On Covid and Fiscal Stimulus

John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or jswift@trustbenchmark.com
July 19, 2020

Market Risk: Covid Outlook

On the Covid front, several local governments are either pausing parts of their reopening or reimplementing certain restrictions. The problem for the market is that the June case spike will show up in other statistics over the coming weeks, creating a news flow overhang.

The case numbers last week from Florida, California and Texas were “better-than-feared” in that the percent rise was less than recent days, and another positive that you see from the Covid data so far is that this is not a March/April repeat meaning that the severity of these hospitalizations overall is lower, and we are benefitting from earlier checks and improvement in therapeutics.

The reality, though, is that we must get used to disruptions in pockets across the globe. I do not find it surprising that cases are rising most in regions with the biggest 1-month improvement in consumer spending. The question that remains is around consumer confidence at least until you get a vaccine. If the NYC Tristate area numbers remain contained, the market may trade in volatile, choppy sideways pattern next few weeks.

In other Covid news, Texas and California both recorded record tallies in new infections, and fatalities in California soared 69% over the two-week average. Texas posted 10,791 new cases for a daily record. Cases in the US increased 2% to 3.47 million, but markets focused on comments from Dr. Fauci who said there will be an effective vaccine by year-end, and Oxford University’s vaccine trial will report “positive news”.

About the Banks

The Fixed Income Clearing Corporation numbers this past week documenting fixed income trading were huge which probably means the larger banks/brokers are set up to post very robust trading numbers in a few weeks.

The bank capital announcements were net negative due to Wells Fargo Corporation (WFC). WFC says it will be cutting its dividend, but more important is the fact management says the Q2 reserve build will be “substantially higher” than Q1. This could raise worries about the entire industry heading into Q2 earnings especially as COVID trends are deteriorating once again. The Goldman Sach’s (GS) Stress Capital Buffer (SCB) is high at 6.7% (highest of the major banks), but it looks like the company is not as far away from this stress test benchmark as it was originally feared. GS will end Q2 with its primary Common Equity Tier (CET1) above 13% vs. the new 13.7% limit. So, that is a positive.

One additional item from JP Morgan Chase (JPM) that is interesting, but not necessarily market moving, is the fact JPM may be suspending ALL share repurchases in Q3 (technically banks are allowed to make repurchases to offset employee-related issuance, but JPM will be suspending that for the next quarter).

Three Factors Affecting the Market

The problem facing stocks right now is threefold:

1) A lot of buying lately has been motivated by non-fundamental factors like “stimulus”, performance chasing, “fear-of-missing-out”, etc., and these weak hands won’t have much patience for sustained weakness (if the market were to suffer another sloppy week it would invite even more selling, creating a cascading effect). Buying motivated by genuine fundamental enthusiasm would be comfortable sitting through a period of volatility, but those types of owners are few and far between.

2) The recent spike in COVID cases will not reverse on a dime and these new cases will be showing up in other numbers in the coming weeks with the key question being answered on fatalities. The weekly claims numbers are already starting to flatten out.

3) The recent spike in COVID figures is coming at a bad time, just a few weeks before the Q2 earnings season, and this could make corporate management teams more cautious when providing guidance (or it may spur companies to keep guidance suspended).

Maintaining Cautiously Positive View

However, against these market concerns, I am hesitant to deviate from my positive market call even with the price action last week. We are still looking at a quarter where US stocks are on course for their best quarter in ~ 22yrs and the 4th best quarter going back to 1950. This has been the best quarter since Q4’99 for Nasdaq; best since Q4’82 for global stocks; best for High Yield & Investment Grade bonds since Q2-Q3’09 (note: Average returns for the next quarter following the 5 best quarters all-time are strong for the S&P, Nasdaq, global stocks, HY, and IG).

Additional factors which allow us to remain cautiously bullish is high frequency data like google mobility, Open Table trends, credit card data and Fed’s weekly economic index. Everyone seems so bearish on this market (the most unloved bull market in history) that I think it will be unusual to see a big downside when everyone is looking for it.  

Fed and fiscal policy remains supportive, and the fifth stimulus bill now looks likely (though down to the wire), and the Fed support of market prices remains in place. My market ‘tells’ remain largely the same: watch the curve – failure to steepen out greater than 80 bps on a consistent basis means policy past peak; watch AUD/USD cross trade for information on US dollar strength; credit (LQD > $130; HYG > 81.50; Hard for equities to crack without credit cracking), and the copper/gold ratio. Finally, the market’s main support, information technology companies, has wobbled for the last several days and bears monitoring.

Fiscal Stimulus: Round 5

On the fiscal stimulus front, Pelosi suggested she would accept a cut in the $600/week of unemployment benefits so long as another round of one-time stimulus checks are sent. Republicans seem to be pushing for $200-400 of federal benefits vs. $600 now and another round of checks, but to fewer people than was the case with the Cares Act (GOP is set to unveil its proposal next week).

The Financial Times had an interesting story on these benefits: Americans who received enhanced unemployment benefits spent more money than when they were working. So, while that may not be too surprising, I guess it does make one pause about the upcoming fiscal cliff.

Debunking the Inflation Narrative

There is a market narrative that talks about the prospect of inflation picking up appreciably on account of the policy largesse provided by fiscal and monetary authorities in the U.S. and around the world.  This narrative looks to money supply growth as evidence of mounting inflation which was part of the theory of Monetarism espoused by Nobel Laureate Milton Friedman. 

To this point, the graph below juxtaposes the current consumer price deflation indicated in the Personal Consumption Expenditures (PCE) Price Index versus the growth in M2 Money Supply Growth.  M2 Money Supply measures money as cash and checking deposits (M1) added to money in savings accounts, money market funds and cash balances in mutual funds.

Now, if inflationary forces were mounting, we would see price increases in commodities such as oil, natural gas, and agricultural commodities, as well as seeing increases in industrial utilization. 

Industrial Capacity Utilization (ICU) refers to the manufacturing and production capabilities that are being utilized by a nation or enterprise at any given time. It is the relationship between the output produced with the given resources and the potential output that can be produced if capacity was fully used.  An ICU rating of 82-85% is considered optimal with measures above that level being considered inflationary.  Higher levels mean that end demand is outpacing our capacity to fulfill that output level with corporate managers scrambling to add a fourth shift when only three, 8-hour shifts are available in any given day.

The current ICU level in June was just 68.6%, which is 11.2 percentage points below its long-run (1972-2019) average and represents considerable slack in the economy.  Now, ICU levels will continue to improve as we work our way past Covid, but even in the best of times the ICU level has not provided any indication of mounting inflation over the past 15 years.

Another important point from the graph above is to notice that the PCE Price Index has not exceeded the Federal Reserve’s inflation target of 2% on a sustained basis since the Financial Crisis, and it speaks to the point that the Fed’s initial zero interest rate policy and Quantitative Easing (QE) in response to that crisis did not have the ominous effect on inflation rates that many feared it would when the Fed first launched its QE program to help stem the deflationary effects of the Financial Crisis back in 2008. 

Finally, the market does not expect inflation to rear its ugly head anytime soon. The 5-Year Breakeven Inflation Rate (BIR) implies what market participants expect average inflation to be over the next five years and this measure stands at just 1.30%.  The 5-year BIR is calculated as the difference between the yield on a 5-year Treasury Bond and a 5-Year Treasury Inflation-Protected bond or TIP bond.

Catching Up

We look forward to catching up with each of you, and we will be reaching out to schedule a time to meet over the phone or by a Zoom/MS Teams video link.  In the interim, if you would like to get something on the calendar, please send me a note with some dates and times.

Warm regards, John