maintain very low interest rates on government bonds. The combination of very low Treasury interest rates and low credit spreads means that corporate dividend yields are also very competitive in the eyes of investors. For example, on the first of May Coca-Cola issued a bond due in on the first of June 2026 with a coupon of 1.45%, substantially below the company’s dividend yield of 3.60%. Coca-Cola has paid a dividend each year since 1920 and has increased its annual dividend for fifty-eight consecutive years. We believe investors have been drawn back into equities in part due to the lack of alternatives for swelling cash balances and the relatively paltry returns available in the bond market.
While it is only July, investors are likely to soon turn their attention to the November elections. Although seemingly around the corner, four months is a relatively long-time in the current environment. The Standard & Poor’s 500 Index may be a better indicator than election polls as we approach the election. Generally, if the equity market is higher in the three-months immediately preceding the election, the incumbent party has won, and if stocks are lower in the three-month period, the opposition party has won. This has been true in every presidential election since 1984 and 87% of the time since 1928.
The virus pandemic ended the longest economic expansion on record, but the recession that ended it may be the shortest on record. The economy peaked in February and fell into a severe recession as a result of state governors’ lockdown orders to impose social distancing. The slow reopening of the economy since mid-May has already resulted in a large upswing in data series such as gasoline consumption and electricity usage, which are near real-time proxies for economic activity.
The Federal Reserve is trying to ensure that credit continues to flow to households and businesses during this difficult time and that the financial system does not amplify the shock to the economy. Fiscal policies aimed at limiting the permanent damage to the economy have been enacted so that when the pandemic recedes, the economy is positioned to supply goods and services to meet demand. Following a sharp rebound in economic activity from a very low level, the shape of the extended economic recovery will depend a great deal on progress to combat the coronavirus. We believe the companies that you own are financially strong and will emerge from this economic and health crisis well-positioned to compete as the economy begins its recovery.
FINANCIAL MARKET TOTAL RETURN*
*Total Return Includes Income
Michael C. Yeager, CFA
July 3, 2020
The commentary set forth herein represents the views of Luther King Capital Management and its investment professionals at the time indicated and is subject to change without notice. The commentary set forth herein was prepared by Luther King Capital Management based upon information that it believes to be reliable. Luther King Capital Management expressly disclaims any responsibility to update the commentary set forth herein for any events occurring after the date indicated herein or otherwise.
The commentary and other information set forth herein do not constitute an offer to sell, a solicitation to buy, or a recommendation for any security, nor do they constitute investment advice or an offer to provide investment advisory or other services by Luther King Capital Management. The commentary and other information contained herein shall not be construed as financial or investment advice on any matter set forth herein, and Luther King Capital Management expressly disclaims all liability in respect of any actions taken based on the commentary and information set forth herein.