A Bridge Over Troubled Water

John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or jswift@trustbenchmark.com
April 13, 2020

The Fed Builds a Bridge Over Troubled Water

The U.S. economy needed a bridge to the other side of the COVID-19 shutdown, and the Federal Reserve looks intent on doing whatever it takes to build a gilded bridge over these troubled waters.

In a sweeping, and stunning, announcement, the Federal Reserve said on Thursday that it is taking additional actions to provide up to $2.3 trillion in loans to support the economy. Those actions include, among other things, a liquidity facility for state and local governments, new provisions to buy ETFs with exposure to high yield bonds and opening a Main Street Lending Program to businesses employing up to 10,000 workers or with revenues of less than $2.5 billion.

These actions should allay fears about the near-term economic future, especially since the Fed, backed by the Treasury, still has the capacity to do even more to support economic activity. Some have even suggested that it’s an all-clear signal to come back to the stock market.

If the Treasury market’s response to the Fed’s latest bridge-building effort is any indication, one may need to re-think those assertions.

The Treasury Market’s Muted Response

Would you ever imagine that the 10-yr note would rally after the chairman of the Federal Reserve said inflation is not a “first order” concern right now? Well, it did.

The 10-yr note yield, which ran up to 0.77% from 0.72% soon after the Fed announced its new lending capabilities, went back down to 0.72% after Fed Chair Powell indicated during an interview that inflation is not a first order concern right now.

It’s fair to say that inflation is not going to be an issue for the time being, not with the collapse in oil prices and the collapse in demand that has been a consequence of the shutdown measures employed to contain the spread of the coronavirus.

Still, with interest rates at the zero bound here and elsewhere, and with the world’s leading central banks flooding financial markets with liquidity, the specter of inflation becoming a serious issue down the road can’t be dismissed.

That said, it’s nothing the Treasury market seems to be concerned with now, which should be a bit concerning insomuch as it relates to the upbeat perspective on the Fed’s latest policy actions.

Not a Normal Response by the Treasury Market

Theoretically, the back end of the Treasury curve should have gotten hit hard on the Fed’s stimulus- minded policy announcement.

It’s possible the Fed itself had a role in keeping yields from taking off, as it’s no mystery that it is active in the market and wants to keep long-term rates low to support an economic recovery. Nevertheless, the Fed doesn’t control long-term rates.

It’s possible, too, that yields were tamped down as market participants pursued some safe-haven positioning in front of the extended holiday weekend.

Still, the Fed’s news was big news in terms of its size and reach and it would have made more textbook sense to see yields move noticeably higher following the announcement. The fact that they didn’t suggests to us that the Treasury market isn’t convinced the Fed’s actions, as laudable as they are given the situation, are going to be the ultimate cure.

Something else that jumped out at us in the same light is that copper futures barely moved on the news. Copper has widespread use in industrial applications, which is why it has important status as a leading economic indicator.

What Does This Mean to the Market?

Perhaps in the days and weeks ahead, longer-dated Treasuries and copper prices will show more of a textbook response to the massive efforts designed to see the economy through this unprecedented shutdown period and to stimulate it when things open again.

The Fed’s actions will take some bankruptcy risk off the table, but it isn’t clearing the table of that risk. Sadly, some businesses, probably most of them small, won’t recover from this situation, or, even if they do, they won’t come back easily or quickly to what they were before the COVID-19 shutdown.

Many will have to start all over again, reconnecting with customers, re-establishing supply chains and distribution networks, and reclaiming employees who will need to be re-trained for a post- COVID-19 world. The same is true for many medium-sized and larger businesses, too.

That won’t happen overnight even if there is a governmental bridge financing option available.

What the Treasury Market is Saying About the Economic Recovery

We hear all the time that there was nothing fundamentally wrong with the economy going into the COVID-19 shutdown phase and that business was good. That is true in a general sense, but it presupposes a view that all we need to do is launch some Fed lending facilities, hand out some direct payments, and everything will be just fine on the other side when the shutdown orders are lifted.

That view is naïve.

Things will be less bad than they would be otherwise without the Fed’s lending facilities and the direct payments, but they will be far from fine or normal, especially until there is a vaccine for COVID-19. There may not have been anything fundamentally wrong with the economy six weeks ago, but there is now.

The economy is fundamentally broken in a way that has never been seen before. It isn’t beyond repair, but the break runs deep and the Treasury market’s response to the Fed’s repair effort is signaling that it won’t be an easy fix.

To borrow some wisdom from my sailing experience, I have found over time that the Treasury market is the pessimist who complains about the wind; the Stock market is the external optimist which expects it to change, and the Portfolio Manager is the realist who adjusts the sails. When the Treasury market and the Stock market are at odds, as they are now, I normally look for the prevailing economic winds somewhere in the middle.

The Paradox of Bear Market Rallies and Recession

Telling investors to sell now, during the coronavirus crisis, feels a bit like yelling fire in a crowded room—even if there are no crowded rooms anymore. Still, history tells us that it is the right thing to do after the recent rebound in the market. One of the many takeaways about the Covid-19 crisis is the speed at which things happen. It has been breathtaking. And investors must prepare for a dip faster than they would have in prior downturns.

Take this past week’s market action. The S&P 500 index rose 12%, to 2789.82—its best week since 1974—and finished 20% off its March low. The corresponding gain for the Dow Jones Industrial Average was 13%, up 23% from its low. The Nasdaq Composite jumped 10.6%, raising it 16% off its low.

Source: Yahoo!Finance

All these gains came after the S&P 500 had fallen 34% from its high in just 33 days. That kind of speed is unprecedented. During the Great Recession financial crisis of 2008-2009, it took roughly 10 months for the market to drop 20%. It rallied for six weeks off the bottom before selling off again and retesting its November 2008 lows with a final bottoming achieved in early March 2009. Compared with the Covid-19 whirlwind, the action back then looks positively pedestrian.

Still, just as in 2008, investors should expect a retest of the 2020 lows, likely at an accelerated rate.

This is all very typical intra-recession stock-price behavior and so tilts us tactically cautious, as the market starts to digest the implications of the upcoming earnings reporting period. Short, sharp swings in sentiment and stock prices are normal during deep recessions and were a real feature of the 2008-09 bottoming process.

Recent Bounce in the Market is Justified, but Earnings Season Looms Large

The recent bounce isn’t exactly misguided. The Federal Reserve has backstopped the market in a big way, while investor fears about Covid-19 peaked recently, as did the Cboe Volatility Index, or VIX, which topped out on March 18. Less fear has meant less selling pressure, and stocks not only stopped going down—they started going up. But now comes the 1Q20 earnings reporting period. Eventually, investors will have to stop worrying about fiscal policy and peak pandemic and start worrying about earnings performance.

No one knows the extent of the damage done to the economy by Covid-19. The recovery could be V- shaped, swoosh-shaped, U-shaped—many letters are being debated. The worst-case scenario is L- shaped, in which the economy doesn’t bounce back at all. As the numbers start coming in, investors should get more answers—and they might not like what they see.

So far, estimated 2020 earnings for S&P 500 companies have fallen about 15%. And cuts will accelerate after numbers get reported. The earnings cuts by sector will be huge. There are losers and survivors in this battle. Energy profits are expected to evaporate, but consumer-staples estimates have barely budged.

Even if we trust the estimates—never a good idea at a time like this—the stock market looks far from cheap. The S&P 500 is trading at about 15 times estimated 2020 earnings, but 2020 looks like a lost year, which is why we prefer looking ahead to 2021. Based on those estimates, the market trades at about 12 times. But both numbers are higher than the 10 times stocks fetched near the bottom of the financial crisis.

Of course, it isn’t all about valuation. We would respectfully disagree with the bears who think valuation multiples must collapse. This scenario is different than the Great Recession—a couple of weeks in, we already have record monetary and fiscal stimulus.

With stocks up at current levels, however, we see a downside risk—starting with first-quarter earnings season. We think the cuts in estimates will be enormous, and that could halt the market’s rally in its tracks.

The first round of estimate cuts should be the most severe. Equity guys love to look at the rate of change, and slower declines are, ultimately, bullish for stocks. So, when the inevitable selloff arrives, we would rather “buy the dips” than “sell the rips,” to put it in Wall Street parlance.

We are in the W-shaped recovery camp and believe the U.S. will be getting back to work, at least on a limited scale, by the end of the second quarter. Then cuts will start getting smaller.

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 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. I would be delighted to hear from you.

Warm regards, John