22 Oct GUEST COMMENTARY: Gord Glagau, CFA – The Three Stages of the Pandemic “Recovery” (OCt 16, 2020)
I love to learn. And when asked about the best days of my life, my answer is always when I was in university. For sure, gaining some independence by living away from home, getting together with new friends, playing sports…all of these were great. But one of the things I liked best was the discovery of new ways of looking at the world. I learned a lot from studying world history, languages, and political science. And, here is where I have to admit, I’m also a bit of a math geek. This served me well in economics, because what I learned was the importance of understanding the mathematical relationships between various parts of the economy. Exchange rates, corporate profits, commodities, imports/exports, inflation, equity prices, employment, interest rates, taxation…all of these are connected in some way in the complicated world we live in.
If these relationships weren’t complicated enough in a static world, constant change adds yet another level of complexity. The dynamic nature of the economy is what drives economists to focus not only on the absolute level of corporate profits, imports/exports, etc., but also on the rates of change. And it is these rates of change that are often the subject of economic forecasts, driven in part by the linkages in the economy as well as changes in expectations.
These expectations are powerful drivers of economic behavior. They lead us to make investments – often in risky assets – that we think will provide a return in the future. Financial markets work as a clearing house of these expectations, finding a price at which there is a buyer for every seller. And, in my view, underlying the current market are a set of expectations that I’d like to summarize:
- Almost unlimited monetary and fiscal support will continue for the foreseeable future;
- Inflation is in check and interest rates across the yield curve will not rise for a long time; and
- The pandemic will be “cured” by a vaccine widely available to all within a few months.
Monetary and Fiscal Support
“Don’t Fight The Fed” has become the rallying cry of many investors. This is the view that the US monetary authority has almost unlimited powers and is committed to doing whatever it takes to get the economy back on track. In 2020, the US Federal Reserve was the primary buyer of US securities, and extended those purchases to corporate bonds and mortgage-backed securities. Prior to the 2008 financial crisis, the US Federal Reserve held about $1T ($trillion) in assets. As recently as March of this year, that number grew to $4T and now stands at over $7T! This additional liquidity has driven bond yields to historic lows forcing investors into riskier assets such as junk bonds and equities.
Fiscal support has also been unprecedented. This year, the US budget deficit is forecast to be 17.9% of the size of the economy and by June, 2020, the accumulated federal debt to the size of the economy reached 136%. Other economies, such as Canada, are running budget deficits at over 20% of the size of its economy. To put this in perspective, the European Union promotes financial stability by limiting annual deficits to 3% and debt to 60% of the size of each individual country’s economy.
One of the biggest enemies of the bond market is inflation. Currently, 30-yr US treasuries are only yielding 1.5% against an annual inflation rate of 1.4%, leaving a real return of only 0.1%. For shorter maturities such as the US 10-yr treasury, the yield is only 0.73% for a negative real yield of 0.67%. It should be noted that in order to support a well-functioning economy, the US Federal Reserve targets inflation at 2.0% over the longer-run. So what does this say about the current prices for US Treasuries?
One thing that is true about this pandemic is that it has made amateur epidemiologists of us all. Almost every conversation I’ve had with friends over the last six months has started off with a critique of the social distancing measures, masking, and progress on a vaccine. Just to be clear, I am not an expert. But I think reaching “herd immunity”, when most of a population is immune to an infection so transmission is stopped, is quite a ways off. Using history as a guide, most successful vaccines take years not months to develop. Now, I know this pandemic has focused international efforts in a way that almost no other virus has. But, in many ways, you just can’t rush the science.
You may have already concluded, like me, that the expectations underlying the market are overly optimistic. Globally, a second wave of the pandemic is underway which is likely to strain fiscal and monetary authorities even further. There must be some limit to the amount a government can borrow in the same way as a central bank’s balance sheet must have an upper limit. And, as I have written before, the conditions for creating inflation have never been better. There will come a time when bond investors will no longer be happy with a negative real yield and start driving interest rates higher. And this will happen at a time when central banks have already used all the tools available to them to keep rates low.
So, here are my thoughts about what the market should expect: a three-phased recovery.
- We’ve already been through phase 1, an unprecedented drop and almost instant recovery in stock and bond markets.
- But as I argued, the markets have gotten ahead of themselves. I think phase 2 will be characterized by higher volatility in both stock and bond markets, but ultimately trade sideways for quite a period of time. It will take time to recalibrate profit growth, particularly given uncertainty about the health of the underlying global economy.
- And finally, perhaps a few years out, we will reach phase 3, which will be a “new normal”. This stage will be characterized by higher inflation (leading to higher interest rates) and higher taxation.
To take advantage of the expected near-term volatility, keep a larger than usual allocation to cash. And if you need some yield, it is better to go into high-quality dividend paying equities such as utilities and especially banks and insurance companies. To take advantage of the volatility, consider banks with a larger trading business such as JPMorgan (JPM) and Citigroup (C) in the US and Royal Bank (RY) in Canada. Avoid banks with a larger retail business that is more exposed to the health of the consumer.