CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
April 1, 2020
I. Equity Markets
A. Consumer-Led Expansion Turns into a Virus-Led Recession.
- Everything changed during March. The longest business expansion on record, which had gotten a second wind as 2019 ended with an easing of trade tensions and three rate cuts from the Federal Reserve, suddenly ended. The economy entered a sudden stop recession in early March. The bull market in common stocks, which barely reached its eleven year anniversary on March 9, fell into a bear market, reaching a trough on March 23, -33.9% below the all-time high reached on February 19, just 23 trading days earlier.
- The fast spreading COVID-19 form of coronaviruses has prompted many countries around the world to effectively lock down their economies in order to contain the outbreak. The draconian measures have placed massive restrictions on the daily lives of hundreds of millions of people, from so-called stay at home and shelter in place orders and school closures to strict guidelines on social distancing and bans on public gatherings. We are living through an unprecedented response to an intensifying global health crisis, leaving everyone to question exactly when things might revert to normal.
- The key difference between the current recession and the 2008-09 recession is that the economy was very healthy when the outbreak of the virus occurred. We have not entered a recession as conventionally defined because the current recession is the result of an intentional, partial shutdown of the U.S. economy.
- In terms of the data to be reported in late April for 1Q 2020 real GDP, the very weak data for March, when the economy hit an air pocket, will be combined with relatively healthy consumer and residential construction data for January and February to produce the first quarter real GDP data point. Given the severity of the drop off in economic activity last month, we expect that a negative growth rate in the realm of -3% to -5% will be reported for 1Q 2020.
- The majority of the negative impact on the economy should show up in the 2Q 2020 real GDP data, with very weak data for April and possibly into May being combined with data that should show some stabilization in June. We expect a very negative growth rate to be reported for 2Q 2020, likely on the order of -15% to -20%. Admittedly, forecasting the rate of contraction in the economy this quarter is largely a guessing game as the spread of the virus and the impact of the stimulus bill passed last week on consumer demand and unemployment are unknown at this point.
- Think of the downturn as a national pandemic adjustment period, a costly investment in public health. We expect that the downturn in economic activity will likely be deep and short as the economy is for all intents and purposes shut down over the months of March and April, with some stabilization and improvement starting in May and into June.
- President Trump extended national social distancing guidelines to April 30 last Sunday in an effort to keep the projected COVID-19 death toll in the U.S. from reaching a catastrophic, worst case scenario. While President Trump previously said he hoped the country could reopen for business by Easter, public health officials convinced the President to extend the stringent social distancing timeframe as the success of getting the spread of the virus under control will determine the duration of the economic contraction.
- The challenge is striking a balance between protecting against the virus and resuming commerce and business that is crucial to getting people back to work. The current at home quarantines across the nation are buying time to slow the spread of the virus, as well as to ramp up the production of masks, personal protective equipment, and ventilators and to keep the virus from overwhelming the health care system.
- The economy is expected to rebound during the second half of the year. The more stunning the contraction in the economy during 2Q 2020, the more outsized will be the rebound during 2H 2020 and into 1Q 2021. The third quarter is likely to be a transition quarter with some lingering worries of the virus returning, but much improved testing capability should mitigate the economic fallout, with growth rebounding in the 5% to 10% range. The fourth quarter and the first quarter of 2021 could turn out to be very strong with growth rates near 10% as pent up demand kicks in.
- We are very encouraged that policymakers are pulling out all stops to bridge the economy to the third quarter. The Federal Reserve has taken unprecedented steps to cut interest rates, purchase fixed income securities, and establish credit facilities to help ease stressed credit markets -- discussed later in this ISS. The central bank has undertaken an open ended asset purchase program -- including municipal debt and investment grade corporate debt -- to keep the economy and the financial system functioning during the shutdown period so that when the all clear is sounded, the economy can quickly return to normal.
- Congress did its part last week by reaching a deal on a massive $2.2 trillion relief bill, easily the largest rescue package in modern history, to combat the economic impact of the coronavirus outbreak. The bill will rush financial assistance to Americans through direct checks to households, enhanced unemployment insurance benefits, emergency loans to small businesses, more resources for hospitals and medical equipment and loans, loan guarantees, or investments to or in businesses, states, and municipalities damaged by the crisis. The bill contains certain measures to keep employees on the payroll and keep small and medium-sized businesses in business, so that jobs are available once the economy returns to normal.
- Everyone seems to be asking, “How could a microscopic organism destroy nearly -$12.5 trillion in U.S. stock market wealth from the high on February 19 to the low on March 23 and -$9.1 trillion to the end of March?” It is startling and mind-numbing, but it occurred. From February 19 to March 23, the major stock market measures plummeted -30.1% to -40.7%. Following a 12.2% to 17.9% rally from March 23 to the end of the month, the stock market indices are lower by -14.2% to -30.9% since year end and declined -10.1% to -21.9% during the month of March.
B. Investors Need to Look Through to the Rebound in the Economy and Earnings.
- For long-term investors, there are a couple very important facts to keep in mind. Since 1930, there have been 13 bear markets in the U.S. Each of those bear markets were the result of a recession in the economy and a serious decline in earnings. As stated earlier in this ISS, the economy fell into a recession and suffered through a rapid fire bear market during March. A key thing to keep in mind during these very stressful times, however, is that each of those 13 bear markets ended.
- Each of the bear markets ended when investors could see through to the end of the recession and an eventual rebound in earnings. The end of this bear market will follow the same process. Since the current recession is the result of a forced shutdown of large parts of the economy, the recession will end when America can resume working. Likewise, the bear market will end when investors can see through to the day when America can resume working.
- With all of the very aggressive and positive policy measures undertaken by the Federal Reserve, the Trump administration, and Congress over the past two weeks, investors are trying to see through to the day when America can go back to work. Keep in mind, however, that the policy measures are intended to provide a bridge to the other side when the spread of the virus is over. As stated before in this ISS, the success of getting the spread of the virus under control will determine the duration of the recession, which will eventually mark the end of the selling and the bottom of the bear market.
- Could the recent low in the S&P 500 and the DJIA on March 23 mark the bottom of this bear market? For the March 23 low to hold, we think the number of new virus cases and new deaths must peak in mid-April as the health officials in the Trump administration currently suggest is possible. Developments on testing and diagnostics are supportive of the March 23 low and discovering therapeutic treatments shortly would help.
- The sharp rebound in stock prices since March 23 can only hold if America can begin the process of getting back to work by early May because the spread of the virus did get under control. Additionally, the massive monetary and fiscal policies put in place over the past couple weeks must be effective in providing an economic bridge to the third quarter.
- Obviously, we would all love for that to indeed be the case, but realistically, no one knows. Volatility will likely remain high as news on the spread of the virus waxes and wanes over the next couple weeks. Additionally, the economic data that will be reported over the next 60 days or so will be very negative as the impact of shutting down a large portion of the economy shows up in the data. The first of those very negative reports on the economy was the surge in initial unemployment claims to 3.28 million last week, easily surpassing the previous all-time mark of 695,000 in October 1982.
- While we do not know when the spread of the virus will end, when the selling will stop, or when the economy will begin the next expansion, we know all of those events will occur. We will get through this. The economy and earnings will recover. Stock prices will move higher.
- Long-term investors will look through the short run disruption to earnings and look to invest in the normalized stream of earnings growth which will resume after the disruption has come to an end. Consider that during the second half of the year, the economy will benefit from lowered trade tensions, a very accommodative monetary policy, low mortgage rates, a massive fiscal policy response to keep employees on the payroll and support demand, and a surge in pent up demand.
- This is a time for investors to stay the course and stay with and/or add to the wealth building assets which create household wealth over time. It is not a time to turn your back on a well thought out investment program. Fear and negative psychology is a much stronger short run driver of stock prices than fundamentals and hard facts.
- Over time, we expect fundamentals and hard facts to win out. No one knows when the selling will end, we just know that many great American companies have gone on sale and we expect the disruption to the economy to pass. Stick with the high quality, dividend paying companies which we recommend as the right path to consistently build wealth over time.
C. A Final Thought, Hang in There!
- Investors need to keep two things in mind today when thinking about the stock market. First, investing in common stocks is a long term proposition and that the excess return over cash equivalents and intermediate bonds earned by investing in common stocks is not free. The excess return is earned by withstanding the inherent volatility associated with owning common stocks in the short run. Of course, no one is concerned about volatility when stock prices are rising, it is only the volatility that accompanies falling stock prices which gives investors angst.
- Secondly, we should be expecting a temporary hit to domestic growth from the onset of the coronavirus in China. Virtually shutting down the world’s second largest economy for several weeks is going to have some impact on global growth. The key is that the health scare and the disruption to economic growth most likely will be temporary, eventually leading to a rebound over the summer months.
- It appears that the U.S. remains relatively insulated and arguably has the best health care system in the world. Long term investors will look through the short run disruption to earnings and look to invest in the normalized stream of earnings growth which will resume after the disruption.
- Volatility has been amplified by momentum-influenced trading done by computers which has created an unprecedented herd effect that moves in unison and blazingly fast, bringing about sharp and exaggerated price swings. While unsettling, it is just part of the market dynamics investors are forced to deal with these days.
- This is a time for investors to stay the course and stay with and/or add to the wealth building assets which create household wealth over time. It is not a time to turn your back on a well thought out investment program. Fear and negative psychology is a much stronger short run driver of stock prices than fundamentals and hard facts. Over time, fundamentals and hard facts will win out. Stick with the high quality, dividend paying companies which we recommend as the right path to consistently build wealth over time.
II. Monetary Policy
A. Federal Reserve Goes “All in.”
- Federal Reserve lowered the target range for the federal funds rate to zero to 0.25% in two emergency rate cuts last month on March 4 and March 15 and unleashed an increasingly aggressive series of new programs aimed at stabilizing the financial markets as the efforts to restrict the spread of the new coronavirus pushed the U.S. economy into recession. The central bank also announced plans to purchase $500 billion of Treasury securities and $200 billion of mortgage-backed securities “to support the smooth functioning of markets” and to keep longer term borrowing rates down.
- Over the next week, the Federal Reserve announced a special credit facility to purchase short-term corporate debt -- commercial paper -- from issuers that have been having a difficult time finding buyers on the open market. The commercial paper market involves short-term lending critical to day-to-day business funding. Mid-week the central bank launched a lending facility to backstop the $3.8 trillion money market mutual fund industry and expanded the facility to accept municipal money market funds and highly rated municipal securities of less than twelve months by the end of the week.
- On March 23, Federal Reserve Chairman Jerome Powell’s whatever it takes moment arrived when the central bank announced an open-ended asset purchase program. The central bank said that the purchases of Treasury and mortgage-backed securities would now take place without limit, and added commercial mortgage-backed securities to the purchase list. It also launched a lending facility to buy securities backed by small business, student, and credit card loans. The Federal Reserve also moved to support large corporations by establishing facilities that will lend to investment grade companies and, for the first time, buy high grade corporate debt and U.S. listed exchange traded funds in the investment grade corporate bond market.
- In an extremely important measure, the Federal Reserve said it would set up a new lending program to support small and mid-sized businesses. These are the businesses -- restaurants, bars, hotels, arts, entertainment, retail stores, and more -- that are at the epicenter of the new coronavirus crisis, suffering through a dramatic decline in sales as the population took up social distancing measures and then, as more state and local authorities announced stay at home and shelter in place orders, largely went dark.
- There are around 29 million businesses with fewer than 500 employees in the U.S., representing almost half of total private sector employment, or over 60 million employees. The sooner those businesses can get the support they need to survive, the more jobs will be saved during the crisis and the better off the economy will be once we get to the other side.
- Federal Reserve policy shifted into a higher gear to try to help support the economy which appeared to be in freefall in mid to late March. The central bank has shifted from being not just the lender of last resort, but now is the buyer of last resort. The central bank is trying to provide a bridge to the third quarter, help the U.S. economy in a race against time, boost consumer and business confidence, and help ease stress in the U.S. financial system which had become dysfunctional at times over the past couple weeks. To Mr. Powell we say well done and to all of you we say stay tuned!
III. Treasury Market
A. Treasury Yields Move Lower as Economy Plummets into Recession.
- The The yield on the ten-year Treasury security fell to an all-time closing low of 0.54% on March 9 as recession fears mounted and stock prices took a sharp turn lower with the DJIA tumbling more than 2000 points. The new low yield on the ten-year Treasury beat the previous low of 1.36% recorded on July 8, 2016 following the vote in the United Kingdom to leave the European Union. The drop in Treasury yields marked the latest milestone in a decades-long bond rally driven by persistently low inflation.
- Yields across the Treasury yield curve have fallen quite substantially since the end of 2019. Yields on three-month and one-year Treasury bills have dropped -148 and -141 basis points, respectively, while the yield on two-year to thirty-year Treasury securities have fallen -107 to -132 basis points. At the low in Treasury yields on March 9, yields on Treasury securities across the yield curve were below 1%. At month end, only securities with maturities longer than 20 years were above 1%, with the yield on the thirty-year Treasury bond at 1.32%.
- Since the low in ten-year Treasury yields on March 9, yields on ten-year and thirty-year Treasury securities have risen 13 to 32 basis points, largely on the expectation that the $2.2 trillion relief package, and possibly additional spending programs, will be funded by a large issuance of Treasury debt. Yields on three-month and one-year Treasury bills have fallen another -28 and -15 basis points, respectively, since March 9 as the Federal Reserve slashed rates by another -100 basis points on March 15 to zero to 0.25%. Yields on Treasury bills out to three months were carrying negative yields in the range of -3 to -9 basis points last week, but ended the month in positive territory, in the range of 1 to 6 basis points.
- The extent of the flight to safety is very evident by looking at the dramatic drop in ten-year Treasury TIP yields -- a widely followed indicator of real growth expectations -- over the past fifteen months. Notice that at year end 2018, despite the Federal Reserve raising rates four times that year, the ten-year Treasury TIP yield was 0.97%. The TIP yield fell into negative territory at the low in Treasury yields on August 27 at -0.07% when the fears of recession peaked last year.
- The ten-year Treasury TIP yield fell to -0.48% on March 9 when the nominal ten-year Treasury note hit its all-time low of 0.54% as recession fears rose and investors scrambled into safe haven assets. Following the Federal Reserve going all in over the past couple weeks and the passage of the massive $2.2 trillion relief bill last week, the yield on the ten-year Treasury TIP has become a bit less negative, ending the month at -0.26%.
- Expect Treasury securities to remain very well bid until health officials around the world begin to signal that the spread of the coronavirus is under control. Our working assumption is that the uncertainty over the spread of the disease may be with us for up to another month or two.
- Once this health scare passes, we expect the yield on the ten-year Treasury note to resume its climb toward 2% as the economy begins a new expansion during the second half of the year. The pace of economic activity will benefit from lowered trade tensions, a very accommodative monetary policy, low mortgage rates, the massive fiscal policy response to support payrolls and small and large businesses, and a surge in pent up demand.
Joseph T. Keating
Chief Investment Officer
Pierre G. Allard
Director of Research
The opinions and ideas expressed in the commentary are those of the individual making them and not necessarily those of CenterState Bank of Florida, N.A. The statistical information contained herein is obtained from sources deemed reliable, but the accuracy of such information cannot be guaranteed. Past performance is not predictive of future results.
CenterState Bank of Florida offers Investments through NBC Securities, Inc. (NBCS”). NBCS is a broker/dealer and a member FINRA and SIPC. Investment products offered through NBCS (1) are not FDIC insured, (2) are not obligations of or guaranteed by any bank, and (3) involve investment risk and could result in the possible loss of principal.