In the first quarter of 2020, we experienced the first unexpected and unprecedented shock wave from the COVID-19 pandemic. The estimates on what will happen next are open to a wide range of guesses, from a V-shaped recovery (via CNBC) to a brief recession (El Erian), to a global depression (Ray Dalio). There seems to be a consensus that things will get worse before they get better. Does that mean we are in the eye of the hurricane? If I had to take a side, I’d say “yes”. What comes next?
No limits on support from the Fed and Congress
Congress and the Fed have shown a willingness to quickly supply money to the unemployed and to any business in trouble. Benefits are easy to get, money is flowing, and current financial pain is moderate. Congress may vote $4 trillion more of benefits in the coming months. Depending on how you count, that is $10 trillion of direct support to consumers and businesses, small and large.
The result has been a bit of recent market euphoria and a sense that the worst is over. Most of the rally has been in the most sensitive businesses like restaurants, malls and cruise lines. As earnings season starts, we will discover the extent of the financial damage.
There is a limit to how much the Federal Reserve can buy, but nobody knows what it is or what the effect will be. The Fed’s balance sheet is expected to go from the current $6 trillion to $10 trillion this year. It can go higher, but what if it gets to $20 trillion? That number is higher than the highest estimates. There is a realistic fear that too big a Fed balance sheet will create the problems Japan now has: deflation, zero interest rates, no growth and no returns. It’s clear that the Fed will exit this storm with an enormous balance sheet. There is no incentive for them to reduce it.
Like the Fed, Congress will also exit the storm with an enormous deficit. There may be incentives to reduce the deficit (via inflation) but there is no ability to reduce the deficit unless, and it is a big unless, taxes go materially higher in a sharply progressive way. We would need a dominant Democratic sweep of the presidency and Congress in order for that to happen.
Earnings in 2020
Revenue (not just earnings) have evaporated from retailers, restaurants, entertainment companies, and from all companies who must deal with crowds. That means roughly one quarter of all revenues are missing entirely. With reduced energy demand, oil and energy companies are massively unprofitable.
Financial models are tweaked and adjusted quarter to quarter based on nuanced variations in trends. Even in calm markets, it’s difficult for analysts to accurately predict earnings. Needless to say, nearly every input for financial modeling today is unlikely to be accurate for 2020. More than ever, stock prices are based on gut feel, momentum and an extremely limited view of the future.
Howard Marks said this week in his investment memo: “In short, it’s my view that if you’re experiencing something that has never been seen before, you simply can’t say you know how it’ll turn out.”
The Virus and the danger of calling it “Just A Flu”
Realists point out that if the virus is deadly to the elderly and immunocompromised then the rest of us should be able to go back to work. On the other hand, the virus is clearly contagious and vicious enough to require the closure of entire countries at extreme economic and societal cost. Critics of the shutdown say, “the cure is worse than the virus”. That’s hard to determine as both sides of the argument involve significant losses. At this point, it seems that persistent rolling shutdowns will be a part of life until we have a vaccine or a miracle breakthrough.
Taking a step back, going into 2020 the markets and economic outlook were balanced and generally optimistic. Corporate profits and buybacks (now despised) were strong enough to carry us through another positive growth year. Interest rates, perennially depressed from the financial crisis were yielding 1.5%, households had increasing disposable income, a tailwind from cheap mortgages and rising real estate values. On the negative side, the bull market was at record length and the business cycle seemed to be strained or late in the cycle. We expected a short recession at some point in late 2021 or beyond.
The post-COVID world may usher in major demographic changes. Education was already expensive at full employment. What will it look like at 10-30% unemployment? Consumers seemed to be OK with having very little in savings. Will this shock introduce a hoarder’s mentality for cash similar to the 1930s? What does that do to a consumer based economy? Will the baby boomers look to offload houses to unlock their wealth? Millennials have much higher debt and lower incomes than their parents, so who will be buying houses other than institutional investors?
Perhaps everything will go back to how it was pre-COVID. Equity markets are good at predicting the future, and so far it seems that markets see a return to normal. We’ll find out in the next quarter whether or not this event will last for years or longer.
The last time we had a recession, 10% of classic dividend payers defected. In other words, companies that had increased their dividends for 20 years or more finally broke the trend and cut or eliminated their payments. A track record of increasing dividends for 20 years is a coveted distinction. So far, despite some of the heaviest economic headwind imaginable, none of the major 20 year dividend payers have issued a cut. It’s very early days.
As Good as Gold
During the first selloff in March, the price of gold fell significantly just like every other asset. Gold does act, in some ways, as a currency reserve. As a result, gold is among the first assets to be sold during a crisis where liquidity is needed.
In 1971, the US severed the fixed relationship between the US dollar and the price of gold. This allowed the Fed to print money without having to balance the dollar supply against an expensive gold supply. Since then, we’ve printed money to solve all kinds of financial problems in the US. Most recently, during the Global Financial Crisis in 2009, we printed trillions of dollars to support troubled assets and bailout financial institutions. Since every major currency is printing money without an end in sight, there is upward pressure on gold from all sides.
When is this all over?
As Fauci has said many times, “the virus controls the timeline.” A miracle is possible, but the best estimate for a vaccine is the fourth quarter of 2021. With so many unknowns, we feel that it’s best to protect capital from a material and persistent erosion in global economic activity.
Cash, some gold, and certain quality US companies make the most sense to us as investments during these unusual times. Every family is different and so called “good investments” are not universal. Family structure and future liabilities are crucial to answer the question of where, when and how to invest going forward.
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