July 30—What do the Fed, fiscal stimulus, vaccines, and the election mean for the economy and your investments going forward?
Chief Investment Officer Tony Roth, Chief Economist Luke Tilley and Head of Investment Strategy Meghan Shue analyze the key drivers behind the market’s recent run.
Moderator: At this time, let’s begin today’s webinar, Diagnosing the Disconnect: A COVID-19 Economic and Market Update. I would like to introduce our first speaker for today and that is, of course, Tony Roth, Chief Investment Officer, Wilmington Trust. Tony, with that I’ll turn it over to you.
Tony Roth: Okay. Thank you very much. And good afternoon, everybody. I hope everybody’s having a nice summer week. So, it’s been about two months since we had our last webcast and a lot has happened since then. We’ve had these webcasts intentionally. Rather than at set dates, we’ve done them opportunistically when we feel that there’s a lot to talk about. And it so—just so happens that a lot, there’s a lot to talk about today, that a lot has happened in the last couple months. The metaphor that we’ve used in the past was that the economy was essentially a patient and in order to protect the patient we had to intentionally put it into a coma and the coma took the form of the lockdowns, the mitigation efforts, in order to tamp down the virus.
We reopened the economy a number of months ago slowly across the country and it’s been, frankly, a mixed bag. We’re seeing some of the effects of that mixed success now in a lot of the economic stats that we’re seeing. We’re starting to see other forms of stress in the economy. We’re even starting to see some stress in the market. And to the title of today’s call, Diagnosing the Disconnect: A COVID[-19] Economic and Market Update, we’ve seen a remarkable recovery in the markets despite the significant and continuing economic distress that exists in the country and it’s that disconnect between the market and the economy that we are seeking to diagnose for you today and to talk about what are the key factors to focus on going forward to try to understand the trajectory of, ultimately, the markets and the economy.
So, to help us with that task today, as we often do, we have, first, our Chief Economist Luke Tilley. So, welcome, Luke, and thanks for joining us today.
Luke Tilley: Good afternoon, everybody.
Tony Roth: And we also have our head of Investment Strategy Meghan Shue. And Meghan, great to have your voice and your face and everything with us today as well. So, thank you for being here.
Meghan Shue: Thanks, Tony.
Tony Roth: So, I think the place to start in diagnosing the disconnect is we’ve come up with a list of five reasons specifically that we believe that the markets are performing as well as they are, notwithstanding the underlying economic distress. And it’s interesting, because when we see the markets behave in a particular way and we have an economic-led investment process and we see all of this underlying economic difficulty, we look at the markets with a very high degree of humility and we say to ourselves why is it that the markets aren’t really reacting to the underlying economic picture and we’ve come up with these five reasons.
And so, we’re going to go through each one and weave into the conversation where we see the risks and the opportunities with respect to each of these going forward. And we’ve ranked them in the order of essentially their stability, which is to say how likely are they to continue to be a support, how much uncertainty is there within any particular factor going forward around the role that the factor might continue to play in supporting the markets and, to some degree, the economy?
So, we’re on the first slide now that says the drivers of disconnect and future performance on the top of the slide. And the first item is—well, let me read off … and then we’ll go to the next slide. So, we have fiscal policy, essentially the Federal Reserve. We have Fiscal Stimulus. Well, we have, excuse me, monetary policy, the Federal Reserve, the Fiscal Stimulus, which is essentially all the cash transfers to the tune of over $3 trillion so far that have come out of Washington to consumers and to small businesses. Then we have the third one, essentially the whole ecosystem around the virus from a medical standpoint and the enthusiasm and optimism that exists with respect to a vaccine and therapeutic developments, which is certainly buoying the markets considerably. The next is the Labor Markets and the fact that they have bounced so quickly. But that’s also one of the greatest sources of risk, which is why we have it ranked so lowly here. And then, of course, the U.S. Election. We can’t have a conversation around the future of the economy or the markets without talking to some degree about the election. Although, just a caveat, we are nonpartisan and anything that we say that may be interpreted to be condoning or otherwise criticizing a particular party is not intended as such. Our sole goal is to understand what the particular policies might actually—how they might actually impact the economy and the markets.
So, with that, let’s get into it and let’s talk about the first factor is the Fed. And Luke, can you talk to us about what the Fed has done and why it is that if we were to give the Fed a grade, if you will, for its engagement around this crisis, it’s probably the one area of the government we’d give an A+. Maybe start with market liquidity. If you certainly do a compare and contrast with the great financial crisis, where market liquidity was such a big deal and markets stopped functioning correctly, we haven’t seen that at all here. Perhaps, that’s a good place to start.
Luke Tilley: Yeah, it is and that’s definitely where they would get their A+ from. And this chart is showing what they’ve done back through the previous crisis and now. And, of course, the defining feature of the chart is the jump in their balance sheet in this current crisis since they recognized it in mid-March.
So, as you said, ensuring liquidity for the markets as soon as the crisis really hit in early- to mid-March, we saw, everybody saw that lack of liquidity, even for U.S. Treasury securities to a large degree, sort of a worrisome lack of liquidity there. And that’s, of course, the backbone of the U.S. and the global financial system.
So, what is being shown here is the Fed really jumping in with both feet and buying a tremendous amount of securities. Their balance sheet is up $2.7 trillion since before the crisis in February and that is largely because of the purchases of U.S. Treasury securities and mortgage-backed securities and that restored liquidity to the financial system. They are still buying those securities, anywhere between $30 and $50 billion per week, and that’s where they get the A+, because they basically staved off a financial crisis, Tony.
Tony Roth: So, that has been, I think, very apparent to markets. What’s less apparent is that they’ve also tried to actually organically support the economy through lending programs. But interest rates have—were already low coming into this crisis while they’ve moved lower. Has that really been something that is, despite their efforts is it something that really has mattered, because it doesn’t seem like availability of capital is the real problem here. What do you think about that?
Luke Tilley: Yeah. So, this is where they get an A for effort and you might get different grades from different teachers, because they’ve done everything that they can to promote lending. They’ve got their traditional lending to banks within the financial system. They opened these other special facilities, especially the ones that were part of ensuring liquidity for the commercial paper market and for the money market mutual funds and those types of things.
But, in terms of being able to push lending to support economic growth, of course that’s different from ensuring liquidity. That’s where they have created programs, like the Main Street Lending Fund. They’re backing up the Paycheck Protection Program from the SBA. But it’s really not had the largest impact. It is encouraging that they are there and that they stand behind the markets. But, in dollar terms they’ve made a total of something like $200 billion in loans. Just to put that in context, that’s about 3% the size of their purchases.
So, they are there and they’re doing what they can. But it’s hard to fault them, because when you get in an environment like this, basically the demand for loans is very low. Although they are supporting them and trying to do everything they can to keep interest rates low, it’s a little bit like economists like to say pushing on a string. It’s hard to push money into the economy if there’s nobody there that’s really looking for it and qualifies for it, Tony.
Tony Roth: So, Luke, they’ve also—when you look at everything they’ve done, they’ve essentially deployed a toolset in breadth and depth that is really unparalleled to anything that’s happened in the past. And they have pushed rates to zero. They’ve been very insistent that they don’t want to go to a negative rate environment, primarily because it hasn’t worked anywhere else and it’s caused a lot of harm to the banking and the financial industry, which we believe would be the case if it happened here.
So, given their very clear and strong reluctance to go to a negative rate environment, if we have more stress in the economy and the markets, and we’ll talk more about the likelihood of that as we go through the call today, how much dry powder does the Fed have? They can’t go to—they can’t push rates any lower. What else could they do? How much quantitative easing might they engage in? Is there a limit to the size of their balance sheet? Do you think that there’s enough dry powder for them to continue to make a difference, if needed as we move forward?
Luke Tilley: Yeah. In short, no, not really. They can do everything within their power. They don’t have a limit on their balance sheet, but there’s a limited effectiveness. They will always say that they’re there to do everything they possibly can, and Chair Powell said it yesterday after the Fed meeting in the press conference that they’ll do everything that they can. And they will do everything to keep interest rates low, not go negative like you said.
But, you know, barring any major changes to the actual Federal Reserve Act, they’ve sort of done everything that they can, and they’ll continue to stand behind it. As Chair Powell says, they’re able to lend money but they can’t give it away. And he really has been pointing, more than any other Fed Chair in the past, towards fiscal policy and the need for fiscal policy, because Congress is able to basically give money away and do grants like we’ve seen and like they’re probably going to do again soon.
I should also add that the one thing that is different in this environment, as you said very different, is their purchases of corporate bonds, which has had a tremendous impact, of course, on that asset class as we look at the performance of asset classes and is also very new. And we know that that corporate bond market was in—was very bloated and large as—as large as it’s ever been in history. So, that has had a big impact, too.
But most of the Fed actions are done here. They’ll keep doing them, but they’re—we can’t look to them to keep growth, you know, going higher from here, Tony.
Tony Roth: Yeah. And it’s one thing that I just would note, it’s really interesting, Luke, is that sometimes the Fed expressing its intentions around an area, particularly if it’s something they haven’t done before, can be all that’s needed. So, in the case of their corporate bond purchases or their muni bond purchases to some degree, just the intention to engage in those markets has had a pretty big impact on prices without even having them purchase an awful lot of securities. And similarly, we don’t have time to get into the dialogue today around yield curve targeting, but there’s been a lot of concern around the yield curve going too low, maybe the 10-year, the—or, excuse me, the back end of the yield curve moving too high over time, particularly as all this issuance comes out of the Treasury, etcetera. And maybe they need to target the yield curve to keep the long bond at a lower level.
And there’s a lot of conversation around that and just the intention for them to do that may be enough to keep that 10-year yield lower if, in fact, there’s upper pressure on it. But, of course, today we’re seeing the opposite. We’re actually at 54 basis points on the 10-year. But, it’s interesting the way that dynamic plays out in the market. Sometimes just an expectation of Fed behavior is enough to control prices and to control the shape of the yield curve.
So, Meghan, one of the things that comes with the Fed policy, as we’ve talked a lot about here, is this incredibly low interest rate environment. How important has that been, in your mind, in buoying the equity market? We’ve used this term TINA in the past, there is no alternative, so money in a very low rate environment migrates out of bonds and into stocks. How important is that in your mind in why stocks have been so resilient?
Meghan Shue: Yeah. Thanks, Tony. I do think it’s been incredibly important for the performance that we’ve seen from the equity market. Coming into this year we were looking at a 10-year yield north of 1%. As you pointed out, we’re now below 60 basis points. The dividend yield on the S&P 500 is roughly three times that, even more if you’re willing to look at stocks outside of the U.S.
So, I think what we’ve seen here is, again, if you think about a stock as a series of future cash flows, the fact that you’re discounting those future cash flows at such an incredibly low interest rate definitely supports the valuations and is at least part of the reason why we’re seeing valuations as elevated as they are today. And then spreading out beyond equities, I do think that Luke’s comments about the Fed’s purchases of corporate bonds, municipal bonds, even those bonds that have been downgraded from investment grade to high yield, these are hugely significant steps from the Fed compared to what they’ve done in the past. And that’s definitely done quite a bit to decrease the rate that companies have to pay to access the capital markets and continuing the functioning of capital markets. So, I think it’s been huge in terms of driving fund flows from bonds, which essentially are a really challenging place to see future return to equities, which are taking on more risk, but you’re getting at least a little bit more incremental return in order to do so.
Tony Roth: Yeah. And also, the housing market has been one of the bright spots in the economy actually. And while there are a number of reasons for that, certainly low mortgage rates, record low mortgage rates, is probably a major contributor I would think.
Meghan Shue: Yeah. That’s a great point. The housing market has been incredibly robust in the last few weeks. Other areas like autos have seen a nice bounce, too. But, much of that, whether we’ll see the sustained continuation of that trend depends on a lot of things that we’ll be talking about in a few minutes, I’m sure.
Tony Roth: Okay. Thanks, Meghan. So, let’s move on to the second factor that probably is the single most important factor. It’s not ranked number one, because the certainty of it continuing to provide the support it has in the past is not as high and you can see that manifest in what’s happening in Washington right now. But, it’s basically the fiscal support.
So, Luke, without going through all the detail, I think that people can read on the slide the different stages of the fiscal support that we’ve had and we’re moving into stage four essentially right now, hopefully. But we’ve had over $3 trillion of these so-called cash transfers from the federal government to consumers, etcetera, to keep them moving.
One of the fascinating things about working at a wealth manager within the context of a bank is that we have visibility into daily debit and credit card information and what we can see is that there’s been a tremendous increase in debit card usage largely because unemployment insurance in many states goes right onto a debit card and that goes directly back into the economy in terms of consumer spending, very much of it. Credit cards, on the other hand, are down in terms of usage, because they tend to be more oriented towards people that either aren’t working for their income or are working but still have their jobs and are not being funded, if you will, through the UI system. And you’re seeing a lot of decline in those credit card receipts relative to past years.
So, if we have a big hit to the debit card system, essentially the cash that’s flowing through that system through unemployment system, that could really stand to impact negatively this recovery that we’re trying to do essentially sustain as we take the patient, the economy, out of—off of the life support and out of the coma. So, maybe just give us to start here, Luke, give us a dimensioning from your standpoint of just how critical this fiscal stimulus has really been in keeping us out of a depression or something of that nature.
Luke Tilley: Yeah. Sure, Tony. And I almost feel like restating your statement that we’re not taking political sides here. We’re just sort of observing what might come out and what the impacts have been. And clearly, if you are looking at the slide, you know the phase three planned CARES Act was so massive, I mean $300 billion sent to U.S. households. We’re up to $80 billion a month being added to the unemployment insurance. And as you said, Tony, that is really supporting spending.
The places in the economy where we have seen resurgence … encouraging numbers have been in retail sales, where we know that this money is going out and being spent specifically. And it looks to us like it is people who manage to – who have kept their jobs but are also getting these checks from the government are shopping at home improvement stores. They are buying treadmills at sporting goods stores. It is all of these large-ticket purchases probably helping the auto sales market as well, which you mentioned as one of the positive things. And that has really kept spending going. And then, of course, another component is the Paycheck Protection Program, which a lot of that money is running out.
So, where are we right now? The House Democrats, the House passed a plan spearheaded by the Democrat side in mid-May that was $3.5 trillion in total size. The Republicans, as you’re probably aware, all listeners are aware, proposed their plan this week, which is $1 trillion, so a fairly wide gap between the two. And the biggest differences are in those unemployment insurance benefits, which we can talk about in detail a little bit more. But, the size of those is really going to make a difference for the amount of spending that we see, because it has supported spending and, you know, it also has the downside that it might entice people to stay out of the labor market and there’s a longer discussion to go there. But the immediate impact if it were not passed would be a decrease in spending as we go forward.
There’s also one of the big differences between the two plans as the two sides are debating it right now is the level of support for state and local governments where Democrats have something like $500 billion and the Republicans did not include it in their plan. So, there are very big differences between the two. We do think that because of some of the slowdown we’re seeing in the economy that we’ll talk about in a few minutes, that we’ll end up seeing something passed, probably $1.5 trillion. But we await the details of that and that’s one of the reasons that we have to be cautious.
So, it has definitely helped in helping diagnose this disconnect. In terms of what it looks like going forward, we await news on that, Tony.
Tony Roth: And I’d like to ask you in a sense is there a number in terms of weekly unemployment benefits that you think we need to get to in order to keep us out of, you know, a real red zone from an economic standpoint? There’s a pretty big bid/ask spread. The Democrats want to keep the $600 per week and I think maybe until the end of the year and the Republicans are at $200 per week. There’s—I don’t know if there is a particular number you have in mind or whether or not it’s really just sort of a continuum and more is better for the economy short-term, but perhaps worse for the problems of the deficit and the dollar, etcetera, over the long-term.
Luke Tilley: Well, I think some sort of transition or tapering is necessary here. So, again, not to weigh on what should or shouldn’t happen, the scale of these extra $600 a week is stunning, because for most people in the country if you were making less than $60,000 a year now with this benefit you’re actually making more on unemployment than you were before. To scale what’s going out the door right now, $80 billion a month, that makes up about 15% of retail sales or 7% of total consumer spending.
So, some of the encouraging numbers that we’ve seen, if the benefit were to go to zero tomorrow or as it actually technically has done this week, we would expect to see a huge decline in spending and that would be discouraging, and it would be challenging for the recovery and for markets. However, if you keep it this high forever, it would be incredibly challenging to get a labor market restarted.
So, in terms of smoothness, there’s some mix of decreasing the benefit but having it taper over time and neither side is really looking at a gentle taper. So, we’ll have to see what comes out here. But, that’s basically what you’re weighing is the short-term pain of pulling some of that money away against the longer-term goal of having people return to work and we’ll just have to wait and see how they calibrate it. But we expect to see something probably above that $200, but have it taper over time, Tony.
Tony Roth: So, thank you, Luke. Meghan, when we look at the markets the way they’re trading this week, I mean today the Dow’s down around 250, which is not in today’s volatile environment particularly notable. But, on the other hand, the—in the bond market, the ten-year note is down to 54bps, which is really a low number now, which is—feels like a real risk off type of move in the bond market. Do you think that the market’s really holding its breath here, starting to price in a bad outcome? How do you think the market’s sort of taking the fact that the sides seem to be so far apart just a couple days before unemployment—increased unemployment insurance runs out?
Meghan Shue: Yeah. It’s really hard to ascertain how much the markets’ movements this week are attributable to challenges in Washington with coming up with some sort of extension of these benefits and how much might be due to some of the weaker data that we’ve gotten today and in recent days. So, today we got GPD, which was pretty abysmal but expected and, yet, some of the other higher frequency labor market data was maybe not as expected, but also starting to weaken. I think that’s got something to do with what we’re seeing in the markets.
But I would say I don’t think the market necessarily has a dollar figure in mind for what they’re expecting or hoping for. I don’t think that this is necessarily the last time that Congress can meet to, in order to provide aid to the economy. But clearly, with each successive round it gets a little more challenging. And as we approach the election, that’s also going to complicate any additional bipartisan agreement that needs to happen.
So, I think the market needs to see something, some sort of continuation, maybe in that $1.5 trillion package size that Luke referenced. But anything materially less than that I think would be a disappointment if there was no indication that Congress will keep going back to the well for more and more support.
Tony Roth: Okay. Thanks. So, let’s move on to the next factor that we think has been really supporting markets, which is the optimism around medical developments. And on the one hand, the way I’d frame this moving onto that next slide again, is that it’s really remarkable the degree to which medicine has been able to engage the scale at which resources have been directed at this problem and some of the progress that’s been made.
We certainly had a lot of medical experts with you directly at the early stages of the cycle of our client WebExes and presentations and whatnot. Once there was sort of a saturation point reached across the media world around that kind of information, we sort of pulled back on that. But I want to summarize for folks where I think we are right now, because a lot’s happened.
And just by way of how much progress has been made, I think it’s fascinating that when you look at the SARS outbreak from 2005, it took scientists almost a half a year to essentially crack the genetic code on that virus and sequence it. In the case of the 2020 pandemic, COVID-19, it took less than one week, less than a week to actually sequence the virus. The Chinese did that and put it out on the public website. So, it’s been an incredible acceleration of the pace of development and we’re so fortunate for that, because it typically takes 10 years if you’re able to make a successful vaccine from the start to the finish to actually have something that’s relatively efficacious and safe.
So, here what we’re seeing is a whole coterie of companies focused on the vaccine development and this is an area where the Administration has recently come up with the Operation Warp Speed, which more than anything else simply is a pot of money, about $10 billion, that can be utilized to fund the various mechanics and logistics of running these clinical studies and being prepared to produce the vaccines en masse if, in fact, any particular company gets over the hurdle of the—of FDA requirements in order to have a vaccine that’s sellable and sufficiently protective.
So, what we have is three companies in particular, Moderna, the Pfizer/BioNTech and Oxford working with AstraZeneca that are sort of the leaders overall. But we have many other very reputable companies—Novavax, Inovio Pharmaceuticals, J&J, Merck—that are very, very skilled and have long histories in the case of two of those companies, J&J and Merck, in developing successful vaccine programs. We have the top three that I mentioned that are now in Stage 3 of their clinical trials and they already have enough people that have signed up to fully satisfy their desire to have around 30,000 participants in their Phase 3 trials.
Now, one of the things that I think is important to point out with respect to vaccines is that while we’d all like to have it be sort of a binary outcome where if it’s successful that means we have a silver bullet, we go get inoculated once and then we can move on with our lives and put this whole very, very messy and difficult episode behind us. Hear what the FDA actual recent announcement has been around the standard that a vaccine needs to meet in order to be approved and here’s what it is. It has to be at least 50% effective to prevent a disease or diminish the severity of its diseases—of the disease. That sounds to me like a very different kind of outcome than one I first described we all might associate with a vaccine, like in mumps or measles or chicken pox where you get the vaccine and that means you’re not going to get the disease and you just get it once and you move on with your life.
This, unfortunately, seems that it’s the kind of virus that there’s a good chance that the vaccine will provide a meaningful measure of immunity and a meaningful measure of protection if, in fact, the immunity doesn’t work and you still contract the disease. But it’s not going to provide the level of protection and the level of certainty that we hope it will. That’s the likely outcome when we look at this kind of virus and what we’re hearing from people on the inside baseball, if you will, around the vaccine development.
So, we’re just going to have to wait and see what happens. The good news is that there are so many different companies that are very reputable with a lot of money behind them pursuing many different approaches that we think that there’s certainly a strong likelihood that we have one, if not more, vaccines that make it over that FDA standard that I articulated by the end of the year.
Now, the other area of, I think, optimism for the equity market when it looks at the medical environment are therapeutics. And we all know about remdesivir, I think, which is the Gilead drug that has been shown to reduce mortality by around 40%. So that has been, I think, one of the reasons that when we look at the overall reopenings and one of the things that’s very important to focus on in assessing the success of the reopenings is not just the level of disease incidence, but also the level of deaths.
And so, what we’ve seen largely speaking is a big spike up in disease incidence and, yes, we’ve recently seen sort of the saddle effect in the data around deaths, where it was very high, it’s come down, and now it’s starting to pick up again. Up until today it was—had come back up from around 300-400 to around 1,000 a day. Actually, in the last 24 hours it spiked up to 1,500. So, that death rate is very critical in understanding how consumers, and I say the word, I call people consumers because from an economic standpoint that’s what matters to us is how active are they going to be and engaged out in the community spending money. That’s what they’re most worried about.
In reality, we know, you know, we know that the disease actually can leave very—it seems that, unfortunately, the disease, even if you recover, can have very long-lasting, debilitating impacts. But, in general, people think of it as sort of a binary thing, am I going to die, am I not going to die. And so, to the extent that the disease incidence is broad, but the death rate doesn’t pick up and doesn’t spike significantly, that’s something the markets are very focused on. And the markets are going to react negatively when the—if and when the disease starts to—the deaths start to really spike up again.
So, to that point, I think it’s important to notice that we have had, it seems, like a much lower death rate with this second round here or second wave of COVID, if you can call it a second wave at this stage. And we don’t know whether that’s because it’s a younger cohort, whether it’s because people are benefiting from some of these therapeutics like remdesivir or some of the ones that may not be approved but are still in clinical trial, the Regeneron drug. And there’s also one that is certainly not benefiting people here in the U.S. yet, but it’s a drug that was in the UK by a small biotech shop that announced its first results. Synairgen is the name of the company and the drug is SNG001. And it’s basically a drug that you can take at home because it’s an inhaler and it’s an inhaled interferon beta candidate and it seemed to reduce the risk in about 102 patients of developing severe disease compared to a placebo in a double-blind study by 80%.
So, when you put this all together and you think about how the market’s reacting to emergence of the coma of the patient and seeing that there’s still disease out there and still people getting sick and that’s spiking up, but at the same time, the vaccine is coming and people aren’t dying at the same rate. The death rate seems to be much lower now and that there are therapeutics that seem to be starting to work and they’re coming faster. That all is supporting the market right now.
But, the thing to be very concerned about is if, in fact, the death rate does spike up higher in coming weeks and the death rate typically will lag, of course, the initial tests of positive COVID diagnosis, then we could have a problem and reversal in the economy. And that brings us, I think to the next topic, which is the labor market. And this, I think, one of the most fascinating ones, because the labor market was probably the singular, I think, catalyst in the shift in the equity market where we came out initially with this massive 5.5 million new jobs in May followed by another five or six million new jobs in June and nobody was really expecting the labor market to recover that quickly.
So, Luke, can you sort of take us through, if you will? We had that massive sort of shift in the jobs picture. But what’s happened since then? We have a labor report coming on August 7th and we think about the labor market, we think about the absolute level of jobs. So, we had lost about 23-20 million jobs. We’ve added back around 10 million, so eight to nine million on a net basis, maybe a third of the jobs lost. But what matters is how fast do we keep adding them back, what we call the second derivative, if you will.
So, when you look at that based on the high-frequency data and all the other stuff that you economists look at all the time, you’re always adding another data subscription to your resource base here, what is all that telling you? What’s going on now in the jobs market? What should we expect to see on August 7th? Is it as rosy as we thought it was two months ago or, excuse me, over the last two months?
Luke Tilley: Yeah, Tony. So this, of course, is incredibly important and it brings together a lot of the things that we’ve already talked about, which is fiscal policy and, you know, the small business program that encouraged and enticed people, small businesses to bring their people back to work and paid for it and that money has run out. It has to do with the spread of cases, where we know that when the cases are spreading more quickly and in some states we see that decline in activity in those states. And then, we also know that in the background we’ve had still, you know, as of this morning more unemployment claims of people who are going on unemployment for the first time.
So, there’s a lot of different factors here that weigh into what’s going on. And as you alluded to, we’re using this small business index. It’s a daily tracker and this has, things like this have really become incredibly helpful in this pandemic. And this comes from a company called Homebase. And as we’ve done here, if you’ve seen this in newspaper articles or anywhere else, you would see a different version of it with just the line going down and then slowly tracking back up to somewhere where it was, the total number of employees.
And the national level data for Homebase for all states is showing that small business employment is really only back to about 80% of its level. And what we’ve done here is to sort of flip it upside down, turn it into an index, and translate it to growth rates, because we want to do exactly what you’re asking, Tony, which is how does it compare to the actual official data that we’ve seen. And these, just the last description is these lines are showing you the—where they snapped the chalk line to do the jobs report.
And this data source is showing us the same thing that we see in the BLS data. It was very strong growth rates for the month of May, and we know that the unemployment rate dropped precipitously, and millions of people went back to work. Same thing happened again in June. But now, in July, that growth rate has slowed significantly and actually towards the end of the chalk line period moved into negative territory.
So, this would hint or suggest that we might even see a negative number a week from tomorrow on August 7th and that would obviously be a, in my mind, be a shock to markets and it’s not what is priced in. I think nobody’s really expecting the same rate of growth that we’ve had over the past two months. But there is an expectation on the positive side that it would keep building.
If this data source is accurate and we might even see a decline, that would be very troubling and obviously would bring back all of those arguments about unemployment insurance and how much of this Paycheck Protection Program is going to be included in this next round of stimulus. Now, we have to caution here. This data source is not perfect. There is a lot of differences between a private data supplier and the BLS, the Bureau of Labor Statistics, which is counting all employment. But it is a warning signal. And we also have another high-frequency tracker from the Census, which has a very wide sample, that shows that we may have seen some job losses in the month of July as well, which matches up with Homebase. And in the worst case, we might even see the unemployment rate jump as high as 15%, back up to the peak, next week. We’re not expecting that, but we’ve got enough signals saying that between the spreading cases and then the expiration of those PPP funds, we might be looking at some downside risk as we go forward with the labor market, Tony.
Tony Roth: Yeah. I’m glad you mentioned the PPP, because as I understand it, companies that have now spent their PPP and spent it within the guardrails of what the program required are now free to lay their people off if they need to and that PPP money will not somehow reconvert to a loan. It’s still going to be money spent, money that doesn’t have to be returned.
Luke Tilley: That’s correct. They were given a certain pool of money and those businesses needed to spend it on certain things, primarily on payrolls and bringing people back to work, in order to qualify for the forgiveness and have it turn into a grant. The deadline for spending it was pushed off in the future, but if you were open and your business was operating and you used it to pay people, as long as you used that money, and for a lot of people that would be running out over the past few weeks, then you are free to let those people go, as long as you spent the pot of money appropriately. So, and that’s a reason that both sides are including some sort of PPP provisions in the proposed fiscal stimulus packages under debate right now is to try and get that going again, Tony.
Tony Roth: Thanks. And Meghan, just real quickly, from a market standpoint if we print for the month of July, let’s say, no new jobs or flat or even if we maybe at a million after having added five or six million in the last two months, does the market look at that and say, well gee, we’re still 12–13 million jobs off the bottom and, you know, what’s one month? Or does the market look at it and say, wow, that’s a complete rollover or collapse, if you will, of the second derivative of the pace of adding new jobs and that’s just really bad and problematic? How do you think the market perceives that?
Meghan Shue: Yeah. That second derivative, that rate of change has been a key support for the market, as you can see from these charts that sharp bounce off the bottom. I think from a long-term perspective, a month or two of weakness would not be overly problematic. But, looking at what the market’s priced in at this point, where valuations are, just the level of optimism in—priced into the market at this point, I do think we are setting ourselves up for a period of volatility if we do have one or two months that are a little bit bumpier in terms of the labor market.
Tony Roth: Okay, thanks. So, let’s go to the last and I think somewhat surprising factor that we’re citing for market support right now, which is the election. And I think that if—and just to echo what Luke said and what I said in the beginning of the call again, we have no opinion as to who should be elected or who will even be elected at this point, but our goal is simply to understand what the policy outcome will be given different paths for the election itself.
And what’s interesting is that the typical paradigm would hold that if you have a Democrat who has already avowed that he will increase taxes if he’s elected and appears has some, you know, good chance of flipping the Senate, that would be really problematic for a bull market, which by any tactical measure we’re in a bull market right now having… this bottom 35% ago earlier in the year. Yet, the markets have not seemed to price in any negativity around this potential Democratic outcome in Washington. Do you think that’s because the markets don’t believe any polls anymore after what happened in 2016? Or do you think it’s something else, Meghan?
Meghan Shue: Well, I think it’s a combination of factors. I do think there’s a little bit of skepticism around the polls. But we’re also just entering the period where investors really start to focus on the election. It tends to be about three months out from the election. So, we are—we’re right on the cusp there.
I do think there’s a few things that have changed the game a little bit and changed some of the importance of the tax and regulatory issues and broadened it a bit and one is the economy. We are clearly in a very weak economy. It’s improving, but we’re going to still be clawing our way back for the near future. And so, there might be some idea that we’re going to be perhaps pushing off any tax increase or maybe the Democrats would withhold from raising taxes altogether.
So, I think that’s a potential consideration. And the other, one of the other, I think, big considerations from my view, especially as we look at the makeup of leadership in the stock market and how much of it has been dominated by the tech industry. I think the relations with China play a very important role going forward and I don’t see really any appetite from either party in Washington to take a soft stance on China. But certainly, if we had a Democratic administration, we would expect a little bit of a different approach, probably not as much reliance on tariffs and perhaps relative to a Trump administration a little bit more of perhaps a conciliatory approach to China. That would benefit the technology companies that rely on overseas and China for revenue, for workers, for technology partnerships. So, we would expect that to be part of the reason why if you are seeing a higher probability of a Democratic administration those tech stocks might do a little bit better in that scenario.
Tony Roth: Yeah. And I think it’s fascinating, Meghan, the relationship between the big tech stocks and the country’s attitude or potential attitude towards China, because as Biden has risen and risen in the polls, we’ve seen an even acceleration of the leadership from the Apples of the world, the tech stocks, that have very significant dependency from a market standpoint, but even more dependency in certain cases from a supply chain standpoint. And we recently released a two-part podcast on our WealthWise podcast series, which if anybody’s interested you can find on Android or Apple or any of the places you go to find podcasts. And we recently had Steven Roach, who is a very well-known scholar on the relationship between U.S. and China, and he noted that, you know, it’s somewhat ironic, because certainly one very positive measure that the Trump administration has had is to really elevate the dialogue and the focus on our relationship with China, because it’s so important relative to some prior administrations.
So, in any case, so this has been a great conversation. And we have very many questions that have come in through the email. We have about 13 minutes left, and we want to get to as many of them as we can. So, let’s go through these questions. I’d ask you guys to please keep your answers as succinct as you can. And if—we will not be able to get to them all, so for anybody who does not hear their question answered, we will certainly make sure that we get it answered outside of the scope of the call.
So, the first question that I’d like to tee up and I’ll—this is for Meghan, is given that the interest rates are so low, as we’ve talked about 54bps on the 10-year, are bonds an effective diversifier in portfolios? They would seem to be a pretty unattractive asset class. This is me; I’m commentating a bit here. But they would seem to be fairly unattractive given that the carry or the yield is so low on them. Is it a hedge to equity investments? Is it a diversifier in portfolios?
Meghan Shue: In terms of generating return or income, bonds are certainly nowhere near they were in years past. But I do still think they’re an effective diversifier against equity risk and I think they’re an important part of the portfolio. So, we’ve actually found some opportunities, specifically in the municipal bond portion of the market. That’s an area that saw an extreme amount, an uncharacteristic amount of liquidity—illiquidity and stress back in February and March and we added to municipal bonds at that time, because we saw it as really a historic opportunity.
So, we’re still finding opportunities in the bond market. Clearly yield is starved. But we think they’re an important part of the portfolio.
Tony Roth: Where would you look for a hedge if you didn’t feel that a bond was going to provide enough of a hedge for any reason?
Meghan Shue: [We] do think that gold is an attractive hedge at the moment. Not only is it benefiting from relatively low yield, and as we all know, gold is not an income-producing asset, so you give up some income by investing in gold. But today, that opportunity cost is very low. So, that’s a support for gold.
Additionally, we see it being an effective hedge against the two main tail risks. One of the left tails which would be a severe risk-off environment from any weakness in the labor market or continued prolific spread of the virus, we would expect gold to do well in that environment. Or conversely, if we see a pickup in demand, a pickup in activity, a weaker dollar, and rising inflation, we would expect gold to hedge against that as well. So, we think gold provides some interesting dual optionality at the moment.
Tony Roth: Yeah. And one other point that I would make as well is that for clients that are looking for income in portfolios, this is a really interesting and opportune time to be writing covered calls against your equity positions, because equities are at such high levels right now from a traditional perspective in terms of price to earnings, etcetera. We don’t think that there’s all that much upside in the short term for equities. So, writing covered calls against your equity position can add up to 2% of additional yield on port—in portfolios and that’s something that we’ve been doing for clients recently.
So highly recommend that that be considered as another diversifier in portfolios. Again, anytime you can add income to a portfolio you’re adding a shock absorber essentially to your total return and diversifying.
So, with that, let’s move on to another question, which is for Luke. Luke, given that a payroll tax reduction would act as an immediate essential—essentially cash transfer into workers’ pockets, why is it that the payroll tax idea of the administration was so quickly dispensed with in favor of whether it be checks going out to people or whether it be unemployment insurance increases or other types of measures?
Luke Tilley: Yeah. So, there are lots of obviously menu options on the table. The good thing about sending checks directly to people is you know that for the most part they are going to spend it. We have seen a lot of that flow into savings or paying off old credit card debts. But, for the most part those funds are going to be spent over time. And if the goal is to support the economy, that can help and it has its downsides, too. It gets very expensive.
The payroll tax cut was dismissed, at least if you believe the press reports mostly, by congressional Republicans. That is a very important and large source of revenue for the government and, you know, unwinding those things can be challenging. So, when it comes time to roll that back, you can have a knock-on effect later that would prevent some hiring if you need to reinstitute it. So, it’s hard to undo that one.
And then, the other point with that is you have very little control of how a company reacts to that kind of a tax cut. Right now, companies—and I realize that this is the payroll tax cut and it’s connected to how many employees you have, but companies are very much looking for any way they can to put away some dry powder and get operating cash and it wouldn’t necessarily prompt any kind of economic activity.
So clearly, different people have different beliefs about what is best. They all have their pros and cons. But it looks like that payroll tax cut is not even really on the table right now.
Tony Roth: Okay. Thanks, Luke. Meghan, how do we view emerging markets and China? China makes up about 40% of the emerging markets now, so it’s really a China question, I think. Given that COVID has been tamped down pretty considerably by China, I don’t think they’ve had a COVID death in—if I—at least as of a few days ago, they haven’t had a COVID death in months, frankly. Given their managed economy, the fact that they are much further ahead of the curve than we are from a COVID standpoint, why aren’t we overweight in emerging markets and China specifically right now?
Meghan Shue: Yeah. Well, the clarity that we have into China, whether it’s their handling of the virus or the economy right now is still not quite as clear as we have in other parts of the world. But we are seeing an improvement in Chinese data. It’s tapered off a little bit, similar to some of the improvements we’ve seen in our own economic data. And typically, a low interest rate environment, easing central banks, weaker dollar, that would favorable—favor emerging markets.
So, it’s an area that we are looking at. We hold a modest underweight at this point given some of the risks around China’s economy, their concentration in the index, and what we believe is a reliance on continued support from their government and monetary body. So, not an area that we dislike necessarily, but just kind of hedging our risks to the Chinese recovery at this point.
Tony Roth: Yeah. And I will note that it’s an area that we may move into with greater excitement at some point in the near term. We may not, but we may. And one of the reasons that both the emerging and the developed, non-U.S.-developed space is compelling potentially is because we have been, while more aggressive and more salutary from a short-term standpoint in spending to negotiate this crisis, at the same time we have also really increased our deficit, both current account deficit and federal deficit and percentage of debt, publicly held debt to GDP. And that all makes for potentially a decline in the dollar. A lot of very smart people are calling for a decline in the dollar and holding non-U.S. assets would be a great diversifier to that type of outcome. So, that’s something that we continue to think about very carefully.
Luke, another question that’s come in for you is what would be the, if you will, a precursor or a hallmark or an indicator to you that we may actually be slipping seriously towards a negative rate environment. And when I say negative rate, I mean negative policy rate.
Luke Tilley: Yeah. If it’s negative policy rate, I, I’d—you know, as you said early on, I don’t really think it’s under consideration. The Fed has watched what has happened in Europe, in Japan and a few other places, and they really think that the benefits you get from that don’t really outweigh the cost of how much damage it does to the banking system and to returns on short-term money funds. So, I don’t think that they’re moving there. But, of course, they don’t take it off the table.
If the Fed was to go there, it would almost be like they’d have to be forced into it. If, you know, they don’t have that much control over, as much control over longer-term rates, they, you know, if they saw, if the market saw a very deep downward move again and started buying up longer-term Treasuries and those rates go negative, well then the Fed is looking at they’ve got a zero policy rate on the short end and then negative rates on the long end. They almost feel like they’re forced into that. But even then, they’re more likely to react by trying to exert some influence on the longer end.
So, again, I don’t think it’s something that is very much under consideration right now and I think that we would have to have a very serious turn back to the downside for that to happen, Tony.
Tony Roth: Okay. And by the way, for—without question, a negative rate environment would be very bad for banks and most financial institutions. Certainly, pension plans, anybody with fixed liabilities would be—would find themselves I think in a very difficult position in that kind of situation. Possibly, the housing market would benefit. But rates are already so low from a housing standpoint and a mortgage standpoint. And as you say, Luke, the negative rates would be accompanying, I think, a pretty grim economic picture at that point.
So, it’s hard to imagine too many companies thriving in that scenario. You’d probably see on a relative basis in a downturn like that possibly associated with more COVID, etcetera, continued leadership by the big tech names that dominate digital, because they continue to essentially provide the interface through which we can communicate and work with each other as we’re doing right now, rather than in-person communication. And so, they’re going to continue to benefit we think in most environments and continue to perform relatively well.
So, we’re running out of time. I want to get to as many questions as I can. Luke, is there a point at which you get concerned about the absolute size of the Fed’s balance sheet? You said earlier that the Fed didn’t have that much more dry powder. Its balance sheet is how big now? About I want to say –
Luke Tilley: Seven trillion.
Tony Roth: Six trillion?
Luke Tilley: Seven trillion.
Tony Roth: Seven trillion.
Luke Tilley: Yes.
Tony Roth: What about a $10 trillion balance sheet? What about a $15 trillion balance sheet? At what point does it get problematic in your mind?
Luke Tilley: Yeah. So, in the interest of time I will point towards our debt podcast, our two-part debt podcast that we did, and just say that I don’t think in and of itself the Federal Reserve’s balance sheet is much of a concern and it’s going to—if you listen to that podcast, there’s a lot of interplay with government debt, which I still think could go higher and that yet is something you have to deal with.
So, I don’t worry about the levels of either one of those things. The biggest concern I would have is on an ongoing basis if you have those two organizations working together where the federal government is taking on a lot of debt and the Fed is buying all of it, then you’re in a lot of trouble, because then you end up with high inflation and interest rates, and that’s what we’ve been able to avoid over time. And that’s why we’re an attractive place to invest. But we do have a podcast about debt, and I would point listeners to that, Tony.
Tony Roth: Okay, great. Another question that’s come in asks about the range of values around residential real estate, probably multi-family homes from the tone of the question, but not necessarily, urban and suburban housing. And I think that the—one of the things that’s fascinating about the cycle is that as we pivot from an externally oriented lifestyle to a more internally oriented lifestyle, what we’re doing is in many cases we’re much more focused on our homes. We’re focused on the amount of space we have. We’re focused on our home as a place to work and a place to learn for our children. And that’s actually supporting in equity markets homebuilders. It’s supporting the Lowes and the Home Depots of the world that have performed quite well. And we actually think that the residential REITs, particularly outside of the deep urban areas, are one of the interesting investment plays right now.
So clearly, multi-family housing in an urban setting is going to be hit hard if we have another COVID downturn. So, we’re somewhat cautious there. But when you get out into the suburban arena, we think that there’s more economic durability and there’s a lot of really interesting opportunities there. And we think that certainly residential is much more attractive right now than commercial.
So, maybe we’ll take one more question and I’ll direct it to, I’ll give you the last word, Luke, which is around forbearance. Banks like ourselves have engaged in a lot of voluntary forbearance, which is to say that there’s a lot of small businesses out there that are not paying various interest on loans. And as we see essentially what’s inevitable, which is going to be a wave of bankruptcies in the country, starting from the ground up, starting from small companies where the openings are not as vigorous as we might have hoped in certain—in a lot of areas of the country or even in reversing in certain areas of the country. At what point do you think these banks essentially pivot off of the forbearance policy and move to try to foreclose on assets while they still have some opportunity to get some money out of their loans? How is that dynamic going to play out, Luke?
Luke Tilley: Oh, it’s going to be very challenging, of course. I mean currently there is from the CARES Act a lot of protections for mortgages and it’s just for conforming mortgages and very little for small businesses. So—but banks have taken their own actions there. So, there’s no real consolidated number in seeing where that might be coming to an end.
But clearly, what was done there was to try and get people past the roughest of times and if these stimulus payments are coming out and get people, bridge them from the shutdowns to the other side, then that would be – then that – and if they’re able to survive after that, then that would be good. But I don’t think that anybody believes that, you know, every small business and every business, large business, is going to be able to survive an episode like this. So, it’s going to be challenging. It’s going to be up to the banks unless a bill passes like the Democrat House plan includes much wider forbearance, mandatory for consumers and small businesses. If that doesn’t happen, then we would expect to see that dynamic of more closures and more bankruptcies.
But banks don’t want to own those businesses either. So, it’s a very challenging environment and a lot of it is going to hinge on that legislation. And then, back to the earlier part of the conversation, how do the vaccines, how do the therapeutics work out? Does the—is the economy able to keep moving upwards? And that would obviously be an upside surprise. But I expect that we will see some pain in the second half of this year.
Tony Roth: Okay. Thank you so much, Luke. I’m going to summarize what I think are the three key takeaways from our conversation and then a fourth that we didn’t actually talk about, but I’m going to introduce it quickly and then we’ll wrap.
So, the first is that overall here’s what we would focus on in coming days and weeks to understand the trajectory of the economy and the markets. Number one is keep a very close eye on this fiscal package in Washington. How long does it take to get it done and what is it going to include specifically for unemployed individuals in the country, which is a bigger and growing group perhaps than we think it is given Luke’s assessment of the labor market and what the month of July might end up looking like compared to the prior two months, which even raises the stake further in terms of the significance of this fiscal package making its way through Washington. That’s very, very important to see and if we don’t get enough money going to the unemployed it’s going to be problematic for consumer spending and for the economy. So, that’s number one.
Number two is keep a very close eye on the death count within COVID. There’s no magic number. But certainly, if we have sustained death count over 2,000 a day in this country for, you know, call it five or seven days, I think you’re going to see a very different and a much more cautious approach on the part of the consumer across the country and, indeed, governments are going to, I think, take this last round of increased disease incidence even more seriously than they already have in terms of mandating pullbacks in reopenings. And that’s a leading indicator. So, take, keep a very close eye on that.
The last thing to look at going forward is, again, keep a very close eye on that [August] July 7th labor report. There’s a very wide spread between what economists think is going to happen on that date. We tend to have a more negative assessment, thinking that we may get a very low number of net new jobs or even a negative number net new jobs. We don’t think that’s priced into the market, as Meghan said, and so that’s something that’s very important and it really shows the overall health of the economy right now. And because it’s not priced into the market, it may stand to have a big impact on market levels.
And the last thing, which we didn’t talk about explicitly, is stay invested. We don’t believe that the situation is clear enough that anybody should be running for the hills. We think that there are real potentials around these therapeutics and vaccines if we can get there fast enough to really give this economy a big lift. And in that environment, the hardest thing to do in investing is to get out when the market’s high, when the market is at one level and get back in if the market moves higher. It’s the hardest thing to do in investing.
So, right now we are largely fully invested. We’ve stayed largely fully invested throughout this crisis. We’ve had, you know, very nice performance for you all as clients. Resist the urge to jump out, because if the markets don’t go where you think they’re going to go, they go up, they continue to go up, getting back in is just extraordinarily difficult. And in the long term, we know we’re going to get past this. We know the markets are going to be higher in the long term and trying to be too cute or too tricky in the short term is just going to end up hurting almost everybody that tries to do so.
So, with that we want to thank, special thanks to you, Luke and Meghan.
Meghan Shue: Thanks, everybody, for joining.
Tony Roth: And, yes. And thank you all for joining today and we’ll talk to you again soon. That will end our presentation today.
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Investing involves risks and you may incur a profit or a loss. Asset allocation/diversification cannot guarantee a profit or protect against a loss.
Options risk. Options strategies are designed to minimize risk by hedging existing portfolios. While options act as safety nets, they’re not risk free. It’s important to understand risks associated with holding, writing, and trading options before you invest in this strategy.
Gold risk: The gold industry can be significantly affected by international monetary and political developments as well as supply and demand for gold and operational costs associated with mining.
Investing involves risks and you may incur a profit or a loss. Asset allocation/diversification cannot guarantee a profit or protect against a loss.
Options Risk. Options strategies are designed to minimize risk by hedging existing portfolios. While options act as safety nets, they’re not risk free. It’s important to understand risks associated with holding, writing, and trading options before you invest in this strategy.
Gold Risk: The gold industry can be significantly affected by international monetary and political developments as well as supply and demand for gold and operational costs associated with mining.