Present, Past, Future—Rip Van Winkle

SUMMARY

• The New New Socioeconomic COVID Perspective: The speed and durability of a late 2020 or early 2021 economic rebound depends on several factors, including the virus, the Fed, Congress, the election, other countries, and the regular flu season
• Present: Had a contemporary Rip Van Winkle fallen asleep on New Year’s Eve 2019 and awoken in August 2020, he’d be perplexed by vibrant U.S. and Chinese equity markets and strong global bond performance despite high unemployment and severely disrupted local and global economies
• Past: Looking back over the last eight months, governments have held firm to our prediction of “bigger, faster, and greater” fiscal and monetary stimulus to keep as many businesses and people afloat as possible
• Future: Headline concerns seem to regard what will happen between now and the time when there is a well distributed vaccine or cure; we additionally ponder one step beyond to how economies will react and wean off government largesse once a medical solution is widely distributed

DETAILS

As the U.S. is probably past the nadir of the pandemic, let’s review where we are in light of what we foresaw, and what we still face. 

WHERE WE ARE: Had one fallen asleep on New Year’s Eve 2019 and woken up eight months later in August 2020, a Rip Van Winkle nap, one might be perplexed.

U.S. stocks values range from flat to up and bonds values are up, but unemployment has jumped from 3.5% to 11.1%, bankruptcies and store closures are rampant, and most people are cloistered around their homes. The S&P500 stock index is up +3% for the year, the NASDAQ stock index is up nearly +22.5%, and many European and Asian stock indices are double digit negative, while China’s equity index is up +16.6%. Global bonds are up +6.2%, U.S. aggregate bonds +7.8%, U.S. municipal bonds +4%, Euro aggregate bonds +2.3%, and even the bond sectors typically regarded as risky, Emerging Market and US high yield are up +3.4% and +1.2% respectively*. Rip Van Winkle fell asleep for twenty years and missed the American Revolution; he closed his eyes on King George III and opened them on President George Washington. Our eight-month napper has probably missed the worst of unemployment, market spikes, panics, and defaults, but has still awoken amid volatility and change brought about by the COVID-19 pandemic, government reaction, and moves for social change.

WHERE WE WERE: Let’s bring our Rip Van Winkle napper up to speed on what we’ve said over the last few months and what we see going forward.

• In March we wrote about defensive and offensive government support: “Global monetary support from the central banks is bigger, faster, and greater than ever. Furloughs, unemployment numbers, and defaults will look bad; but perversely, the worse they are, the more it may spur government help.” To date, this philosophy has held true in developed countries across North America, Europe, and Asia. Government fiscal (administrative) and monetary (central bank) support quickly ramped up into multiple trillions of dollars, euros, yen, and renminbi. We also wrote that “Shutdown and quarantined economies are extremely difficult to stimulate; tax cuts won’t boost spending much with consumers locked down, fearful, and without activities to do and businesses to shop.” This has been verified by second quarter gross domestic product (GDP) numbers which have been worse than expected. However, we also postulated that, “Once we are past the shutdown stage, government stimulus can turn offensive—in order to spark a near-term recovery—with direct government spending and business and consumer incentives.” We seem to be somewhere amid this transition with some parts of the economy still shutdown and others reopening. To conclude, we posited from an investment perspective, “Don’t fight the Fed,” and especially “Don’t fight an alignment of all the central banks and all the governments.” To date, this has been the correct side to be on. 
• In April, we tried to help “set expectations and comfort levels that help you frame market volatility” by predicting what long-range annual returns could look like for the S&P. We wrote that “Since 1931, the S&P 500 price index has compounded at 6.83% per year,” and “Since 1931, the S&P 500 with dividends reinvested has compounded at 10.67% per year,” and that in a “zero percent world” almost any positive return can look attractive.
• In May, we reviewed global markets considering our underweight international equity allocation and our less-than-upbeat assessment. We noted that China was especially incentivized to appear resilient—“Xi Jinping is politically motivated to post strong economic numbers ahead of next year’s 100th anniversary of the founding of the CPC [Communist Party of China]”—while many other countries faced serious issues. As it happens, Chinese (and Korean) stock indices are among the few to post strongly positive returns along with the U.S. NASDAQ.
• We also concluded in mid-May—in the final sentence of our thought piece—that, “In many areas, COVID-19 has probably catalyzed and accelerated processes that were already in place like nationalism, populism, and anti-globalization.” This was a few weeks ahead of the untimely, tragic, and unnecessary May 25, 2020, death of 46-year old George Floyd in Minneapolis, Minnesota; the Capitol Hill Autonomous Zone (CHAZ) and Capitol Hill Organized Protest (CHOP) established on June 8, 2020 in Seattle; and hundreds of nationwide and international social and Black Lives Matter protests.
• Later in May, we re-emphasized our position that “Defensive and offensive government stimulus programs are absolutely and relatively gigantic,” and that “Stocks and risky assets tend to do well after a crisis and are worth owning if you can look through the volatility”. We concluded that:

“for all their daily, monthly, and quarterly volatility, stocks are still worth owning for their long-term return potential and their tendency to do well when emerging from a crisis. We need to look through all the noise; the bottom line is that from here, a virtual standstill for many—even though some companies won’t survive—business activity will revive. The government should muster its offensive stimulus and the overall economy will improve.”

This too has mostly come to pass, especially on the stimulus and equity recovery side although underlying economic improvement has lurched in fits and starts, and many entertainment, travel, and hospitality businesses are permanently damaged.

• Additionally in May we wrote, “State and local municipalities face a very different fiscal situation than the federal government, and thus may raise taxes sooner.” This seems to already be the case, as California’s legislature considers Assembly Bill 1253 which levies a surcharge income tax of 1% on those with more than $1 million income, 3% on more than $2 million, and 3.5% on more than $5 million, thus raising California’s top marginal tax rate from 13.3% (already the highest in the country) to 16.8%.
• In June, despite the headline uncertainty of economists, we re-highlighted that “central banks and governments want to be perceived as decisive with their supportive monetary and fiscal measures” and emphasized that, “countries do not have to return to their past peak performance right away or even in the next twelve months, they just need to convince the majority that their ship is steady and moving forward.” Even more recently, we wrote about real estate and municipal bonds as assets that continue to hold well in a low-interest-rate world specifically because low interest rates make them more attractive, much as they do all assets. I.e., a 4% return in a 1% world is relatively more attractive than an 8% return in a 6% world; thus, even when nominal returns decline, asset prices can increase.
• The misses! On the other hand, I have had a couple forecast misses.
• My assertion that there would be a COVID baby boom nine months after shutdown may not come to fruition. The 2020 Guttmacher Survey details that potential parents may want to delay or reduce their expected number of children. Uncertainty over income, job security, childcare, and healthcare during a combined health emergency and economic crisis has created strong disincentives and may even lead to a birthrate bust, according to the Brookings Institution.
• Another big miss was my hope and thought that the U.S. would be as successful as China or Korea in capping the COVID-19 outbreak within three months. The realization has been that the U.S. has not handled COVID uniformly—but rather as 50 separate republics with hundreds of individual rules and porous borders—thus challenging effective and efficient containment. 

WHAT WE FACE: Economic growth will increase in the third and fourth quarters of 2020. Along with additional fiscal unemployment and corporate relief this year, expect Congress (and possibly the Fed) to supply some form of additional aid to states and municipal governments over the next two years—to the tune of $200 to $300 billion—in order to avoid economic disruption at the local level. If our Rip Van Winkle naps once more, he undoubtedly will again awaken to a much different world.

Expect a clear economic growth rebound in the third quarter and a further increase in the fourth quarter, albeit from low second quarter numbers. Gross domestic product (GDP) will be lower at year-end than before the virus, and downside risks will remain. The U.S. has already witnessed numerous large and small corporate bankruptcies this year; they will continue. Many small businesses, restaurants, hotels, and theaters won’t return. Other small and medium-size firms will have to reorganize, digitize, and downsize. Some bankrupt firms will remain open, reorganize, shed debt, renegotiate leases, preserve as many jobs as possible, and emerge leaner and stronger, either independently or as a merged entity of another firm. The business landscape will change.

Businesses will disappear and specific tastes will shift, but historically, overall consumer and business demand tends to return and grow. American consumers love to consume.

“I bought some pretty good stuff. Got me a $300 pair of socks. Got a fur sink. An electric dog polisher. A gasoline powered turtleneck sweater. And, of course, I bought some dumb stuff, too.” —Steve Martin

Historically, each $1 billion increase in e-commerce retail sales equals 1.25 million square feet of industrial real estate demand for warehouse and last-mile locations for online fulfillment. E-commerce growth has accelerated in the second quarter of 2020 and will remain strong. Technological advancements in logistic operations and booming internet sales will bring warehouses closer to consumers. Recall that Sears, JCPenny, and Kmart sales did not vaporize, they just transferred to other businesses like Amazon, Walmart, Target, and The Home Depot. Similarly, Toys “R” Us sales did not completely disappear; they transferred to Costco, Walmart, Amazon, Best Buy, and video game makers. E-commerce sales are only approximately 15% of all retail sales. Retail sales haven’t disappeared as much as they have shifted. Bankruptcies have led to some creative destruction where brick-and-mortar names downsize and digitize and some online names open physical stores—Warby Parker, Glossier, Away, Koio, Rent the Runway, Casper, Amazon Go, Indochino, and The RealReal—a trend called clicks to bricks. Pandemic sales of bicycles, inflatable pools, patio furniture, and home appliances have soared; retailers are low on supply and many items are on backorder. The retail of tomorrow will include necessities (groceries and pharmacies), values, experiential fun retail (with learning and interaction like that found at an Apple or Tesla store), services (salons, gyms, yoga studios), and cool destination retail (with curated restaurants and specialty retailers such as galleries, florists, jewelry, and bike shops). Regular retail is not dead, but some traditional physical retailers are better than others, and e-commerce has room to grow.

Support from the Fed has been robust. Near zero percent interest rates and a credible promise to do whatever is necessary to ensure smooth market function means that the February and March chaos is long past. The Fed’s quantitative easing (QE) program has acquired approximately 60% of the increase in the public debt since February. This means that the Fed is monetizing debt on an unprecedented scale. When the Fed buys securities from non-bank entities, it directly boosts the M2 money supply—cash, cash in banks, money market funds, and certificates of deposit—which has accordingly jumped up over the past three months. This monumental surge in liquidity is a key factor behind the equity rally, and it won’t reverse anytime soon. In addition, for stocks to do okay, reopening does not have to be smooth; it just has to be better than analysts’ low expectations.

The economy hit bottom in early April; most indicators of activity have risen substantially since then. With low interest rates and a demand for private yards, the recovering housing market could see home construction surpass post-2008 highs. A 16.6% jump in June pending home sales elevated the index to a 16-year record. Auto sales could also recover based on a reluctance to use public transportation. For better or worse, some people may make purchases now while they still have jobs, income, and credit. In an ironic twist, fear of more unemployment and income loss may compel people to purchase homes and automobiles while they remain employed with steady income and solid credit scores, knowing that if they were to switch jobs or employment status, they may lose their chance at such a purchase. 

Core durable goods orders are already close to pre-COVID levels thanks to recent consumer and business demand. So far, the hit to orders does not look like the crash of 2008 because back then every part of the economy dropped in unison, whereas in 2020 the pummel has mostly been constrained to certain sectors. Even so, the severe hesitancy of business capital spending means that a full manufacturing recovery is a ways off. A timely return to pre-COVID levels of discretionary consumer and corporate capital spending will require a cure or mass vaccination, hopefully by spring 2021. Meanwhile, home mortgage refinancings at lower interest rates will free up funds for consumers and help finances. Here is what we foresee over the remainder of the year:

• August/September: Once Congress agrees on a new stimulus bill, the Federal Reserve may again ramp up quantitative easing (QE): i.e., buy more Treasury bonds, push Treasury yield curve interest rates lower, boost the money supply, and further support asset prices.

This is also back-to-school (and college) season, normally one of the busier retail seasons of the year, but sure to be a mixed bag for merchants with many store shelves still empty and different institutions opening in a myriad of ways. How schools, parents, media and local healthcare react to the seemingly inevitable cases of superspreaders that will arise in schools remains to be seen. 

• September: The regular flu season will kick into gear. 2020/21 may be a relatively mild flu season because of all the hygienic precautions taken with COVID. Nonetheless, the Centers for Disease Control and Prevention (CDC) will emphasize flu shots as every sneeze, cough, throat tickle, and ache may create excess concern and confusion. “It may be hard to tell the difference between them based on symptoms alone,” cautions the CDC, “and testing may be needed to help confirm a diagnosis.”
• October: Halloween 2020, which falls on a Saturday, will probably be a tightly controlled affair with little random trick-or-treating. Candy and chocolate companies, although still hopeful, will be haunted by reduced sales compared to Halloweens past. Companies will produce less Halloween-themed packaging than last year in order to reduce the potential for unsold leftovers. Festive nose and mouth masks with little ghosts, witches, and skulls will be all the rage. Costume and mask contests will move online; call it Zoom-o-ween.
• November: Pre-election volatility and jitters will increasingly command headlines into the night of Tuesday, November 3 and the morning of Wednesday, November 4. The House will most likely remain under a Democrat majority, the Senate may flip from Republican to Democrat majority, and White House control remains a big question mark the entire world will watch. In 2016, U.S. stock markets responded positively to Donald Trump’s victory and the promise of lower taxes and less regulation. It remains to be seen how markets will respond to either candidates’ win or loss in 2020. Nonetheless, U.S. stock markets usually respond well to certainty, therefore, known election results should be a net positive.
• December: Employment and unemployment numbers will churn as more retail, restaurant, hospitality, and entertainment businesses reopen, but more higher-income employees are released.

NEXT STEPS: Currencies and debt are relative. Every government will walk away from the pandemic with more debt. If only one or two nations were to walk away with more debt, it would be very bad for them since debt and currency strength tend to be a relative game. As long as most major countries increase their debt burdens, relative valuation shifts will not be devastating. In other words, the U.S. dollar may weaken, but not devastatingly so relative to the euro and yen, which also have increased debt levels.

As stated previously, we expect third quarter GDP to be up sharply from an abysmal second quarter, and for it to rise further in the fourth quarter of 2020. Considering all the trillions of dollars of defensive and offensive monetary and fiscal stimulus supporting disposable consumer income, corporate lifelines, and asset prices, every new solid step that brings the world closer to a COVID-19 vaccine or cure will probably boost investor psychology and thereby stock and real estate values. What we will try to prepare for—for our clients and ourselves—is what will happen to business, employment, economy, and social welfare once a vaccine is widely distributed; the widely held assumption is that the socioeconomic world will return to normal growth, but that might not be the case as we wean ourselves off of so much stimulus.

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*Bond indices mentioned: Bloomberg Barclays Global-Aggregate Total Return Index Value Unhedged USD, Bloomberg Barclays US Agg Total Return Value Unhedged USD, Bloomberg Barclays Municipal Bond Index Total Return Index Value Unhedged, Bloomberg Barclays EuroAgg Total Return Index Value Unhedged EUR, Bloomberg Barclays EM USD Aggregate Total Return Index Value Unhedged, Bloomberg Barclays US Corporate High Yield Total Return Index Value Unhedged

Disclosure: The opinions expressed herein are those of Running Point Capital Advisors, LLC (“Running Point”) and are subject to change without notice. Running Point reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. This should not be considered investment advice or an offer to sell any product. Running Point is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Running Point, including our investment strategies, fees and objectives can be found in our ADV Part 2, which is available upon request. RP-20-25