A Smarter Way to Invest Market Summary 11-04-2020

October began optimistically with hopes for economic stimulus leading US equity indexes higher until upward momentum slowed and eventually reversed course. As the rolling average of Covid cases in the US spiked and any hope for stimulus before the election disappeared, markets began to sell off into the end of the month. The major US indexes (S&P 500, -2.7%; Dow Jones Industrial Avg, -4.5%; NASDAQ Composite, -2.3%) all finished lower but mid cap (S&P 400, 2.2%) and small cap (S&P 600, 2.6%) stocks actually held onto their gains for the month. These indexes were not immune to the end of month selling, they simply had larger gains in the first half of the month that prevented them from turning negative. Utilities (XLU, 5.1%) were the only sector posting gains while Technology led to the downside (XLK, -5.0%). International indexes were also divided with developed markets (MSCI EAFE) down 4.0% and emerging markets (MSCI Emerging Mkts) up 2.1%. Despite the selloff in equities, US Treasuries also fell 1.3% with investment-grade corporates down 0.2% as well. Somewhat counterintuitively, high yield corporates were up 0.5% amid the equity slide with international bonds (0.5%) also providing a buoy. Commodities ETF DJP was up 1.9% while the gold ETF GLD (-0.5%) fell slightly.

As mentioned above, one of the main reasons being cited for the selloff is the lack of further economic stimulus from Congress despite the economic recovery losing steam. As summer ends and cold weather returns, the infection curve has begun increasing again which has already led to renewed restrictions in some areas that will almost certainly get worse. More restrictions will undoubtedly lead to reduced economic activity again but we have also learned much more about how to minimize risk and live with the virus since the first round of lockdowns. This next round of shutdowns will attempt to walk the thin line between reducing deaths from Covid infection versus minimizing the suffering from second-order effects[1] while hopefully incorporating some of the knowledge gained since March. This is a delicate balance between minimizing current suffering while maximizing future well-being without any clear path to follow. A scenario with no restrictions could lead to a spike in infections and deaths that diminish the strength of the next recovery. If restrictions are too tight, we could see physical and human capital begin to decay over time. Infrastructural goods and services begin to disappear, people’s skills atrophy, and children’s intellectual growth is stunted as they miss more and more school.

With Q3 GDP figures just released at the end of October, we do have some data to draw from when making these tradeoffs, namely what impact various levels of lockdown could have and how to blunt the economic damage. The headline number for Q3 GDP was an annualized increase of 33.1%[2]. The first thing to realize is that this is an annualized figure which means that if GDP grew as much for four straight quarters as it did during the third quarter of 2020, it would increase by 33.1% in total over those hypothetical twelve months. For the third quarter alone, it grew by 7.4% which would still be incredibly impressive if it didn’t follow a second quarter decrease of 9.0% (-31.4% annualized). When looking at the absolute numbers instead of percentages, the level of GDP at the end of the second quarter was on par with the first quarter of 2015, and the current level is right around where we were in the first quarter of 2018. In other words, we eliminated five years of economic growth in the span of three months but gained back about three of those years over the following three months.

The second factor to realize when looking at a 33.1% increase is that a loss of a given percentage requires a recovery of more than that percentage to get back to even. If GDP was $1,000 at the end of Q1 and fell by 9.0% in Q2, GDP at the end of Q2 would be $910. To get back to $1,000 would require GDP to increase by $90, or 9.9% ($90/$910), almost a full percentage point higher than the drop. While a 33.1% annualized GDP increase sounds great, we needed 45.8% to recover all that was lost in Q2. According to these figures, we are still down 3.5% from Q4 2019.

With this in mind, lawmakers would ideally be able to decide what level of restrictions are prudent and what level of stimulus is needed to bridge the gap to the other side. Clearly, we wouldn’t want lockdowns to be so severe that we lost five years of growth every three months, but some level of economic sacrifice would be acceptable to offset loss of life. Not only do we need to consider that tradeoff, but there is also the question of longer-term impacts. Traditional economic theory suggests that an increased supply of money (via stimulus efforts, for example) inevitably leads to inflation. This was one of the big criticisms of the Federal Reserve’s three rounds of Quantitative Easing (QE) after the Great Recession. However, even after that drastic increase in the supply of money, inflation remained persistently below the Fed’s target of 2%. So much so that they changed their policy of targeting a strict 2% inflation rate in favor of an ambiguous “2% average”. A recent study of studies found that on average, every 1% of GDP that went into QE after the Great Recession resulted in a cumulative price level increase of 0.21% in the US[1]. If that held true this time around, the enormous amount of stimulus injected so far in 2020 would result in inflation of just 2.9% in total.

It is possible that this time is somehow different than the Great Recession, but given the information above, we could conceivably tolerate a much bigger increase to the money supply before inflation became a serious worry. We should also consider the extreme opposite scenario and why deflation would also undesirable. We briefly touched on the possibility of deflation in this newsletter a couple of months ago, but deflationary pressures have continued to persist[2]. While increased demand during the pandemic has driven up the prices of things like books, media, medical care, and bicycles, modest price increases in those items are being offset by decreases in the prices of airline fees, suits and dresses, hotel rooms, and city transportation costs. Energy is not factored into the Core CPI figure, but decreased oil demand has driven those prices down as well. In housing, the increased prices of suburban homes are causing the “owner’s equivalent rent” (the hypothetical amount of “rent” a homeowner pays to themselves) figure to swell while actual renters in some cities have seen their rents fall. For now, the forces outlined above have been counteracting each other to result in diminished, but still positive inflation.

Ultimately, even if we thread the needle and avoid both severe inflation and deflation, there will still be a price to pay down the road. A great article reviewed the history of the Fed and its use of policy to minimize the negative impacts of various economic events going all the way back to Black Monday in October of 1987[3]. The summary is that with each successive catastrophe avoided, the Fed has expanded its reach throughout the economy; debt has increased at the household, corporate, and government levels; and the short-term controlled burns that purge unworthy firms from the market and that are a foundational principle of capitalism have been delayed. The article refers to zombie companies that have been propped up by decades of increased liquidity but are destined to eventually fall and suggests that the Fed’s credibility and creative solutions will eventually lose their effectiveness. The picture being painted is certainly grim as the author envisions the cumulative sins of the past eventually being paid for with a generation of economic malaise. Avoiding the worst repercussions of the Dotcom bubble, the Great Recession, or the current pandemic fallout were worthy goals at the moment, but each episode ultimately left a little bit of kindling that compounded over time to create the ideal conditions for an uncontrollable wildfire.

Adam Blocki, CFA, CFP®

Sr. Portfolio Manager