A Smarter Way to Invest Market Summary 6-3-2020

MARKET SUMMARY

Provided By: Adam Blocki, CFA, CFP® – Senior Portfolio Manager

The S&P 500 traded within a relatively narrow range for most of May before breaking out above 3,000 in the last few days of the month. Asset prices continued to rise across the board again in May with stock, bond, and commodity indexes all rising from April. The S&P 500 Large Cap (4.5%), S&P 400 Mid Cap (7.1%), and S&P 600 Small Cap (4.1%) indexes all rose, even though small caps continued to lag behind. The MSCI EAFE international developed markets index (4.1%) and MSCI emerging markets index (0.6%) both saw gains as well. Internet-focused companies also continued to demonstrate impressive resiliency as the NASDAQ Composite rose 6.8% while Communication Services (7.4%) and Technology (7.2%) were the largest gaining sectors. While not quite as impressive, even the laggard sectors posted gains with Consumer Staples and Energy up 1.7% and 2.0% respectively. In the bond market, Treasuries continued to hold their levels with modest gains (IEF, 0.2%) while investment grade (VCIT, 2.4%) and high yield (HYG, 2.5%) sectors saw bigger gains. Finally, gold continued to act as a safe haven with the GLD ETF rising 2.6% while commodities took a pause from their downward spiral (DJP, 5.4%) as oil prices seemed to finally stabilize this month with a nice bounce off their April lows.

With just one week of trading left in the month, the S&P 500 was up only 1.5% from April’s close and it seemed to have hit a ceiling. Despite the stall, it seemed contradictory that the index could hold this level amid an environment where the word “depression” is used casually as economic data that parallels the 1930s is reported, expectations shift from a quick V-shaped recovery to a prolonged U or L-shaped recovery, Fed Chairman Jerome Powell warns of an extended period of economic weakness, and the US Consumer Price Index dropped 0.7% from the previous month (that’s high for month-over-month). After another 3.0% surge in the final week of March it is worth asking again, “Why are stocks continuing to rise?”[1]. We addressed this to some extent last month by explaining the forward-looking nature of the stock market and a tendency to overprice good or bad news. Other factors have played a role, however.

One explanation is the acronym TINA which stands for “there is no alternative”, meaning there is no other option than to invest in stocks. With Treasury rates back near 0%, large institutional investors like pension funds and fund companies need to generate some level of return even if the outlook for stocks is somewhat muted at current levels. Another factor is what is often referred to as the Golden Put. A put option allows the owner to sell a security at a predetermined price, no matter how low the market price may fall, limiting the total losses. The Golden Put idea refers to the sentiment that if stocks begin to drop again, the trio of the Federal Reserve, Congress, and the President will do everything in their power to limit stock market losses acting like a put option on the market as a whole. A final factor that may be contributing to buoyancy in stocks is the shift in business models over the last decade or so. With gravitation to online sales, remote and outsourced workers, and digital services, some companies rely less on in-person interaction and can weather social distancing more efficiently. This is reflected in the fact that the NASDAQ Composite is actually up year-to-date along with the Technology and Communication Services sectors.

Other Fed actions have also made people more comfortable holding assets that would otherwise be considered risky[2]. In the depths of March, there was concern about liquidity in the corporate debt market. The spread between BB-rated corporate debt (just below investment grade) and Treasury bonds measures how much extra risk the market perceives in the debt of BB-rated companies compared to that of the federal government. This figure rose from 1.90% to 8.65% in just over a month, an indication of rapidly increasing credit risk. In response, the Federal Reserve promised to backstop corporate debt with $750 billion and pledged to ignore changes in credit ratings as long as the companies were investment grade prior to the current crisis. This ensured that companies such as General Electric, AT&T, and Boeing could access credit to continue operations and led to the largest single month of new issuances in the investment-grade debt market.

Subsequent lobbying efforts widened the scope of this backstop to include smaller companies, including those that used the widely manipulated EBITDA figure in their financial statements. This opened the door to significantly increasing the level of risk in the Fed’s bond portfolio and indirectly condoned the use of such vague financial metrics. The question that will undoubtedly be asked once the immediate crisis has abated is whether financial market stability actually exists (a mandate of the Federal Reserve) if it requires extreme intervention whenever something goes wrong. Also up for consideration is whether or not any lessons were learned from the recovery that followed the Great Recession, namely how long to keep interest rates near zero, a factor that likely contributed to the enormous debt load currently burdening corporate America.

The Federal Reserve is only one of the many central banks currently providing assistance to markets but concern has started to creep in as to how this aid is being implemented[3]. Prior to our current crisis, there was a growing chorus calling for increased fiscal stimulus to help where monetary stimulus was proving ineffective. Normally these two levers of economic stimulus act independently. Central banks manipulate interest rates and bank regulations to provide more or less capital to markets in order to influence economic activity and they do so independently of political influence. This prevents politicians from having the ability to print money in an attempt to stimulate the economy and inadvertently causing runaway inflation. Alternatively, fiscal stimulus comes from an increase in government spending which is either financed by taxes or by borrowing money via bond issuance. The line between these two options has become increasingly blurred as central banks have stepped in to purchase Treasury bonds, meaning that “fiscal” stimulus is increasingly being enabled by monetary means. The U.S. is not alone in this regard as other central banks in Europe, Japan, and even some emerging market countries have resorted to similar tactics.

As mentioned above, the concern with this arrangement is normally that inflation will ensue. The bigger risk this time, however, is that we may end up confronting deflation[4]. With demand for goods and services evaporating since March, many companies have slashed their prices to attract consumers and generate whatever revenue they can. While food prices rose during April, the overall US Consumer Price Index still dropped over the same time period. While a few consecutive months of deflation isn’t unheard of or difficult to recover from, longer periods increase the risk of entering into a negative feedback loop. As prices fall, consumers begin to delay purchases of big-ticket items such as cars, appliances, or home renovations since they anticipate that those items will be cheaper in the future. This leads to weaker current demand, weaker growth, and even lower prices. With inflation, central banks can theoretically raise interest rates as high as they wish to halt the momentum and rein things in, but deflation isn’t nearly as simple to combat. Aside from being an economic phenomenon, deflation is also psychological. Consumers will only begin spending normally again once they think that prices are going to increase in the future, a very difficult thing for monetary policy to achieve.

Avoiding the worst-case scenario doesn’t necessarily require inflation (which remains an elusive goal ever since the Great Recession), it simply requires price stability. This is one of many things that we will get more insight into as economies begin to reopen around the world. If things go well and infection rates increase at a manageable rate, then we may avoid the worst and start to see the economic recovery gain a foothold. If we reopen too quickly or too slowly, then the economic malaise that we have seen since March may persist. Too quickly and a rapid increase in infections leads to the return of shutdowns; too slowly and you cool the economy beyond the point of easy resuscitation.

Adam Blocki, CFA, CFP®

Sr. Portfolio Manager