Risks Are Distributed, Not Eliminated

May 5, 2020 - John Osbon (5 mins to read)

The Federal Reserve remains in the spotlight for supporting markets and businesses. The depth and speed of the actions by the Fed have effectively put a floor under stock prices in the United States. The consequences may include deflation or significant inflation, and neither is a good outcome. Warren Buffett did say last Saturday he was worried about ‘extreme consequences’; at the same time he’s made very few changes so far. Other countries have followed suit and expanded their central bank balance sheets significantly. The positive case is that there will be zero inflation here for many years. Let’s look at each case and consider a range of outcomes.

Deflation: price discounts and reduced economic activity

The oil price collapse and the massive drop in business activity have created a deflationary shock in the US. How long will deflation be with us?

Japan has battled deflation for decades. Japan has expanded their central bank balance sheet repeatedly, incurred fiscal deficits, raised taxes, and done just about everything to get out of their cycle of deflation. Their central bank has even bought Japanese stocks. Nothing has worked. As a result, Japanese stocks have provided no return for more than ten years and interest rates range from zero to negative. 

Fortunately, we are a long way from the extreme actions Japan has taken. Each interest rate adjustment in Japan has been tiny, .10% at a time, while in the US the standard has been a more meaningful .25%. Japan’s fiscal debt to total gdp is beyond 100%, that’s what’s known as the “danger ratio”, and is expected to reach 250% by the end of 2020. The US can avoid deflation if it can find a path to economic growth. 

International inflation could be a problem

As the world’s reserve currency, the US dollar is unlikely to experience high inflationary pressure. The global inflation rate is expected to be 3.4% for the next several years, according to Statista. While the United States has a current Consumer Price Index (CPI) of 1.5%. What accounts for the difference in projections? Generally speaking, countries outside the main currencies of the dollar, pound, yen, and euro are experiencing a much higher level of inflation. 

Examples of international inflation can be seen in Brazil and India. Brazil and India have the ability to devalue their currencies to keep their economies growing, but they do so at the risk of letting inflation run away from them. With major currencies at 0% on interest rates, a 4% inflation rate is very expensive. None of the four major currencies have been experiencing inflation and they would counteract it immediately if it appeared. International investing could become increasingly difficult for investors. If you find an international equity market yield of 4%, that would barely cover the cost of inflation.

The good news – no inflation here

There is no indication that the US is heading to inflationary rates anytime soon. TIPs are the best inflation indicator here and they are currently indicating zero to slightly negative inflation for a long time. What does that imply for US stock returns? We see a transition from older, lower-growth companies to newer, growth-oriented companies. That transition will take time and could be frustrating for many investors. Hence we see two areas of opportunities and we are focused on sectors that will thrive in this “work from home, stay at home, cook from home” new normal.

One area is large technology companies, many of which have sailed through this crisis. The other is dividend paying large capitalization stocks outside of troubled areas like energy and financials, and in growing areas like healthcare, staples and communication.  A portfolio of high growth and progressive dividend payers is looking more attractive with each passing week. 

A few words from Warren Buffett.

At last weekend’s Berkshire Hathaway annual meeting, Warren Buffett had some comments about the Federal Reserve. He said Berkshire started to get inquiries about loans and investments but those stopped as soon as the Fed stepped in. He praised the central bank but said it’s hard to tell what the long term outcome of its moves will be. The Berkshire Hathaway portfolio did not change much in strategy except for the sale of all airline stocks – a small amount. Cash remains high at $137 billion. In other words, nothing overwhelming or very attractive to buy for the Berkshire Hathaway folks. 

Still a wide range of outcomes

While everyone is hailing that the VIX (fear index) has come down from 80 to the low 30’s, we can’t ignore that it’s still 3 times its level we saw a year ago, or even in the beginning of the year. It will be challenging to navigate these volatile markets. We have to acknowledge what we don’t know and we will have to be nimble enough to change our views as more facts are presented to us. The COVID-19 challenges may seem like they are rapidly fading, but second and third waves seem like a reality to us. At times investors will have to make decisions with imperfect information, but as long as those are taken with calculated risks, investors will be ok.

New Normals

We have a key indicator this week, the monthly unemployment rate. It is expected to rise to 16%. In April it was 4.4% and in March it was 3.5%. The monthly number is expected to peak at 20% in July. Extra unemployment benefits run out July 31st, at which point the rate is expected to already be dropping rapidly. The open question is whether it will stay stubbornly high at 8% or go back to 4%. Stubborn 8% unemployment could weigh heavily on productivity and GDP growth. The Treasury has also announced it is going to borrow $3 trillion this quarter, a necessary and helpful amount. In other words, even though the reported numbers are very big, the market is largely shrugging them off. We are looking for reliability in markets, and that has started to show up over the past two weeks. If you would like to know how we are navigating all the information and of the market challenges, please give us a call.


Photo credit: AgnosticPreachersKid

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