CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
June 1, 2020
I. Equity Markets
A. Hope and Worry about Reopening the Economy and Hope for a Vaccine.
- After rebounding sharply off the March 23 low and through April, stock prices posted additional solid gains during May, but at a somewhat slower pace as the jobs data reported that nearly all of the jobs created in the past decade were lost during March and April, a sobering view that reflects the depth of the recession brought on by the government. Investors also digested mounting evidence that soaring joblessness and months of social distancing will impact economic activity well into next year. While we expect that the economy started the recovery process during May as selected businesses reopened, there will be challenges ahead considering the health risks involved.
- Among the challenges worrying investors, social distancing will make it difficult for large scale activities -- concerts, sporting events, theme parks, casinos, theaters, cruise ships, arts, weddings, graduations -- to return to their pre-virus level of activity anytime soon. Airlines have started to take permanent steps to reshape their businesses as they prepare for a yearlong recovery rather than a quick rebound. Restaurants that have reopened are allowing in fewer customers at a time, placing their viability in question and surveys point to consumers being wary of returning to shopping malls. Significant behavioral adjustments by consumers have occurred and it will take some time for these behaviors to return to some resemblance of normal. Consumers must feel safe from a health perspective to resume activities approaching anything close to normal.
- Mid-month Federal Reserve Chairman Jerome Powell reinforced those worries by stating that policymakers may have to use additional weapons to pull the country out of an economic downturn that has cost more than 30 million jobs in two months and caused “a level of pain that is hard to capture in words.” Mr. Powell stated that the economic outlook was highly uncertain and had significant downside risks and that he was concerned about a prolonged recession, followed by a weak recovery. He went on to say that the coronavirus had triggered a situation unlike previous recessions the U.S. has endured and that additional policy measures would likely need to come from Congress rather than the Federal Reserve.
- While Mr. Powell noted the unprecedented strength of the fiscal and monetary measures already taken, he stressed the importance of making sure that the deepest slump since the Great Depression does not get out of control. Jerome Powell said the recovery is largely dependent on a number of questions surrounding the virus, such as how long it will take for treatments to arise, whether the attempt to reopen the economy will spur new outbreaks, and when consumer and business confidence will return. “The answers to these questions will go a long way toward setting the timing and pace of the economic recovery,” he said.
- The DJIA surged over 900 points on May 18 on news that the first human study of an experimental coronavirus vaccine by biotech startup Moderna has shown promise in early clinical trials. Last week, the DJIA jumped over 500 points on both Tuesday and Wednesday following biotech company Novavax announcing it started the first human study of its experimental coronavirus vaccine. Markets have been particularly sensitive to any developments suggesting progress toward a vaccine for the virus. The cause of the recession was a biological event and fully restoring the economy and returning to a pre-virus normality will require another biological event, i.e. a vaccine.
- Prior to the news on the progress toward developing a vaccine, the S&P 500 traded within a fairly narrow range over the previous six weeks as stock prices largely moved sideways in a very normal consolidation process of backing and filling as investors attempted to digest the rapidly evolving situation regarding the decline in daily new cases of the virus, progress on developing therapeutics and vaccines, the initial attempts to reopen the economy, and the worries discussed above about the challenges to reopening the economy.
- So far, evidence from Europe and China shows little sign of a resurgence of virus cases or deaths or a second virus wave as the mobility restrictions have been relaxed, increasing investors’ confidence that the reopening process could continue uninterrupted in the U.S. Nonetheless a full recovery in the U.S. economy is a long way off. We expect it will likely take until 3Q 2021 for the economy to recapture the level of real GDP in 4Q 2019. The unemployment rate will likely be closer to 10% than 3.5% by the end of 2021. The sooner the states reopen their economies, the better.
- Depending on the day last month, the market traded on news and hope that the economy would recover sooner and faster or on news and worry that the recovery would be later and slower. From the March 23 low to the end of May, the major stock market measures have risen a remarkable 36.1% to 39.1%. For the month of May, the stock market indices rose 4.3% to 6.8%. The S&P 500 is lower by -5.8% for the year-to-date, which is somewhat remarkable given that it was lower by -30.7% to the low on March 23. The DJIA and the Russell 2000 are lower by -11.1% and -16.4%, respectively, over the first five months of 2020, while the technology heavy NASDAQ is now higher by 5.8% on the year.
B. Getting America Back to Work.
- As we have consistently stated over the past three months, the bear market in common stocks will end when investors can see through to the day when America can resume working. The success of getting the spread of the virus under control -- and now more importantly, keeping it under control, will ultimately determine the pace of getting America back to work again. The success of the effort to reopen the economy will determine the length of the recession, which will ultimately determine if the March 23 low in stock prices turns out to be the low for the bear market. The rebound in stock prices is pricing in a better future with America getting back to work, not a worse future.
- After weeks of living through some of the deepest shocks since the Great Depression, it looks to us that the worst of the economic impact from shutting down large swaths of the economy in March is now behind us. The majority of the negative impact on the economy from the government mandated shutdown showed up in the April economic data and will be evident in the 2Q 2020 real GDP data, as the pace of economic activity hit an air pocket during the second half of March, and then accelerated to the downside during April. We continue to expect the recession to be deep but short. By comparison, the eleven post-WWII recessions lasted between six and eighteen months.
- We are all aware that more than forty million workers have filed for unemployment insurance benefits over the past ten weeks. However, it appears the tide has begun to turn and there are several reasons to believe the economy is slowly turning up, that a bottom in economic activity has been put in place. By the end of May, all 50 states have started the process of reopening their economies and the scope of the reopening will widen over time, as there are growing pressures across the country to get America back to work.
- The time is right to restart the economy because the American public has concluded that the economic harm from lockdown is also a disaster and the historic job losses and food lines are a human tragedy. Additionally, very aggressive policy actions by the Federal Reserve and the Trump administration and Congress, with more to come, have been put in place over the past three months and heightened awareness of how the virus spreads has resulted in cautionary measures being taken by the public. In our view, the economy can successfully reopen using science and logic.
- The economy’s growth rate will pick up as firms and households learn to combine a higher level of economic activity with continued or ongoing virus control through a range of adjustment mechanisms including face mask and glove wearing, social distancing, enhanced low cost hygiene, frequent cleanings of work places, lower office and retail occupancy, and improved testing and contact tracing.
- While there are admittedly some significant risks to the restart of the economy, on the whole they look smaller than one would expect given the magnitude of the economic shock and from a simple extrapolation from past cyclical experiences. In prior recessions, employment, consumer spending, business investment, and production declined gradually, typically along with the Federal Reserve gradually tightening monetary policy. Given the government mandated shutdown of the economy during March, this recession began with a sudden and historic collapse.
- During a typical recession, the key dynamic to monitor is the negative multiplier effect -- the traditional interplay between output declines, job losses, declines in household income, and further weakness in demand. However, this cycle looks very different because of the massive and early monetary policy and fiscal policy response, including the Federal Reserve slashing rates to near zero and instituting multiple lending and liquidity programs, while Congress has appropriated close to $3 trillion in relief funding.
- Three other positives on reopening the economy include evidence that warmer temperatures and higher humidity and low cost hygiene can help contain the spread of the virus, the increased availability of treatment options, and the ability to learn from areas that are reopening on what works and what does not work. So we believe the downturn in the economy reached a bottom in late April/early May and it is now time to bet on a recovery.
- As states loosen up on government imposed restrictions and mobility has increased, green shoots of economic life are emerging. Rail car traffic, truck loads, spending at restaurants, real estate activity, hotel occupancy, gasoline purchases, and air travel are all still substantially lower than a year ago, but all have moved off their late April/early May lows. While first-time unemployment claims remained elevated at 2.1 million last week, continuing claims plunged by nearly 4 million to just over 21 million, which suggests an initial movement toward re-employment.
- As we have stated in the last three ISS’s, long-term investors will look through the short run disruption to the economy and earnings and look to invest in the normalized stream of earnings growth which will resume after the disruption has come to an end. That is the reason the S&P 500 has risen more than 36% from the low on March 23 to the end of May, despite the economy remaining in a free fall through the end of April. Long-term investors are betting on the American spirit and ingenuity to get us through this. The economy and earnings will recover as America returns to work.
- While we expect common stock prices to be higher a year from now as the economy gets restarted and gradually repairs, do not expect a further explosive rally like the 30.2% gain the S&P 500 gave us from the low on March 23 to the end of April. Currently, common stocks, using normalized earnings, are roughly fairly valued, compared to the more than 25% undervaluation back on March 23. Given the scale and scope of the response by the Federal Reserve and the Trump administration and Congress over the past three months, we expect the March 23 low to hold and that the downside risk to the market is limited.
- As a final thought, never underestimate the ability of the American spirit and ingenuity and the capitalistic profit motive to be able to win the day. While the bad news on the economy is plentiful at the moment, we need to remember that our economy is a resilient engine with natural recuperative powers, which are being supplemented by very aggressive fiscal and monetary policies. While we understand that some behavioral adjustments have occurred and it will take some time for these behaviors to return to some resemblance of normal, it is a loser’s game to bet against America.
C. The Seas Could Be a Bit Choppy Near Term.
- There is one current issue and two looming issues which could impact the economy and the stock market over the summer. Currently, the killing of an unarmed black man at the hands of Minneapolis police sparked more than 100 protests, rallies, and vigils over the weekend with protesters and police clashing in cities across America. Many of the protests descended into violence as tensions boiled over and outside agitators took advantage of the situation. Businesses and jobs were destroyed by looting and fires being set, which will make reopening the economy even more difficult.
- Investors are also grappling with escalating tensions between China and the U.S. On Friday, President Trump launched a series of initiatives meant to punish China for tightening its control over Hong Kong and for alleged misdeeds from scientific research security risks to its handling of the coronavirus pandemic. These moves are likely to compound an already tense relationship with China.
- The presidential election is five months away and the campaign rhetoric is bound to intensify over the summer months. While the Democratic platform has not yet been finalized, it surely will contain higher taxes, particularly for corporations, which would reverse some of the benefits of the corporate tax cut passed in December 2017. Given the sharp gains in stock prices since March 23, it would not surprise us if the advance in stock prices took a pause in the near term and a modest pull back took place.
II. Fixed Income Markets
A. Treasury Yields Reflect Later and Slower Economic Recovery and Easy Policy.
- It appears that investors in Treasury securities are anticipating that the economic recovery will be later and slower, rather than sooner and faster, with years of very accommodative monetary policy ahead. After the yield on the ten-year Treasury note plummeted to an all-time low of 0.54% on March 9, it has traded in a very narrow band of 0.57% to 0.75% since March 27. Over that same timeframe, equity investors have shown a good deal more optimism on the outlook for the economy, with the S&P 500 higher by almost 20%. We believe stock investors are looking primarily at the direction of the economy, while fixed income investors are more concerned with the degree and pace of economic activity, which is very uncertain at the moment.
- The persistently low level of Treasury yields suggests investors expect the Federal Reserve to basically repeat its post-financial crisis playbook -- keeping its target for the federal funds rate near zero for an extended period of time. After lowering the target range for the federal funds rate to zero to 0.25% in December 2008, the central bank did not begin to raise rates until December 2015.
- With the economy plunging into a sudden stop recession during March, yields across the yield curve have fallen -98 to -142 basis points since the end of 2019. Since March 27, yields on three-month and one-year Treasury bills have risen by 16 and 7 basis points, respectively, while yields on two-year to seven-year Treasury notes have fallen by -6 to -9 basis points. The yield on the ten-year Treasury note has fallen -2 basis points, while the yield on the thirty-year Treasury bond has increased by 14 basis points.
- Inflation expectations have fallen dramatically with the economy plunging into the sudden stop recession during March. Notice in the table below that at the end of 2019, the implied inflation forecast embodied in the nominal and inflation protected ten-year Treasury securities was 1.79%, a touch below the Federal Reserve’s 2% target.
- 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. The yield on the ten-year Treasury TIP was a touch more negative at -0.51% at the end of May as the demand for safe haven assets remains strong. The implied inflation forecast in the ten-year Treasury securities has stayed just above 1% since March, quite a bit below the Federal Reserve’s target.
- Expect Treasury securities to remain very well bid until health officials around the world begin to signal that the spread of the coronavirus is well under control and the economic data begins to provide some concrete evidence that the initial attempts to reopen the economy are successful. The initial steps to reopen the economy have brought an increased level of uncertainty over the ongoing efforts to control the spread of the virus, however, which is keeping Treasury securities well bid.
- Once this health scare eases further, we expect the yield on the ten-year Treasury note to rise above 1% as the economy begins a new expansion during the second half of the year. The pace of economic activity will benefit from 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.
B. Yield Spreads on Corporate Bonds and Bank Preferred Stocks Are Still Attractive.
- The yield spread on investment grade corporate bonds to like maturity Treasury securities has a historical average spread since December 1996 of 156 basis points. At the low in stock prices on March 23, the yield spread widened dramatically to 401 basis points as the economy plunged into a sudden stop recession and the fixed income markets turned very illiquid with demand for corporate debt drying up as worries over potential defaults mounted.
- The current yield spread on investment grade corporate bonds has fallen sharply to 185 basis points as the Federal Reserve instituted multiple liquidity programs, including for the first time buying investment grade corporate debt and exchange traded funds which own investment grade corporate debt, on April 9. With the yield spread currently above its average yield spread, the Federal Reserve signaling it will remain very accommodative for an extended period of time, and the states beginning the process of reopening their economies, investment grade corporate bonds are attractive for purchase.
- Yield spreads on below investment grade corporate bonds also widened dramatically to March 23, reaching a yield spread to like maturity Treasury securities of 1087 basis points, compared to an average yield spread of 556 basis points going back to December 1996. Similar to investment grade corporate debt, the yield spread on below investment grade corporate debt has fallen sharply to 671 basis points currently.
- On April 9, the Federal Reserve also announced it would purchase below investment grade bonds of “fallen angels” -- corporations whose debt was downgraded to below investment grade since the beginning of the government mandated shutdown, think Ford Motor Company -- and exchange traded funds which own below investment grade bonds. With the yield spread currently above its average yield spread, an accommodative Federal Reserve, and the economy reopening, below investment grade corporate bonds are attractive for purchase.
- For the preferred stock of banking companies which we use in our Custom Income Strategy, the yield spread on preferred stock to thirty-year Treasury bonds similarly widened sharply to 631 basis points on March 18. The yield spread has narrowed sharply to 456 basis points compared to an average yield spread of 385 basis points going back to July, 2007. With the reasons stated above for purchasing corporate debt and the highly capitalized position for U.S. banks, bank preferred stocks are also attractive for purchase.
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.