For the past approximately two months, we have produced a communication each Friday. Our hope was to provide clear information and analysis, as well as consistent support and guidance through what has been a most unusual economic and social period in the country’s history. If what awaits is a “new normal”, nobody knows specifically what that will look like. Clearly, we have some distance to go before that new normal takes
hold. The availability of an effective COVID-19 vaccine and a return to something like pre-crisis full employment are primary measures. Secondary measures include emerging from this bear market and a return to positive GDP growth.
We hope we are beyond the worst of the crisis. For that reason and to avoid boring you to tears with redundancy, we have decided to publish this communication at the end of each month going forward, rather than at the end of each week. If circumstances change, we will return to more frequent communications. If you feel strongly about this one way or another, please do let us know.
Market Review
On January 2nd, 2020, the S&P 500 closed at 3257.85. The index set an all-time high on February 19th, closing at 3386.15, and at that point, was up for the year approximately 3.9%.
On March 23rd, the S&P 500 closed at 2237.40, having cratered 1149 points in 23 trading days, a truly remarkable event. At the end of the day, the index was down 31% for the year and down 34% from the February 19thhigh. We advised throughout that we would not sell into a panic and that any changes to portfolios would be strategic and not reactionary. The S&P 500 closed on Thursday May 28that 3029.73, up 35% from the low on March 23rd but still down 7% for the year.
For most of May, the S&P 500 has moved between 2800-3000, with declining but still noteworthy volatility along the way. Large technology firms have been the primary driver of this first stage of market recovery. In recent weeks, optimism for the development of a COVID-19 vaccine has spurred strong performance for more economically sensitive areas of the market. The financial, consumer discretionary, industrials and energy sectors have all shown early signs of recovery. International equities have outperformed domestic over the past two weeks. Investor demand for these unloved sectors of the market is a welcome sign for the recovery.
While expanding market leadership is quite positive, it appears as though the market may remain range-bound for as long as positive news about COVID-19 vaccine trials is counter-balanced by cautionary comments from health officials. At the same time, developments that would normally cause market turmoil, such as trade issues with China and a highly uncertain US election this fall, have been ignored. This suggests that the market expects a COVID-19 vaccine by the end of the year and is concerned about little else. However, a return to news driven volatility would not be surprising.
As explained in prior communications, the price of the market at any time is not a reflection of its current value based upon recent corporate earnings. It is a reflection of anticipated future earnings. The primary risks in the market today are: 1) the failure of a viable COVID-19 vaccine to materialize within the assumed timeframe, 2) that as economies open throughout the country, consumer spending will fail to recover to a meaningful degree. The development of a vaccine within this compressed timeframe would be unprecedented. However, the best minds of the world are working on the issue with seemingly limitless access to resources. Given the furious competition to be first to market with a vaccine, the optimism reflected in the market is understandable. Should the collective efforts of the pharmaceutical industry fail to deliver, or should corporate earnings fail to recover as anticipated, the market recovery of recent weeks will not be sustainable.
Negative Interest Rates
This term may have crossed your field of vision at some point over the past couple of years. It would be perfectly understandable to have no idea what negative interest rates really means or more importantly, the purpose of this monetary policy strategy. The phrase relates to the short-term rate at which banks (Bank of America, JPMorgan Chase, etc.) can lend or borrow from the central bank (Federal Reserve). It does not relate to the yield of U.S. Treasury securities (government bonds) trading in the secondary market.
Large banks typically “lend” a portion of their reserves to the central bank, the same way individuals keep a portion of their savings in a savings account. Normally banks are paid interest to keep funds in reserve at the central bank, the same way banks pay interest on individual savings accounts. Negative interest rates occur when the central bank charges interest on these deposits.
In theory, negative interest rates promote bank lending, which in turn, supports economic growth. In other words, banks would be better off collecting interest from borrowers than paying interest to the Federal Reserve, and the economy would be better off with borrowers spending loan proceeds in productive ways. In practice, the efficacy of this strategy is unclear.
Banks without sufficient qualified borrowers may actually experience deteriorating financial integrity. The European Central bank implemented negative rates in 2014 and has experienced mixed results, prompting considerable debate. In 2019, after five years of negative rate policy, Sweden discontinued their experiment. The growing consensus now is that a healthy economy needs a healthy banking sector. Forcing banks to pay a tax on reserves during a period when qualified borrowers are scarce and they may be struggling to maintain profitability seems exacerbating and self-defeating.
And yet, the Bank of England, which has been issuing debt since 1694, sold their first negative-yielding bonds at auction last week. This means investors paid the government to keep their pounds safe for the next three years. Although the rate, -0.003%, was only slightly negative, it opens the door to the Central Bank of England (The British Central Bank) lowering their short-term rate below zero to stimulate growth, an idea they have publicly embraced despite the evidence.
Could negative interest rates come to America? At this point it seems unlikely, as Federal Reserve Chairman Powell and several other Fed governors have outright dismissed the idea of the Fed lowering the short-term rate into negative territory. Thus far they prefer to use other policy methods to stimulate growth, such as buying corporate bonds. This policy strategy allows large corporations to raise capital during a period of financial stress without putting the health of the nation’s banks at risk.
We hope this helps clarify the concept of negative interest rates.
Inflation
The possibility of inflation seems of greater interest recently, due to the parabolic increase in the supply of money from the Federal Reserve and record low interest rates in response to our current economic situation. While we believe that inflation is a possibility down the road, at this point it is not a concern. For sustained inflation to materialize, there must be greater demand for goods and services than the market can supply. According to the Atlanta Federal Reserve, GPD is expected to fall by 40% in the second quarter on an annualized basis. To raise inflation expectations, both consumers and businesses will need to regain the confidence to invest and make purchases. With over 40 million unemployed people in the U.S., and a host of corporate bankruptcies, it may be quite some time before spending returns to pre-crisis levels.
News Sources
Many of you have asked recently for our opinion about where to find reliable financial news and information. It is important to note that legitimate and relevant financial data and market analysis are valuable resources. Indeed, one of our firm’s largest operating expenses is the financial information subscription service category.
Free sources of financial information (MarketWatch, CNBC) are in the business of selling ads, not providing rational advice and analysis. When approached objectively, this is quite obvious. The titles of many articles one might see on any given day are intentionally inflammatory and often only loosely related to whatever content actually exists within the text. So please approach these free, mainstream publications with extreme caution. Better yet, avoid them altogether.
There are a few sources that we can recommend. Bloomberg, The Wall Street Journal and The Financial Times all provide sound information and insightful commentary. No one has a crystal ball, but these sources do employ respected financial journalists who are worth reading, in our view.
Closing Comments
As we approach the most beautiful time of the year, our sincere best wishes for good health and happiness. It is our great honor to serve you; thank you for your trust.
If you have questions or comments about this text or anything else, please reach out to your PIM Financial Advisor.
Personal Investment Management, Inc.