July 1, 2020
The epic events of the second quarter of 2020 defy a simple recap. Underpinning them all, though, is the stunning manifestation of how small the world has become, and how interconnected it is, on human and economic levels. A rare virus found in a distant part of the world triggered unimaginable events in all corners of the globe and did so in the blink of an eye. How to navigate this sort of intersection of health, science, politics, and economics will remain crucial questions for leaders and institutions around the world in the months and years ahead.
The Rough and the Smooth
From an investing perspective, the events of 2020 read like the opening of A Tale of Two Cities: “It was the best of times, it was the worst of times.” The fall from economic grace happened quickly. Unemployment leapt from near-50-year lows to 90-year highs. The longest economic expansion in roughly 140 years collapsed to activity levels not seen since the Great Depression. While the official unemployment rate in the United States is 13%, it belies a much larger dislocation in jobs.1 More than 46 million people have filed unemployment claims since the end of February, implying that almost a third of the 160-million-person labor force is under stress. Pictures of long lines at food pantries across the country painted a stark image of what the matte economic releases signaled. The quarantine produced empty streets, stores, and skies. Remarkably, the V-shaped move in equity prices and the inverted V-shaped pattern in option-adjusted yield spreads indicate that the markets believe the economy will be back in good nick in short order (Exhibits A and B).
While a quick bounce back from the current recession is appealing, we think an alternative scenario is likely. A snappy return to the pre-pandemic status quo relies on several core assumptions that we find are far from certain. First, a vaccine will be found in short order and manufactured at scale to create herd immunity. Second, no additional viral flares will occur, disrupting business. Third, the sudden and nearly complete cessation of commercial activity will easily be rebooted, and jobs will quickly be recovered. And fourth, there will be no long-term costs associated with the extraordinary monetary and fiscal aid rendered in support of economies during this difficult time.
Successful development of a vaccine by year-end would be a remarkable achievement. Many viruses, SARS, MERS, and HIV to name a few, successfully evade a vaccine despite Herculean efforts. Indeed, we suffer from the seasonal flu because no “one and done” inoculation exists. Even if a safe and effective vaccine is discovered by the end of the year, its quick production and distribution at scale is unlikely.
That there won’t be a second wave of infections or regional flares of infections seems, unfortunately, to be wishful thinking. Judging from the experience in China and Germany, and most recently in the South and West of the United States, Covid-19 will be a part of daily living until a vaccine is found or herd immunity is achieved. Thankfully, therapeutic remedies are getting better as health systems have more experience with the virus, making the pathogen potentially less lethal and more manageable as science searches for the key to eradicating it.
How easy it is to reboot a $21 trillion economy after a state of suspended animation remains an open question. Will all the 46 million people who filed for unemployment since the end of February return to their places of employment? Based on the spike in bankruptcies of late, including companies such as Hertz, J. Crew, J.C. Penney, Neiman Marcus, and Cinemex Holdings USA to name but a few, the answer is no (Exhibit C).
A more insidious threat to a quick return to economic wellbeing is the downsizing that typically occurs after shocks. Airlines and related businesses in the hospitality sector all expect recoveries that will be slow, pushing into the end of next year. These sectors will be hesitant to rehire workers. Retailers and restaurants will also be slow in recovering their footings.
More broadly, disrupted and reconfigured supply chains, and the failure to achieve prior levels of productivity as a result of social distancing protocols continue as headwinds. None of this bodes well for a V-shaped return to a vibrant commercial landscape.
Trillions of dollars of fiscal stimulus accompanied by trillions of dollars of money conjuring by the Federal Reserve have helped to support the economy during this crisis (Exhibit D). Fiscal spending is deficit spending, and the economy was already running an annual deficit of approximately $1 trillion. The long-term consequences of these actions remain unclear. Will interest rates ever return to “normal”? Will the economy ever be able to operate successfully without the crutch of government-subsidized money? Will prolonged periods of mountains of artificially low-priced money create a bout of inflation not seen in more than a generation? Alternatively, will it create a zombie class of companies that cannot operate without subsidized credit and that thereby pulls down returns for well-run companies? The latter is not without precedent. It would represent the “Japan-ification” of the U.S. economy.
Our read of the current landscape is at odds with the more popular and upbeat investment narrative. We see a path of recovery that looks decidedly W-shaped. This implies the economy moves forward in fits and starts, reflecting the reality of the unknown and unknowable. For context, it took roughly a decade for monetary policy to normalize after the Great Recession of 2008-2009. This “Greater Recession” will likely take longer. Very large fiscal deficits will likely be a feature of our lives for some time to come.
Indeed, the next crisis brewing is in state capitols across the United States. State finances, battered by the Covid-19 recession, are in terrible shape. The remedy we hear from the states is a combination of government bailouts and higher taxes. Financing the bailouts will likely drive federal taxes higher, as the current menu of taxes yield nowhere near enough to cover the cost.
So, a W-shaped recovery it will likely be—a recovery that takes longer to unfold and with interruptions along the way. Markets are not pricing this outcome. The S&P 500 Index’s 39% run from the March 23rd low accompanied by the 44% lift in small capitalization stocks (Russell 2000) represents a victory for policy makers in restoring a sense of confidence among investors. The problem with confidence is that it is ephemeral. It needs tangible reinforcement to make it durable. The ultimate tangible evidence for investors is profits and their growth. While both are likely to be in short supply for the remainder of 2020, hopes are concentrated on 2021. We are hopeful but skeptical of consensus expectations for 2021 S&P 500 earnings per share (EPS) of $163, which is flat with 2019 EPS and significantly higher than the $127 consensus estimate for 20202 (Exhibit E). To be sure, investors get into trouble not through a failure of imagination, but through a failure of skepticism.
The picture post pandemic is a bit blurrier. Events that shock economies tend to act as accelerators of trends already in train. The pandemic of 2020 will likely be an accelerator of the return toward regionalization, a market regime shift from a business cycle to a credit cycle, and the transformation of central banking in the United States with the Federal Reserve’s de facto support of a version of Modern Monetary Theory (MMT). At a distant point in the future, looking back on this time, the real story will not be that of digital photos of 21st century Americans donning facemasks, but how the pandemic fundamentally changed their world. We are living history.
Market forecasts are a devilishly tricky task during the best of times. Forecasting against the backdrop of societal unrest, pandemic, and recession—all happening during an election year—makes assertions about the future of limited value. The ability of the future events to render forecasters befuddled is legendary. Investors nearly always benefit by focusing on first principles: 1) Know what you own and why you own it; and 2) Have a long-term financial plan that is measurable and that not only meets one’s needs but also feels right. Comfortable shoes are worn while uncomfortable pairs sit in boxes and are eventually discarded. Investment programs are the same. Plans that ring true to the owners of capital have a greater chance of being followed. The fundamental determinants of value creation, which is what benefits shareholders over time, continue to be revenue growth, margin expansion, and asset utilization. These all drive profits and can be watched to assess whether a company is worthy of the capital that investors commit. Finally, investors should remind themselves that patient capital well committed offers the best chance for success.
1Source: Bureau of Labor Statistics, U-3 Unemployment Rate Total in Labor Force, Seasonally Adjusted, May 2020
2Source: FactSet Earnings Insight, June 26, 2020.
The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.