My 9th Special Update on the Coronavirus, the Economy, and the Capital Markets

ALL POSTS PRIOR TO 2021 HAVE NOT BEEN REVIEWED NOR APPROVED BY ANY FIRM OR INSTITUTION, AND REFLECT ONLY THE PERSONAL VIEWS OF THE AUTHOR.

Scholar Financial’s 9^th Special Update on the Coronavirus, the Economy, and the Capital Markets

April 3, 2020

The Good (Health and Other) News

Before exploring the impact of the Coronavirus (COVID-19) on the economy, and the capital markets, please permit me to share some “potential good news”:

• Scores of currently available drugs are being tested to reduce the symptoms of COVID-19. Some are showing remarkable results, at least anecdotally. Research studies currently underway will tell us more. Such medications may reduce the severity of the symptoms, lessen mortality rates, and lead to speedier recovery from the illness by individuals.

• At least six, and possibly more, vaccines are in development. At least one is already in human trials (of which there are least three stages – one for safety; the other two stages for efficacy). Johnson & Johnson, and other companies, are rapidly scaling up their vaccine manufacturing capabilities. At best, however, the first batches of an approved vaccine would be ready by early 2021 – and that is if the testing of their most promising vaccine candidate goes well. (Note, however, that often potential vaccines fail during the phases of testing; few vaccines are found to be both safe and effective.)

• Pandemics end when a sufficient number of people have developed immunity, either by recovering from the virus or due to vaccination. But the effect of pandemics can be lessened through effective suppression techniques (social distancing), followed by mitigation (massive testing and tracing efforts).

• The Cleveland Clinic has developed a simple device that can be 3D printed to double the use of each ventilator. They are already being delivered and put to use.

• Ten million U.S. citizens filed for unemployment benefits over the past two weeks. And many more are expected to file in the future. There is naturally a backlog in processing this unprecedented number of claims, but the money will start flowing. (If anyone you know has lost employment, including independent contractors, they should seek to file for unemployment benefits online.)

• Kindness is trending. Stories of generosity, compassion, and gratitude are everywhere.
  
• In most parts of the United States, the “curve” is not yet flattening. Exponential rises in the number of cases are still being reported. Yet (hopefully) the social isolation measures adopted over the past two weeks or so will lead to “flattening the curve” soon – as there is a time lag between suppression efforts and their impact on the number of new cases.

For a view of the "curves" by country, see the Financial Times chart.

THE BAD (ECONOMIC) NEWS

The world is beginning to realize the seriousness of the COVID-19 pandemic. We rightly fear what may be coming. We don’t know how bad it will be. But, at least in many parts of the United States, we are over the “denial” phase. (Many are still in the grief phase, others remain in the “fear” phase, which is natural. Others have moved on to the “let’s do something constructive phase.”)

Millions of Americans are still working, through the lockdown, to deliver healthcare as well as other essential goods and services.

Others – mostly those from higher-earning occupations (mostly office workers) – are able to work from home.

Yet many others are not working at all. They lack any income. With well over half of Americans living from paycheck to paycheck, with little or no savings, the impact upon those Americans unable to work is severe. These Americans – of which there are tens of millions – are not able to pay rent or make mortgage payments, and often are unable to afford food.

As more and more businesses close, due to lack of demand for their goods and services, and/or their inability to produce goods due to mandated stay-at-home orders, more Americans will be unemployed. By May of 2020 we will likely reach a level of unemployment in the United States  that is greater than that seen in the Great Financial Crisis of 2008-2009, and perhaps much higher.

Instead of food lines, we currently have deliveries of food. Often to school-age children, some of whom received their most nutritional meals of the day at school. But food deliveries will need to further expand. Support your local food bank.

It is likely that the U.S. economy will contract in the first half of this year by a factor many times the contraction seen in 2008-9. Technically, “gross domestic product” (“GDP”) in the U.S. could fall this calendar quarter by 30% to 50% below the peak seen in early January 2020. The effects of this huge decline in economic activity could be offset - to a large degree – by the massive federal government stimulus underway.

What is unknown is how fast the rebound will be. Much is dependent upon our ability to suppress the COVID-19 virus via social distancing. Then it depends on keeping widespread outbreaks of the COVID-19 virus from re-occurring, via extensive testing, tracking down those who might have been exposed, and quarantining those individuals.

THE COVID-19 VIRUS PANDEMIC HAS LED TO AN ECONOMIC SITUATION WHICH THE MODERN FINANCIAL SYSTEM HAS NEVER EXPERIENCED.

There are many moving parts at work, in trying for forecast the future of the U.S. and world economy. Predictions of what may occur in the future are dependent on how these parts interrelate, as well has governmental actions and how fast we “win the war” against this coronavirus.

Unlike the Great Financial Crisis of 2008-9, in which the financial and economic crisis led to huge unemployment, here we have huge unemployment (caused by a health care crisis) leading to a large economic crisis.

We have experienced both a huge shock to the demand for goods, as well as to demand for many services. And a huge shock to the ability to supply many goods, as manufacturers have been forced to close.

Into this environment intrude governments. Around the western world, governments are no longer trusting capitalism. They are unwilling to let companies fail, for fear (rightfully so, in some cases) that their nations’ economies will suffer more greatly, or that their nations’ national security could be put at risk.

Central banks around the world, by their measures taken this year, now own about one-third of all outstanding debt in the public markets. This has never occurred before. Never, ever.

The U.S. Federal Reserve balance sheet has ballooned from $3.5 trillion in assets to $5.2 trillion in assets, and it may go up to $10 trillion. 

The Federal Reserve, now backstopped by the U.S. Treasury as a result of the CARES Act recently signed into law, has implemented a ton of programs, including:

• ·      PDCF                Primary Dealer Credit Facility
• ·      MMLF              Money Market Mutual Fund Liquidity Facility
• ·      CFPP                Commercial Paper Funding Facility
• ·      MSBLP             Main Street Business Lending Program
• ·      PMCCF             Primary Market Corporate Credit Facility
• ·      SMCCF             Secondary Market Corporate Credit Facility
• ·      TALF3              Term Asset-Backed Securities Loan Facility

Much of these asset (bond) purchases are being done to shore up the banking system. If the value of fixed income assets fall, banks could fail in large numbers, so the Federal Reserve is propping up asset values by large purchases. 

Capital infusions into large corporations are also authorized, as well as loans. The U.S. government is doing a great deal to ensure that larger corporations, especially those in strategically important industries, don’t fail.

But the huge purchases of fixed income assets by the Federal Reserve, and the potential for capital infusions into large corporations, have no doubt led to distortions in pricing. The prices of bonds should be much lower currently, given the fact that the level of unemployment in the United States is likely to go to a level higher than that seen in the Great Depression – when it hit around 25% by some measurements.

More government interventions will occur within the next few months. To support those who are unemployed. To further support corporations large and small, to try to prevent them from filing bankruptcy. And to otherwise stimulate the economy.

What will occur as we begin to get “back to work” after our actions to fight COVID-19 permit us to do so? At that time the U.S. government, in order to “jump start” the economy, must commit to a large fiscal stimulus via infrastructure spending and other government spending. Already both the Democrats in the U.S. Congress and the White House are pressing for such to occur, although I don’t anticipate an infrastructure spending bill until late 2020, at the earliest.

What is concerning is the continued perception by many that the U.S. economy will quickly recover. There are reasons to suggest this may not happen. First, until COVID-19 is conquered through vaccinations, employers will fear expanding production. Second, there will be a strong rebound in employment as factories and many businesses reopen, but we are talking about unemployment going from 15%-25%, down to perhaps 10% or so. I anticipate that unemployment will remain in the high single digits through 2021, at least. It just takes time for new businesses to be formed, and businesses to expand, after some many businesses have shuttered their doors permanently. And business expansion will be muted as corporate executives worry about paying down debt, as well as saving their cash for the next downturn.

INFLATION – AND DEFLATION – FEARS.

The expansion of the Federal Reserve balance sheet, leading to money creation – together with the huge decline in the prices of most commodities in recent weeks (which prices will rebound once the global economy begins to recover) - should lead to significant inflation this Fall, or next year, or the year thereafter. The 20-year U.S. Treasury Inflation-Protected Security is trading with a yield of negative 15 basis points (-0.15%), indicating a significant fear of inflation exists, although some of the low yields seen results from a flight to safety.

Over the last two weeks, ten million Americans filed for unemployment. Before that, never had there been a week in which more than 650,000 Americans filed for unemployment. Expect many millions more to file for unemployment in the coming weeks.

The $2.2 trillion fiscal stimulus contained in the CARES Act, passed by the U.S. Congress on Friday, March 27, 2020, has been authorized to be spent. But it will take time to get the money into the economy. How quickly individuals and businesses can receive and make use of the funds depends on program design and the efficiency of relief delivery. Fortunately, and unlike what we saw in the Great Financial Crisis of 2008-9, the U.S. government is trying to get the money actually out into the economy, rather than just have the money sit on the books of banks.

After the recovery begins, it is very possible that many corporations, and people, may seek to save more money in the future, given the economic shock we are experiencing now. This may lower demand for goods and services, for years to come. And lower investments in new plants and equipment by corporations. And, all of this may perhaps lower the inflation threat, due to reduced demand for goods and services.

The official level of U.S. government debt is likely to go from $22 trillion early this year to $30 trillion by the end of 2021. (The unofficial federal debt level, which takes into account future unfunded obligations, is much higher.) As a result, the supply of debt will be much larger, and if not offset by much higher savings rates (fueling demand for bond purchases) this could trigger higher interest rates in the future.

Still, once the economy gets going again, in a few years (hopefully), higher inflation will likely occur, and such higher inflation will likely be tolerated by the Federal Reserve. Why? Because it lowers the value of long-term debt, such as that issued by the U.S. government. Rather than have an inflation target of 2.0% to 2.5%, the Federal Reserve may be willing to accept an inflation rate of 3.0% to 3.5% in the future before it intervenes to halt inflation.

Yet, higher inflation is not guaranteed. In fact, deflation – the falling of prices – remains a concern over the shorter term. Economists know that deflation is much worse than inflation. It causes the cost of debt to increase over time. It stifles demand for goods, for potential purchases delay their purchases in hopes of ever-lower prices. During the Great Depression the United States suffered from a significant dose of deflation.

Simply put, economists are trying to model all of these factors, and many others. But this economy, in a modern financial world where massive government fiscal and monetary interventions occur, and where a pandemic exists, has never been seen before (in its totality). Hence, we don’t know what the larger threat is – deflation or inflation.

It is very difficult to make economic predictions. It is fairly certain that the U.S. economy will be experiencing a very, very significant downturn. It is somewhat certain that some rebound in the U.S. economy will occur within the next 2-3 years. But the extent of that rebound is largely uncertain, as is the future direction of interest rates, inflation, or deflation.

But we can ask, what can we do if deflation occurs? Individuals should be, and remain, debt-free. In such an environment, own high-quality, investment-grade fixed income investments, such as CDs, AAA- and AA-rated municipal bonds, and some very-highly-rated corporate bonds. Don’t “stretch” for yield by purchasing longer-maturity or lower-credit-quality fixed income investments. Buy equities when valuation levels are significantly lower than their median levels.

And what asset classes would likely do better, from an ownership perspective, if inflation rears its ugly head, instead?

•          TIPS (“Treasury Inflation-Protected Securities”);
•      Short-term high-quality debt, such as CDs, AAA- and AA-rated municipal bonds, and some very-highly-rated corporate bonds;
•      REITs – via highly diversified low-cost mutual funds; and
•      Equities (i.e., stocks) … maybe. (I’ll explain in the next section.) 

WHAT ABOUT STOCKS – IF INFLATION OCCURS?

There are many theories present as to whether stocks will be a good hedge against inflation in the future. Stocks are generally perceived to be a hedge against inflation (as revenues increase, driving earnings higher; also, values of assets held by corporations generally increase). However, stock prices are often affected by other concerns.

One of these concerns is whether stock buy-backs will continue. Since 2011, U.S. corporations have been the major purchasers of their own stocks. All other purchasers of equities pale in their purchases of U.S. stocks, by comparison.

What if, after this economic crisis, U.S. corporations save cash, rather than use it to fund buybacks, in order to maintain a higher safety net? Already there have been calls by the public, by economists, and among makers of public policy to just “let those corporations who did all these stock buybacks fail,” rather than have the federal government rescue them. In addition, many corporations possessed high debt levels before this all began, and those that survive will possess even higher debt levels. Corporations will desire to reduce their leverage, and public pressure will occur on American business to do just that – to minimize the need for future corporate bailouts.

Another concern is lack of economic growth. The growing debt burdens – both U.S. government, state and local government, and individual – spurred much higher as a result of the economic crisis – may serve to re-direct monies that would have been invested in stocks, and instead see those monies allocated to interest payments and deleveraging (i.e., reducing the principal amount of debt).

And still another concern is whether stocks are “fairly valued” or over-valued or under-valued.

THE EQUITIES VALUATION CONCERN.

Another concern for stocks is that, by some measures, U.S. stocks are not yet “cheap.” U.S. stocks were significantly overvalued by mid-January 2020, and the recent decline in stock values may have made them only more affordable.

For example, the “Warren Buffet Indicator,” which measures the total market cap of U.S. stocks to the U.S. gross domestic product (GDP), stands at 113.8% as of April 3, 2020 (close of the markets). A “fairly valued U.S. stock market” exists at a 100% level. Since GDP in the U.S. is likely to fall significantly in the next month or two, and the current calculation does not take into account this anticipated fall, the Warren Buffet Indicator may in fact today signal an even more significantly overvalued U.S. stock market.

Another measure is the Shiller CAPE10, which levelizes the earnings of the S&P 500® Index over the past 10 years, with adjustments to earnings undertaken for inflation. The Shiller CAPE10 ratio for the S&P 500® Index has fallen from about 32 to 23.49 (as of market close on Friday, April 3^rd). But this valuation level remains far above its long-term median value (1871 to present) of 15.77. However, the current value is closer (but still above) its median value of 20.4 seen for the period 1970 to present (i.e., the past 50 years), and changes in accounting standards seen about 20 years ago suggest that a higher Shiller CAPE10 median might be justified. Yet, even then, by the Shiller CAPE10 measure, U.S. large company stocks are at best fairly valued, and are not undervalued.

Looking deeper into U.S. stock asset classes, using price-book ratios since 1978 for the Russell indexes, shows us a different story. By my own proprietary calculations, U.S. large company stocks are fairly valued; such stocks represent about 80% of the total value of the U.S. stock market.

Yet, as of the Thursday, April 2, 2020 market close, U.S. large cap growth stocks remain 30% to 55% overvalued, despite the recent stock market downturn. At the same time, undervaluations occur in U.S. large cap value stocks, U.S. small cap growth stocks, U.S. small cap (core or balanced) stocks, and U.S. small cap value stocks – using price-to-book ratios. U.S. small-cap value stocks appear the most undervalued, being in the range of 30% to 45% undervalued by my estimates.

I would caution, however, that any such valuation models are far from perfect. Estimates of undervaluation are just that – estimates. And simply because U.S. small cap value stocks are undervalued does not mean that they might not fall further. In fact, a further fall in value of U.S. small cap value stocks – by 20% - would bring valuation levels (as measured by price-book values, only) to their 1979 levels (the first year for which such data for Russell indexes is available, which year also marked a low point in the last 70 years of U.S. stock market valuations, generally).

Additionally, during the 1929-1932 stock market downturn (at the beginning of the Great Depression), U.S. small cap value stocks fell by about 90% in value. By comparison, U.S. large company stocks fell by only 80% in value. Hopefully, such a huge drop won’t occur. And there is reason to believe it will not, in large part because the levers of our economy – monetary and fiscal policy – are much better understood today by policy makers than ninety years ago, and there is certainly a willingness to use such levers.

Compared to international equities, the average price-book ratio for U.S. large company stocks remains higher than the price-book ratios for stocks in Europe, Japan, and emerging markets by a significant margin. This, and other valuation metrics, indicate that expected returns over the next 10 years in emerging markets (China, India, Indonesia, Brazil, etc.) stocks are the highest, followed by expected returns in foreign developed markets (Europe, Japan, Australia, etc.). (Some of the expected returns of foreign stocks are projected to occur by a fall in the U.S. dollar relative to other currencies.) U.S. small company stocks possess lower expected returns compared to international stocks. And U.S. large company stocks possess even lower expected returns.

In all equities markets, however, value stocks are expected to outperform growth stocks over the next ten years.

Again, a word of caution. These returns expectations have a lot of assumptions, such as mean reversion (which may or may not occur). As always, returns are not guaranteed.

PORTFOLIO MOVES FOR THE FORESEEABLE FUTURE.

If you are still in the process of saving (from employment), continue to add to your 401(k) or IRA if at all possible. With valuation levels lower than they were, for equities, you will be buying at cheaper values.

If you are in retirement, and pulling money out of your portfolio, don’t panic. As I explained in a prior “Special Update,” expected returns for equities are higher, as stock valuation levels have drifted lower. The amounts projected to be withdrawn from your portfolio are not substantially different, provided you possess a reasonable amount of fixed-income investments (as my clients do).

As always, stick with a disciplined approach. Adopt a strategic asset allocation for the long term. Rebalance when opportunities arise. (For my clients, I am monitoring your portfolios for the opportune times.) This disciplined process forces you to “buy low, sell high” – never knowing, of course, if the market values go lower or higher. For no one has a consistently working crystal ball.

For those who have not previously considered it, the SWAN ETF, which is approximately 90% U.S. Treasury securities (bonds) with an average duration about equal to that of a 10-year U.S. Treasury bond, and about 10% call options on the S&P 500® Index, can be utilized to guard against “Great Depression” risk. This exchange-traded fund, which has an annual expense ratio of 0.49%, does possess some downside risk – perhaps a maximum of about 25% to 30%. The downside risk of the SWAN ETF is greater than I estimated last year, due to the significant decline in interest rates since then. If the yield on the 10-year U.S. Treasury bond was to rise from current levels, by 3%, the value of such a bond would fall by about 25%.

While a 25% to 30% decline in the value of this ETF is unlikely, such might occur if both the in-the-money call options the ETF holds fell in value to zero with a significant stock market decline, while at the same time U.S. Treasury yields significantly rise (as illustrated above) over a short period of time. Such a significant rise in U.S. Treasury yields could occur as the economy recovers, and if inflation raises its ugly head. As yields increase, bond prices fall.

The SWAN ETF also possesses upside potential in a rising stock market environment. It will not fully participate in the rise of the S&P 500® Index, but rather will participate in a significant portion of such gains. The lower the S&P 500® Index falls in value, the greater the upside potential in the SWAN ETF over subsequent time periods.

I now anticipate that, over a 10-year period, the SWAN ETF is likely to produce a 3.5% to 4.5% average annualized return, though some years will have negative returns and others more positive returns. The returns could be much higher over the next ten years, depending on market volatility. Still, this unique exchange-traded fund has the potential to reduce the risk of a portfolio, should the stock market fall like it did in 1929-1932. The SWAN ETF can, in essence, help guard a portfolio against the impact of the Great Depression, while at the same time providing long-term (10-year or greater) returns that are likely significantly above the returns seen in high-quality fixed income investments.

IN CONCLUSION.

I do believe the U.S. economy will be dealt a significant blow, beyond what it has already experienced.

It is altogether possible that the stock markets are not fully incorporating the risk of same occurring. Still, predicting stock market movements over the short term remains a fool’s game. Attempts to predict the “low point” or “high point” of any market movements are rarely, rarely successful.

Instead of playing such a game, stick with the discipline of strategic asset allocation and rebalancing, which has worked, and will continue to work, over the long term. Over time I have structured my clients’ portfolios to endure over the long term, however the situation unfolds. In order to secure the higher long-term returns necessary to outperform inflation, and to achieve your goals, means accepting the risk of substantial market downturns.

(Though, after 2000-2002, 2007-2009, and now 2020, I wish they didn’t occur so often!)

The future of the U.S. economy, and to a degree the future returns seen in the capital markets, still depends on our collective ability to suppress the COVID-19 virus, and then get back to work. The longer the need for social distancing (and “stay-at-home”) lasts, the greater the negative impact on the economy.

If you have questions or concerns, or just desire to talk, please drop me a line or give me a call.

All my best. – Ron

Ron A. Rhoades, JD, CFP®

Personal Financial Advisor

Scholar Financial

Email (preferred) (for clients and potential clients): Ron@ScholarFinancial.com

Email (preferred) (for students and all others): Ron.Rhoades@wku.edu

Text / Cell: 352.228.1672