CenterState Wealth Management
INVESTMENT STRATEGY STATEMENT
May 1, 2020
I. Equity Markets
A. Economy Plunges into Recession.
- The economy contracted sharply and abruptly during March due to measures taken to limit the spread of the highly contagious new coronavirus. In an unprecedented turn of events, a government mandated shutdown forced the economy into a sudden stop recession in early March when the economy hit an air pocket. The dramatic measures taken to contain the outbreak 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.
- Consider that retail sales plummeted -8.7% during March, the largest decline since the government started tracking the series in 1992. A plunge in sales on motor vehicles, furniture, electronics, appliances, gasoline, clothing, sporting goods, and at restaurants and bars far outweighed a surge in receipts at grocery stores and solid gains at online retailers, building material and gardening retailers, and pharmacies.
- Industrial production declined -5.4% during March, the sharpest decline since January 1946, 30.3 million people filed for unemployment benefits over the past six weeks, the regional Federal Reserve Bank surveys plunged into all-time negative territory, consumer confidence measures cratered, and 1Q 2020 real GDP contracted at a -4.8% rate, despite the months of January and February displaying a fairly healthy pace of growth.
- The contraction in the economy last quarter officially brought the longest economic expansion in U.S. history to an end. Consumer spending fell at a -7.6% rate as all nonessential stores were closed, led by a -33.2% plunge in motor vehicle purchases, a -35.9% collapse in outlays for clothing, a -31.9% decline in recreational services, and a -29.7% drop in restaurant, bar, and lodging outlays. As consumers redirected their spending during March, purchases of household staples -- groceries, cleaning supplies, and paper products -- soared.
- Business capital spending fell at a -8.6% rate in 1Q 2020 as companies slashed spending plans as the pandemic forced business closures and demand plummeted. Residential construction outlays were easily the strongest sector in the economy last quarter, growing at a 21.0% rate. However, the strength in housing outlays took place in January and February as housing starts fell -22.3% during March.
- The majority of the negative impact on the economy from the government mandated shutdown should show up in the 2Q 2020 real GDP data, as the pace of economic activity accelerated to the downside during April. We are encouraged by the initial efforts to reopen nonessential businesses and this week’s encouraging news on Gilead’s remdesivir coronavirus drug trial. The economy should, at least, stabilize during May and June and likely will begin to show hints of growth as America starts to return to work. We still expect a very negative growth rate to be reported for 2Q 2020, likely on the order of -20% to -30% at an annual rate.
- Admittedly, forecasting the rate of contraction in the economy this quarter is largely a guessing game as the length and severity of the recession will depend on the success of returning America to work. We continue to expect that the downturn in economic activity will be deep and short. The pace of economic growth over the remainder of the year will be solely a function of limiting the spread of the virus, increasing testing, and finding effective therapeutics, antivirals, and eventually a vaccine.
- The recovery in the economy during the second half of the year is likely to be choppy and muted at first. The third quarter is likely to be a transition quarter with anxiety remaining high with lingering worries of a flare up in the number of virus cases. However, a successful implementation of the new federal guidelines for opening up the economy in three phases with improved testing capability and effective therapeutics should mitigate the economic fallout with growth rebounding in the 2% to 5% range.
- While not the most likely outcome, do not be surprised if the third quarter turns into a rebound quarter rather than a transition quarter, with much stronger growth -- in the realm of 5% to 10% -- if testing capability ramps markedly during May and June, along with the encouraging news on remdesivir. Fast, widespread testing is a key requirement for safely reopening businesses and returning to something close to normal life because it would allow health officials to detect new cases quickly and stem outbreaks, while the benefits of an effective therapeutic are pretty straight forward.
- The economy’s growth rate should be close to 5% during 4Q 2020 and1Q 2021 as life gets closer to a “new” normal and pent up demand kicks in. We are very encouraged by the series of very aggressive and frequently unprecedented actions taken by the Federal Reserve and the Trump administration and Congress to provide a bridge from shutting down the economy to a gradual, phased in restart.
- After passing a $2.2 trillion relief bill during March, Congress reached agreement with the White House on another coronavirus relief bill last month, the federal government’s latest effort to keep pace with the twin economic and public health crises created by the pandemic. The $484 billion relief bill added $310 billion to the Paycheck Protection Program and included $60 billion for economic disaster loans for small businesses, $75 billion for hospitals, and $25 billion for testing.
- The stock market’s startling plunge into a bear market -- the S&P 500 suffered its fastest drop from a record high to a bear market in history, ultimately falling -34% from the all-time high on February 19 to the recent low on March 23 -- was followed by a blistering rally off its lows to the end of April, with the S&P 500 soaring 30.2%. The rebound in stock prices was fueled by four major factors. The most important was an improved and hopeful perspective on limiting the spread of the virus. Since the current recession is the result of a forced shutdown of large parts of the economy, the recession will only end when America can resume working, of which we are currently seeing the first signs.
- Likewise, the bear market in stocks will end when investors can see through to the day when America can resume working. The March 23 low will turn out to be the bottom if the disease curve in the U.S. continues to decline and the initial efforts to restart the economy are successful, which is the second major factor. The stock market is pricing in a better future with America getting back to work, not a worse future.
- The third major reason was the series of very aggressive and frequently unprecedented actions taken by the Federal Reserve and the Trump administration and Congress to provide a bridge from shutting the economy down to a staggered restart of the economy. These actions went a long way toward turning investor sentiment positive. The fourth factor was a major buying opportunity for long-term investors. The primary valuation tool we use indicated that the S&P 500 was undervalued by more than 25%, using normalized earnings, on March 23.
- From the all-time high on February 19 to the March 23 low, the major stock market measures plummeted a shocking -30.1% to -40.7%. From the March 23 low to the end of April, the stock market indices have risen a remarkable 29.6% to 30.9% and are lower by -0.9% to -21.4% over the first four months of 2020.
B. Three Phase, Gradual Reopening of the Economy.
- Mid-month, President Trump and his coronavirus task force outlined new federal guidelines for opening up the country which places the onus on governors to decide how to restart the economies in their states. The new guidelines, formally known as “Opening Up America Again,” lay out a three phase, gradual and deliberate process of reopening businesses and schools. The guidelines do not include specific reopening dates, they instead encourage states to base their decisions on data and outcomes.
- The guidelines are aimed at easing restrictions in places exhibiting a downward trend in documented new cases of the virus and strong testing, while holding the line in harder hit locations. The guidelines make clear that the return to normalcy will be a far longer process than the Trump administration initially envisioned, with health care officials warning that some social distancing measures may need to remain in place through the end of the year -- and possibly into 2021 -- to prevent a new outbreak.
- It is very encouraging that the initial steps to restart the economy are now beginning, even though the complete process is likely to extend into early 2021, will likely suffer some setbacks along the way, and will ultimately depend upon the development of a vaccine. The time is right to strategize how to restart the economy because the American public has concluded that the economic harm from lockdowns is also a disaster. 30.3 million jobless in six weeks and food lines are a human tragedy.
- The longer the economy is shut down, the more long-term damage there will be in lost human and physical capital -- and the weaker the eventual economic recovery. Americans and their resilient spirit want to defeat the coronavirus and the Covid-19 disease it fosters and have shown over the past six weeks that they are willing to make the sacrifice to do it, but they do not want poverty to be the price they have to pay for victory.
- As stated previously in this ISS, the success of getting the spread of the virus under control -- on this point there appears to be solid progress -- and possibly more importantly, keeping it under control, will determine the pace of getting America back to work again. The success of the effort to return to work 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.
- Investor sentiment is far better today than at the lows back on March 23, but we caution our readers that our emotions will remain under attack over the next couple months. The economic data that will be reported over the next 30 to 45 days will be very negative and in many ways startling as the impact of shutting down the economy for much of March and all of April shows up in the data. Despite the best efforts of the Federal Reserve and the Trump administration and Congress, bankruptcies will accelerate and some businesses will not be saved.
- While the 1Q 2020 earnings reports are very weak -- with 28% of companies reporting, Standard and Poor’s estimates that operating earnings will decline -16% year-on-year -- 2Q 2020 operating earnings are projected to be lower by a brutal -27% year-on-year. Actual earnings could easily decline more than current estimates given the absolutely astonishing rise in unemployment over the past six weeks.
- As we have stated in the last two 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 30% from the low on March 23 to the end of April, despite the economy remaining in a free fall over that timeframe. 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.
- Consider that during the second half of the year, the economy will benefit from a gradual and deliberate reopening of the economy, a very accommodative monetary policy, low mortgage rates, a massive fiscal policy response to keep employees on the payroll and keep small and medium-sized businesses in business, and a surge in pent up demand.
- 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 has given us over the past six weeks. Common stocks, using normalized earnings, are currently 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 two months, we expect the March 23 low to hold and that the downside risk to the market is limited.
- We continue to encourage 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. Many great American companies went on sale over the past two and a half months and we expect the massive 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.
II. Monetary Policy
A. Federal Reserve Announces Extraordinary Interventions in Financial Markets.
- The Federal Reserve took unprecedented actions on April 9, releasing details on nine lending programs aimed at supporting the U.S. economy and the credit markets. Those programs, which total up to $2.3 trillion, included loans to states, cities, and midsized businesses that have seen revenues evaporate amid efforts to combat the coronavirus outbreak. The central bank also said it would expand previously announced plans to backstop lending to large companies by purchasing corporate bonds of companies that had recently lost their investment grade status -- “fallen angels” like Ford Motor Co. -- and exchange traded funds which own below investment grade bonds.
- In a statement which accompanied the release of the additional actions, the Federal Reserve stated the “funding will assist households and employers of all sizes and bolster the ability of state and local governments to deliver critical services during the coronavirus pandemic.” Federal Reserve Chairman Jerome Powell added, “The Fed’s role is to provide as much relief and stability as we can during this period of constrained economic activity, and our actions today will help ensure that the eventual recovery is as vigorous as possible.”
- The Federal Reserve’s policy response was the latest in a series of extraordinary interventions in the financial markets aimed at mitigating the economic fallout from the coronavirus outbreak. The central bank’s crisis response has had three phases. The first was the traditional monetary policy response of slashing the target range for the federal funds rate to zero to 0.25% in two emergency rate cuts on March 4 and March 15, which effectively exhausted its conventional ammunition.
- The second phase was to purchase $700 billion of Treasury and mortgage-back securities, which the Federal Reserve eventually expanded to an open-ended asset purchase program -- that is, without limits -- and to include commercial mortgage-backed securities. The Federal Reserve also committed to lend to banks and bond dealers and offer credit to foreign central banks to meet dollar shortages abroad. This was all done to prevent the financial system from seizing up, part of the central bank’s well established role as the lender of last resort to the banking system, albeit on an unprecedented scale.
- In the third phase, the Federal Reserve used its emergency authority, with the approval of the Treasury Secretary, to unveil special credit facilities to support the commercial paper market, the entire money market mutual fund industry, short-term municipal debt, and securities backed by small business, student, and credit card loans.
- The central bank also announced a lending facility for investment grade companies and, for the first time, will buy high grade corporate debt and exchange traded funds which own investment grade corporate debt. As mentioned above, the Federal Reserve added lending programs for states, cities, and mid-sized businesses, as well as purchasing below investment grade bonds of “fallen angels” and exchange traded funds which own below investment grade bonds on April 9.
- The Federal Reserve went on to announce that it will provide support to the Treasury Department’s Paycheck Protection Program, which is the linchpin of the federal government’s massive $2.2 trillion relief bill and the add-on $484 billion relief bill announced last week. The plan is designed to keep employees on payrolls for eight weeks, limiting the mounting ranks of workers applying for unemployment checks. Borrowers who retain or rehire most of their employees will have the loan and any interest forgiven. Borrowers may also use the money for rent and utilities.
B. Building a Bridge to the Other Side.
- In leading the Federal Reserve beyond prior efforts to support lending and the financial system during the 2008 financial crisis, Mr. Powell is pushing deeper into areas of credit and fiscal policy that the central bank has traditionally deferred to elected officials. During and after the financial crisis the central bank left it to the White House and Congress to provide financial assistance to failing automakers and local governments facing declining revenues, viewing such actions as essentially political.
- Currently, with a far greater swath of the economy shut down to prevent the spread of the virus, companies and local governments of all sizes are struggling to make payroll, pay bills, and service debts. The severe scale of the damage to the economy has prompted the Federal Reserve to signal its willingness to buy assets or make loans in any market it thinks will be necessary to stave off further job losses and business failures. Mr. Powell signaled the central bank was in no hurry to withdraw its crisis support and deflected worries that the expansion of credit would lead to inflation by saying, “…one thing I do not worry about is inflation right now.”
- The Federal Reserve, along with the Trump administration and Congress, are working aggressively to keep employees connected to their jobs and to keep small and medium-sized businesses in business to provide a bridge to the other side when the spread of the virus is under control. It will be very difficult to restart the economy if the jobs and businesses that were thriving as 2020 opened are gone once the “all clear” is given.
- The Federal Reserve did hold an FOMC meeting this week and, as expected, did not announce any new policy measures. The central bank pledged in its policy statement to use “its full range of tools to support the U.S. economy in this challenging time” and committed to hold rates near zero and keep them there until full employment returns and inflation gets back to the central bank’s long stated 2% target.
- As we stated in last month’s ISS, to Mr. Powell we say job well done and to all of your we say be heartened by the extraordinary measures taken by the Federal Reserve to provide monetary stimulus and to stabilize and improve the functioning of the financial system and to add and support liquidity. As always, stay tuned!
III. Treasury Market
A. Treasury Yields Move Lower as Economy Plummets into Recession.
- 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 -146 and -143 basis points, respectively, while the yield on two-year to thirty-year Treasury securities have fallen -110 to -137 basis points.
- Since the low in ten-year Treasury yields on March 9, yields on ten-year and thirty-year Treasury securities have risen 10 and 29 basis points, respectively, largely on the expectation that the $2.2 trillion relief package passed in March and last week’s $484 billion relief bill will be funded by a large issuance of Treasury debt. Yields on three-month and one-year Treasury bills have fallen another -26 and -17 basis points, respectively, since March 9 as the Federal Reserve slashed rates by another -100 basis points on March 15 to a range of zero to 0.25% for the federal funds rate.
- 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 sixteen 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. The yield on the ten-year Treasury TIP was a touch less negative at -0.43% at the end of April as the initial efforts to reopen nonessential businesses is just starting in some parts of the country and being discussed in other parts.
- 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 and the economic data starts to provide some concrete evidence that the initial attempts to reopen the economy are successful. The initial steps to reopen the economy will bring an increased level of uncertainty over the ongoing efforts to control the spread of the virus, however, which will keep Treasury securities well bid in the near term.
- Once this health scare passes, 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 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.