| Studies show humans have a built-in negativity bias, which means we give bad news a lot more attention than good news. Consider a couple of jarring headlines taken from the recent financial press: “Don’t even think of owning stocks unless you’re willing to buy and hold for at least 10 years”[1] “Global losses could be $10 to $20 trillion from a global economy worth $85 trillion”[2] A 2019 study reported in the Proceedings of the National Academy of the Sciences found that this bias transcends borders and cultures, and is likely rooted in our evolutionary biology:[3] Attention to negativity may have been advantageous for survival. Negative information alerts to potential dangers; it has special value in terms of “diagnosticity”, or the “vigilance” that is required to avoid negative outcomes. This account of the negativity bias is evident in literatures in physiology, neurology, and, particularly, work on the importance of “orienting responses” in evolutionary biology. And this is particularly true during periods of heightened uncertainty such as now, especially in our journalism and news coverage: Societies deal with anxiety about future uncertainties in different ways, and the extent to which members of a culture feel threatened by ambiguous or unknown situations may well affect the tendency to focus on negative information… Another dimension of variability is rooted in the institutionally coded professional practices of journalists. A strong professional requirement that journalists routinely cover politics in conflictual terms may also lead to viewers’ habitual expectation and attention to negativity. Further evidence comes from the Pew Charitable Trusts, which studied news reported over a two decade period, and found that the stories that generated the most interest from people focused on war and terrorism, despite the fact that incident rates for both were in decline to among their lowest levels in human history during the study period.[4] While negativity bias is no doubt helpful when running away from a hungry bear, it is not of particular use to an investor in dispassionately evaluating prospects for long-term portfolio selection. Equities Which brings us to a point regarding a topic we introduced last week: how can equity valuations be what they are with the economic news currently so poor? The economic data, while negative, is starting to improve now that all 50 U.S. states are at different stages of opening their respective economies. The stabilization of oil prices in the $30 dollar range is one such recent example, as supply has come down and demand has moved up. With these improvements, markets begin to price in the recovery in advance. Strategas (a Baird company) pointed out yesterday morning that P/E (price to earnings) ratios of stocks spike during recessions when earnings collapse, typically a very bullish indication, and then decline as earnings catch up. Additionally, P/E ratios tend to run higher during periods of low interest rates and inflation such as this one. Why? Consider the role of the discount rate. When looking at any future stream of cash flows, in order to assess their current value we must discount them to the present in light of risk (risk premia) and alternative options (opportunity costs) for return. If rates are lower, then the value (of the combined flows) will mathematically be higher. That’s the finance textbook explanation; a more intuitive explanation is to consider how much a stock that pays a 2% dividend with the prospect of capital appreciation might be worth to an investor versus a 10 year treasury bond that pays only 0.70% coupon rate of interest, and virtually no prospect of appreciation. While we do not expect corporate profits to recover in the very near term, the market is effectively peering through the current economic wreckage and discounting the eventual recovery in corporate profits. By not focusing on the current negative data and re-orienting to the improving data, the market is generally consistent in pricing a scenario we are projecting of a 5% contraction in U.S. GDP with an unemployment rate of around 8 – 10% by year-end (Baird Strategas), with a recovery in latter 2021. Already we are seeing this dynamic feed into the small cap and emerging market companies. On a quarter to date basis, the Russell 2000 index, a barometer of small company performance, is marginally ahead of the S&P 500, 13.6% versus 13.4%, and emerging market stocks are up 9.3% versus international developed, up a mere 6.7%. A thesis we identified a couple of weeks ago is beginning to manifest, and our tilts into both segments in client portfolios have added value. Fixed Income As the fixed income markets digest the long-term impacts of the coronavirus as well as the effects of monetary and fiscal stimulus, they continue to normalize and function more efficiently with credit spreads and yields continuing to compress since the March volatility. The Federal Reserve’s $500 billion Municipal Liquidity Facility program has opened to state and local governments. The program is designed as a last resort for municipalities, with the Fed encouraging them to find alternative forms of financing before tapping into the program. The Fed also recently adjusted their rules to allow participation in states that have competitive bid requirements such as Illinois. Accordingly, the state of Illinois announced Thursday that it is working on a notice-of-interest requirement that it will be submitting to the Fed as a precursor to applying for a loan from the program. Municipal borrowers continue to find ways to access the markets with traditional lenders but have also increased their use of private placements, bank loans and direct lines of credit as alternative funding vehicles. A number of municipalities with lower credit quality, including states such as Illinois and Connecticut, as well as several university systems, were able to come to the market this week and price bonds with healthy demand. The corporate market has seen new issuance volume increase over 88% compared to a year ago, including participation from some of the hardest hit industries such as travel and leisure. Many corporations have come to the market to issue longer-term debt to pay down the revolving credit they took on during the height of the crisis. Overall, we continue to see the fixed income markets positively react to improving market dynamics and Fed support, and we remain focused on maintaining higher quality in the core fixed income portfolios, with a tactical shift into high yield in Diversified Fixed Income. Past performance is not indicative of future results and diversification does not ensure a profit or protect against loss. All investments carry some level of risk, including loss of principal. An investment cannot be made directly in an index. |
