​​Counterpunching

May 5, 2020

By Thomas E. Nugent
Executive Vice President, Chief Investment Officer
PlanMember Securities Corporation

After a tumultuous March when the stock market collapsed in the face of a one-two punch, the coronavirus onslaught and the fall in the price of oil, many equity investors expressed the fear that the worst was yet to come. The announcement of a federally mandated business shutdown brought economic progress to a standstill and measures of economic stability became meaningless as only essential businesses, such as grocery stores and pharmacies, continued operations. Daily revisions to the economic outlook became uglier by the day as economists and strategists rushed to lower their projections on growth and profitability. An explosion in unemployment claims early in April as reflected in the following exhibit confirmed that the outlook was indeed ominous.

As professional investors, one of our jobs is to assess the outlook for the economy and the financial markets and make investment decisions based on that outlook. The blindside impact of the coronavirus and the oil price collapse and their likely impact on near-term economic statistics detract from an ability to forecast related data and trends. As we have said in previous communications, the outlook over the near term is unknown, but a recovery from these events should usher in an improving stock market. When evidence began to appear that the onslaught of the virus slowed, the markets began to recover. For most of April, the recovery continued as the rate of new virus cases slowed. The Dow Jones Industrial Average surged from a low point on March 23rd of 18,213.65 to an April 30th close of 24345.73, a gain of 33.66%. As efforts to come up with both therapeutic and vaccine solutions to the problem accelerated, individual states began to roll back the lockdown procedures that were mandated by the federal government.

The crises that many have referred to as the equivalent of a World War triggered a massive simulative response from the federal government. From the first salvo fired by the President to ban flights from China, the source of the virus, to massive government spending programs, the response was overwhelming. The Wall Street Journal has calculated that the spending amounted to $2.9 trillion dollars, the equivalent to 60% of total spending budgeted for fiscal year 2021. The Congress appropriated this amount of money over a short six-week period. Politicians have signaled that further stimulus packages would be forthcoming if an economic relapse occurs.

The Federal Reserve implemented a similar response to the financial side of the economic challenge. The initial step lowered interest rate targets taking the fed funds rate to zero. The second step the Fed took was to purchase massive amounts of public securities to ensure liquidity across the economy. Initially, the Fed put a value on these purchases of $500 billion in treasury securities and $200 billion in government guaranteed mortgage-backed securities, but on March 23, the Fed made the purchases open-ended meaning there would be no limit as to the amount of these purchases. The program expanded to commercial mortgage-backed securities. Other support activities included backing 24 major securities’ dealers by offering loans against specific collateral, backing money market mutual funds by purchasing securities from those funds under any illiquidity problems and providing an increase in funds for the “repo” market. The amount in daily overnight repo support increased to $1 trillion: $500 billion for the one-month repo and $500 billion for the three-month repo. The Fed also instituted direct lending to corporate borrowers by buying new bond issues and providing loans. Another facility was designed to backstop the corporate debt market for up to $750 billion. In addition, the Fed will buy commercial paper from corporations at 1-2% points above the overnight lending rate. Another $600 billion will be made available through the bank’s “Main Street Loan Facility” to backstop smaller companies. Additionally, the Fed is lending directly to municipal governments through the Municipal Liquidity Facility with up to $500 billion in lending authority.

A third element in the response to the crises was in the private sector where cooperation and ingenuity accelerated the potential for a solution to the virus. Businesses, individual backers and scientists have banded together to end the virus. Numerous pharmaceutical companies are working on therapy and vaccines, many of which are in initial testing phases. Businesses are quickly adapting to a more restricted world where, for example, restaurants are emphasizing take out service as a way to continue operations. When we put all of these responses together, our confidence grows that the “fight” is moving in our favor as reflected by the unexpected rally in equity markets shown in the following exhibit of the price action of the S&P 500 over the past year. In the face of growing negative economic news during April, stocks rallied back to a point where the market recovered almost half of the losses experienced during March. On Monday, March 23, the index closed at 2,237. Since then, the index has gained 30% to close at 2,912 on April 30th.
Source: Federal Reserve Bank of St. Louis

The Federal Reserve is also committed to keeping interest rates low until the economy regains its footing. An unfortunate effect of this low-rate policy is that it penalizes savers who opt for short-term fixed-income securities. Recently the federal government’s 10-year note yielded about 0.6%, which is insufficient to make such securities attractive. Even the long-term thirty-year government bond is yielding only 1.28%! Investors have rushed to these government securities for safety in the face of a potential financial crisis. However, the government’s commitment to minimize any financial crisis tells us that such a need may have passed, and diversifying into corporate bonds can increase current return without taking additional risk. The high-yield bond market has also suffered in the face of the economic downturn, but Fed policies have buoyed even this area, and yields remain attractive for certain high-yield mutual funds that have a conservative investment strategy.

In a recent interview, Chairman Powell reiterated the Fed’s commitment to stabilize the economy until the virus is contained. The Fed has that power because it is not limited to financial constraints made to achieve that goal. We have said many times that the Fed can always “write the check” to achieve virtually any financial or liquidity goal.

As we enter the warmer months of the year, there are theories that the virus may not flourish well in a high-temperature environment. We may also find that the opening up of the economy may trigger a relapse in the war against the virus. If so, we are likely to face continued market volatility. The weak oil price environment will cause continued pain in the energy sector until such a time that equilibrium in the price of oil is reached. Such an event will take some combination of further cuts in production among global producers and an economic rebound. On the other hand, lower energy prices will benefit consumers once they are in a position to resume normal usage. These uncertainties will contribute to ongoing stock market volatility.

We are looking for the turning point where we gain the upper hand in one if not both of these crises. Equity markets have rallied in the face of an enormous government program to stabilize the economy until the current situation passes. For the foreseeable future, interest rates are likely to remain at or near record lows, while equities as a group may continue to move erratically based on the progress of the battle.