Wealth Matters Newsletter - July 2020

The Road Ahead

Written by: Mark P. Bernier, CFA, Senior Vice President/Wealth Management Officer

One of the biggest challenges investors face is preventing emotion from influencing the investment decision.  It’s like being told to reduce the stress in your life; admittedly, that is easier said than done.  The last several months have challenged even the most experienced investors at times.  With the initial shock of immediate economic shutdowns, subsequent start to the first U.S. recession in over a decade, and unprecedented market volatility now behind us, we have to assess a number of factors that will influence markets in both the short and intermediate term: 1) COVID-19 headlines, 2) the upcoming U.S. elections 3) the potential for additional policy/stimulus measures, 4) and the implications for traditional asset prices from current levels. 

Every Generation Faces Its Share of Challenges

Every Generation Faces Its Share of Challenges Chart
Courtesy of Invesco, Ltd.
 

At the time of this writing, states that were early to the reopening game have reported record numbers of new cases of COVID-19.  While some of these increases are attributable to increased testing volumes, it is unquestionable that many, if not most, are due to relaxed social distancing practices.  What is important to note, however, is that mortality rates are not increasing.  Frankly, we will never likely have accurate data on infection and mortality rates due to the challenges with contact tracing, testing volumes, and testing validity.  Though several of these states have rolled back reopening, it is unlikely, in our opinion, that we will witness the widespread closure of the economy that we experienced this spring for two reasons: 1) the healthcare system is better prepared to care for those who need acute care, and 2) the economic costs are too severe.   COVID-19 and headlines associated with the novel coronavirus will be with us for the foreseeable future, but we believe that market volatility will have a new source: election year uncertainty.

A recent Google search on the “History of Presidential Election Year Market Volatility” produced over 14,000,000 results.  In other words, plenty has been said about what happens in markets during election years.  Stock and bond markets typically see muted returns and elevated volatility during presidential election years.  As I have stated to many clients over the years, over the long-run, election cycles have only minor impact on overall returns.  What matters most to investors is the potential for policy changes that would require a repositioning or reallocation.  In this election cycle, close attention will be paid to discussion of taxation, as the Trump Administration tax cuts were a catalyst to stock market performance. 

Waiting for "Your Team" to Win Before You Invest?

Waiting for "Your Team" to Win Before You Invest? Chart

Courtesy of Invesco, Ltd.
 

Policy actions enacted by the U.S. Federal Reserve in the wake of the economic disruptions this spring were nothing short of historic; to list all of those actions and programs in detail in this newsletter would require several more pages.  Reducing the Fed Funds rate to zero, unlimited government bond purchases, introducing a number of targeted lending programs to maintain credit market functioning, and perhaps the most stunning, the purchase of corporate and municipal bonds, including those rated below investment-grade, as part of a $2.3 trillion lending program summarize the unprecedented scale of the Fed’s intervention to support the economy.  Though the scale and scope of these actions have provided necessary support to critical functions of the financial system, they also introduce the idea of moral hazard.  Stock prices and bond prices responded during the quarter.  As of this writing, U.S. stocks are experiencing the best quarterly performance in decades.  Credit markets, too, have rallied; investment grade and corporate bond spreads (the difference between the yields on U.S. Treasury securities and other bonds) have narrowed substantially.  The Fed has been calling for additional fiscal stimulus, following the direct stimulus payments made earlier this spring, as they believe additional stimulus will be necessary to counteract the economic downturn.  Yet with the amount of money already funneled to combating COVID-19 and the economic shock, why haven’t we seen a more substantial economic rebound?  It is largely due to the fact the increases in money supply haven’t resulted in money velocity, or use, within the economy.  See the chart from the St. Louis Fed below: 

FRED Chart

As you can see on the far right of this graph, the U.S. Personal Savings rate jumped to over 30% in April.  Rather than spend the stimulus checks and increased unemployment benefits, consumers saved those dollars.  Only if consumers feel confident about their employment and the overall economy will these saved dollars become spent dollars, which leads us to implications for asset prices.

If consumers continue to save, then the increased money supply will not likely have an impact on inflation or inflation expectations for an extended period.  The Federal Reserve intends to keep interest rates near zero until at least 2022.  Remember, the Fed has two mandates: 1) full employment and 2) price stability.  In essence, the Fed does not think inflation will be an issue until at least 2022.  So with the back drop of interest rates remaining low for an extended period, here are implications for different assets.

Stocks

Stocks are not “cheap”, at least when measured by the forward price/earnings (P/E) ratio.  The forward P/E divides the current price by estimates for next year’s earnings.  At the time of this writing, the forward P/E for the S&P 500 is approximately 24.16.  The 20-year average is approximately 15.5.  By this measure, stocks are nearly as expensive as they were at the end of the “dot-com” bubble.  Before rushing to the exits, however, it’s important to include some interest rate context.  At that time, the 10-year U.S. Treasury was yielding in excess of 6%; today it is yielding 0.66%.  With that in mind, stocks may not be as overvalued as they appear.  In addition, the construction of the S&P 500 index also skews the forward P/E ratio, but that is a topic for another newsletter.  If interest bearing investments are not providing any real competition to stocks for potential real return, then stocks should continue to outperform bonds over the intermediate and long-term.  

Bonds

At current interest rate levels, government bonds are likely only providing a return of capital, rather than a return on capital.  In other words, we do not see much value in U.S. Treasury instruments.  We believe there is some value in portions of the corporate bond market, though we find the most value in the municipal bond market.  Not only are many municipal issues providing yields equal to or better than taxable bonds, the demand for tax-exempt income may increase substantially, if there is a roll back of current tax rates, as has been promoted by presidential candidate Joe Biden.  As mentioned earlier, the Federal Reserve intends to keep interest rates low for at least the next 18 months.  If the stockpile of cash consumers have been building starts to be spent, inflation could become a worry.  As a result, interest rates would rise and bond prices would fall – even more of a reason not to own long-dated government bonds, in our opinion.

Real Estate

It’s important to differentiate residential real estate from commercial real estate and with all real estate, it’s all about location.  With interest rates at historic lows, homeowners (at least those with stellar credit) are finding opportunities to refinance or purchase at rates we never thought likely, in some cases below 3% for 30 years.  In some parts of the country, the desire to leave cities for the suburbs and greenspace has resulted in bidding wars reminiscent of the housing bubble.  Part of the issue fueling pockets of strong residential real estate activity is a lack of inventory, but that issue has been plaguing the housing market for years.  Consumers will grow more confident if real estate remains stable or strengthens.

Commercial real estate, on the other hand, is likely to be challenged for some time.  Plenty of stories have been presented in the media about companies defaulting on lease payments and apartment dwellers asking for flexibility in making rent payments.  As e-commerce continues to represent a growing share of consumer discretionary spending, malls, shopping centers, and other retail-oriented commercial real estate will be challenged.  Office space, too, could be problematic as many employers come to the realization that their employees can be productive working from home, though this theme may take longer to play out. Many investors incorporate real estate investment trusts (REITs) as part of their portfolio construction.  In this asset class in particular, know what you own.

Uncertainty is high around the world today, and elevated volatility will be with us for some time, but don’t let the current environment derail your long-term plans.  If you would like to review your portfolio and make sure you have the diversification you need to stay on track, connect with one of our dedicated professionals and schedule a time to talk.

Read other issues of our Wealth Matters newsletter.


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