Market Outlook & Pandemic Payback

John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or jswift@trustbenchmark.com
May 25, 2020

We’ve Got High Hopes

Times were simpler when Frank Sinatra crooned his iconic song, “We’ve Got High Hopes”, in 1959, but its cheerful expectation is alive and well in today’s stock market.

Earnings per share estimates already price in a full recovery to pre-crisis levels in 2021. The S&P 500 is forecast to earn ~$163, the same as it did in 2019. The multiple is not cheap at 18x (at 2950). So, we must see a virtually perfect reopening/normalization to justify this or anything higher from here. But presently fiscal and monetary stimulus outweighs fundamentals.

The US has already passed nearly $3T worth of fiscal response legislation and the Democrats just proposed another $3T. Meanwhile, the Treasury’s Exchange Stabilization Fund was allocated ~$400B under the CARES Act to use in partnership with the Fed for ~$4T+ worth of lending/purchase capacity. This means stimulus totaling ~$10T has been thrown at COVID in the US alone, or nearly 50% of GDP, and this does not count the Fed’s unlimited treasury bond and mortgage-backed securities purchases taking place under quantitative easing policies, and the Secondary Market Corporate Credit Facility (SMCCF), hasn’t really been deployed yet. You can argue that phase four stimulus will not be $3T but pick your number…. the broader point still stands.

Here is food for thought – The S&P 500 is now above where it stood when the World Health Organization declared a pandemic (3/11). We do not seem to be factoring in any potential risks/volatility a re-escalation of US-China tensions and the upcoming November election.

The market certainly does have high hopes.

Information Technology at High Valuations

As we have previously written, our emphasis on large capitalization Information Technology (IT) stocks such as Apple (AAPL), Microsoft (MSFT), Facebook (FB), and Google (GOOGL) have fared very well during this difficult period. As you might expect, this recent outperformance of this sector has made their shares relatively expensive.

Just how expensive Information Technology companies have become is highlighted in the following graph which shows the relative Price/Earnings ratio of IT and Industrial stocks versus the Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) Price/Earnings ratio.

Although high valuations are a risk factor, high prices do not mean that lower prices are assured over the short-term. A price decline is in response to changing fundamentals which are not present currently.

High Monetary Supply May Not Lead to Higher Inflation

There is not much economic growth happening right now, yet there is a lot of money in supply that can help drive a much-needed pickup in growth. That money supply might not be plain to see in your bank account, but, in aggregate, it is there and it’s a huge sum.

The money supply measure we are referencing is M2, which the Federal Reserve defines as M1 (cash and checking deposits) plus savings deposits, small-denomination time deposits, and balances in retail money-market mutual funds.

The latest report from the Federal Reserve indicated the M2 money stock stood at $17.99 trillion. That is more than double where it stood at the end of 2009 and roughly $2.3 trillion more than where it stood just ten weeks ago.

Why is this important? Well, what happens with that money supply is key to the economic outlook and the inflation outlook.

With the extended lockdown period to contain the spread of the coronavirus, there is unquestionably some pent-up demand ready to be released. That will result in more spending on goods and services that has been severely curtailed during the lockdown period. However, acting on the pent-up demand will not be possible for everyone — not to the extent anyway that everyone likes to envision. That will be the case, both by choice and by circumstance.

More than 36 million people have filed for unemployment insurance over the last nine weeks. That is the “official” log. Some claims have not been processed yet and some people, like undocumented immigrants, cannot file for unemployment benefits.

The point is that a huge swath of impacted workers will be driven to spend according to need, and not by desire; whereas, many others will be compelled to pay backlogged bills and/or to save more, mindful that the recent experience has shown the importance of having cash in reserve to deal with unexpected developments.

There will also be a contingent of people who are worried about health risks and will not rush out to spend on goods and services in the manner they might have before the pandemic.

Everyone’s situation is unique, but the inclination to save more is evident in the personal savings rate, as a percentage of disposable income, which soared to 13.1% in March, eclipsing the post-financial crisis peak of 12.0% seen in December 2012.

Source: Facset

To be fair, the inability to spend as one might have preferred during the shutdown phase likely boosted the savings rate some. Still, the rapid pace of layoffs, furloughs, and announcements of salary cuts provided more than enough reason to favor saving versus spending. Keep in mind, too, that the domestic economic impact of COVID-19 only started to hit in force in the last two weeks of March.

The implication is that the propensity to save more is a ticket to slower growth. The converse, however, is that an inclination to spend more, and save less, is a ticket to faster growth. That is why the savings rate is going to be a crucial component of the recovery process. If it remains elevated, growth in general is going to be subdued.

That was apparent in the post-financial crisis recovery period, which featured a generally higher savings rate than the one seen leading up to the Great Recession and some otherwise moderate GDP growth in spite of a pickup in the money supply, the Fed’s quantitative easing, and tax cuts for both individuals and businesses.

The U.S. Consumer is Key to a Turnaround

The U.S. is the world’s largest economy. It is driven by consumer spending. When the consumer is not spending, the U.S. economy is not going to do well, and neither is the global economy.

That is the state we are in now, but the spending downturn is not limited to the U.S. consumer. Nevertheless, it will be the consumption pattern in the U.S. that helps lead the global economy out of its pandemic-related downturn.

One measure that should prove useful in gauging the economy’s recovery strength is the velocity of money ratio, which measures the frequency at which one unit of currency is used to purchase domestically produced goods and services per unit of time. It is calculated as the ratio of quarterly nominal GDP to the quarterly average of M2 money stock.

In brief, a higher ratio reflects more transactions occurring between individuals in the economy. That is a good thing, but there is a caveat. A faster pace of transactions occurring between individuals can also invite a faster pace of inflation as excess money supply chases limited goods and services.

That is the basis for Milton Friedman’s famous declaration that “Inflation is always and everywhere a monetary phenomenon.” Therefore, one is hearing allegations today that the huge waves of fiscal and monetary stimulus being provided by the government and the Federal Reserve are raising the specter of high inflation down the road.

The Treasury market, which features a 0.66% yield on the 10-yr note, does not look too convinced of that view — not yet anyway — but it is part of the market narrative.

Be that as it may, the experience of seeing the money supply increase following the financial crisis, and the absence of high inflation in its wake, has been a formative one for many participants who point to globalization and the pricing transparency of the Internet as structural factors keeping inflation in check.

One cannot rule out the improved propensity to save more, too, as a reason for the extended period of subdued inflation as the velocity of money has slowed dramatically following the financial crisis.

The Bottom Line

In coming weeks and months, we will hear that there has been an increase in economic activity. People will be spending more. There is no question about that.

The numbers are going to look good relative to an extremely depressed base, but they will still leave a lot to be desired when looked at more closely.

There is an ample supply of money available to conduct transactions, but if that supply is hoarded in a savings push, it is all but certain that growth in an absolute sense will continue to disappoint in the recovery phase. In the same vein, the inflation many people expect to see, given the ramp in the money supply, could remain missing in the general price action, just as it has been since the financial crisis.

The Real Possibility of Delisting Chinese Stocks

The U.S. Senate approved sweeping new legislation last Wednesday that could ultimately bar many Chinese companies from listing shares on U.S. exchanges, or otherwise raising money from American investors.

Sen. John Kennedy, a Louisiana Republican, submitted the Holding Foreign Companies Accountable Act for unanimous consent, a bill co-sponsored by Democratic Sen. Chris Van Hollen of Maryland and Republican Sen. Kevin Cramer of North Dakota. The bill was approved without objection.

The bill would require Chinese companies to establish they are not owned or controlled by a foreign government. Furthermore, they would be required to submit to an audit that can be reviewed by the Public Company Accounting Oversight Board, the nonprofit body that oversees audits of all U.S. companies that seek to raise money in public markets.

This bill is a rehashed version of a Senator Rubio bill that died on the vine last year, but with Congress out on the hunt for Chinese blood, it is pandemic payback time!

This bill passed with unanimous consent in the Senate which places pressure on the House to follow suit. Problem there is that the Democrats in the House do not want to give any political capital to Trump. Trump could say he likes puppies, and the House would quickly pass a non-binding resolution denouncing the critters.

However, I suspect in this current climate hell bent on retribution, a bill makes it to Trump’s desk, and he signs it into law. Initially, the only people getting hurt are U.S. investors in public Chinese shares.

Assuming delisting happens, our Alibaba (BABA), JD.com (JD), and TenCent (TCEHY) shares would trade at a deep discount on the Pink Sheets or the bulletin board exchanges. It would not hurt Chinese companies already listed on U.S. exchanges. BABA got its money years ago, and they would simply delist and move to the Shanghai/London exchange. China’s recent moves to impose national-security laws on Hong Kong, a step that further raises concerns about the city’s autonomy, most likely would eliminate Hong Kong as a viable economic center for Chinese shares.

New Chinese companies seeking capital would be hurt as this would eliminate access to U.S. capital markets if China does not, as expected, give in to the U.S. audit demands administered by a U.S. backed agency, PCAOB. I would be surprised if they do agree to U.S. demands for audit transparency as these U.S. laws countermand existing Chinese security laws, but stranger things have happened.

It makes sense to exit these Chinese positions. We are up nicely in the shares and might as well see how this unfolds from the sidelines as there is just too much political risk presently.

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 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