2020 Second Quarter Interim Review Part 2
Inflating asset prices are currently executing a high wire act with the Federal Reserve playing the role of the balance pole. There is an abundance of Fed-created liquidity flooding the market. That is part of the good news that has the US equity markets shrugging off all signs of trouble ahead with expensive valuations and consistent moves higher. The other part of that narrative is that a V-recovery will occur soon with no major problems coming down the pike; it is nothing but flowers from here on in and all the bad news has already been priced in. 2020 is being written off, the equity markets are willing to forget that it is all happening and move on.
Is it possible that all the good news has been priced in as along with the bad? That V-shaped recovery is an absolute must at this point. We said high wire act, because that is what we are seeing the equity markets execute on. There is no room for a misstep as markets continue to surge higher. All consumer demand must return to pre-COVID levels fast for this to work.
What about the situation on the ground? That always depends on which ground you tread. Southeastern Michigan where we are headquartered was hit hard. Our lockdown was broad and stringent. Our reopening has been full of facemasks and social distancing. The good news is that we have seen Michigan bend our curve significantly down. The cost of that bending has been high with unemployment rates in Michigan looming north of 20%. Other areas of the country cannot understand why there were lockdowns at all. The obvious and what is actionable are two different things. Defensive measures to protect against portfolio losses were called for and were taken as we scaled back our offensive positions on the way down. We have been scaling back into our offensive positions on the way back up.
Interestingly commentators complaining about the short-termism in the market have been mostly silent as every short-term bad piece of information has been ignored in favor of total long-termism. Companies that have missed massively on reported earnings per share (EPS) and withdrawn guidance this quarter are not being punished as they were in the past. Once we got past the initial drawdown, this has been a very accommodating market.
Over the past two weeks we have seen what we call the garbage rally. The companies with balance sheets that were strangled with debt before the crisis, those with dim chances of growing or making a profit, and those that have re-leveraged themselves to get out of the crisis have all begun to rally. This speculative and over-leveraged rally is betting that the economy is turning, that the COVID-induced demand and supply shock will not have any lasting implications. In general, these are market areas that we like to avoid when we can. The markets are betting that the Fed-induced liquidity will socialize their companies’ losses once again.
Where are the next issues?
- Good News!
- Auto purchases are returning to good levels. This is good as there will be a glut of inventory out there due to the failure of some certain prominent companies that hold quite a bit of auto inventory. These companies are letting their auto inventories age or selling some of it off.
- The reopening is going off without any significant new outbreaks at this point. Let’s hope it stays that way.
- “No-Layoff Vows” to expire.
- Will enough time have been bought for companies that took loans with employment restrictions in them to get them running again before they must lay off a new round of workers?
- Remember the largest expenditure for companies is almost always salary. If they need to boost their net income due to a lack of topline revenue growth, there are two quick levers that companies can pull: laying people off and reducing capital expenditures (CapEx). We were already seeing a decline in CapEx prior to COVID as employment costs were increasing due to full employment and rising wages. The decline in CapEx is forecast to continue.
- Enhanced unemployment set to expire.
- Many medium to low wage workers are making more with the enhanced unemployment benefits than they made via full time employment.
- When that stimulus is gone, they will have to find a job at a lower wage.
- This could mean decreased future spending.
- China trade policy will it escalate?
- We have seen China not living up to its end of the trade deal. What happens if Washington decides to push them further and tensions escalate.
- Anti-China sentiment is a bipartisan issue.
- Delinquency rates turning into defaults.
- Many US mortgages are in forbearance right now. Many filed as a precaution. This is a 6-month forbearance. That means when those households must begin to pay their mortgage again discretionary spending could take a big hit.
- Commercial properties are also facing massive delinquency rates. The reopening of American will tell us how serious this could get.
- Powell is Begging for More Stimmy:
- We should maybe stop and question why and what it means that the Chairman of the Fed, Jerome Powel, is begging for more stimulus.
- What is he seeing that the market is not?
- Of course, he is also basically saying that the Fed will not let economic gravity occur and all losses will be socialized.
- The increase in the money stock is being directly mirrored by the deceleration of velocity of money. To simplify, the new money is being parked in assets, not spent.
- Do not forget the election.
- Oh damn, politics…
- If you thought 2016 was a joyless affair and have become tired of politicians just wait. It is all returning, with a vengeance.
- Civil Unrest
- There is an extreme amount of civil unrest in our country, and the world currently.
- Civil unrest and the stock market have very little relation. We often see 1968 cited as an example of a year of great upheaval. The S&P 500 was up +7.6% that year.
- Of course, 1968 did not have a massively contracting economy occurring with the cause a global pandemic. So, the comparison is not entirely apt.
Equities continue to move higher. Negativity surrounding the economic situation is divorced from the equity markets. This can be concerning. We continue to watch and take strategic buying opportunities as they come our way. We pray for a speedy economic recovery, and a healing spirit to come to our torn country. Please stay healthy and know that we are here for you, our clients.
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