Author: Christopher K. Merker, Ph.D., CFA

The second quarter GDP number came out this week and it was the worst on record, contracting -32% on an annualized basis. The projection for the third quarter is now estimated at +18%, which we expect will be one of the best on record. We have been saying since March the data in the short run will look horrific, but the upswing will likely be equally dramatic. However, the shape of the recovery continues to remain dependent on the path of the virus..

The probability for a successful vaccine, perhaps as early as the end of this year, remains high given current developments. A study out this week by the National Institute of Health (NIH) regarding the Moderna vaccine brought further welcome news on that front.^[1] In addition, the FDA is about to approve emergency use of antigen treatments from the blood plasma of recovered patients, which is anticipated to open the way for one of the most promising treatments for COVID-19 patients. 

Here in the U.S., despite increasing cases, we continue to see the level of hospitalization and ICU utilization remain well within capacity limits. Cases in the Sunbelt appear to be leveling off. As of the most recent CDC report (see table below) only 8% of hospital capacity is estimated to be COVID-19 related (about 64,500 patients), and total unused capacity for both hospital beds and ICUs is about 40% (approximately 320,000 inpatient and 50,000 ICU beds). As we have noted before, from the point of view of the markets, it is not the headline number of cases that is the issue, but rather the hospital utilization numbers and mortality rates. 

Estimates[2]	Number	Percentage
Inpatient Beds Occupied (all Patients)	504,432	63%
Inpatient Beds Occupied (COVID-19 patients)	64,496	8%
ICU Beds Occupied (all patients)	75,257	61%

So, we ask the question this week: at what level would new daily case counts overwhelm the hospital system? Given the ratio of hospitalization to current cases is about 3% nationally, and the average hospital duration is 11 days, we can impute the maximum daily case level from current available capacity figures noted above. Based on the hospitalization rate, cases could surge another 11 million before we would hit capacity from the current base of 2.3 million, representing a growth rate of 500%. Factoring in hospital stay duration results in the following: 11 million total cases divided by 11 days = 1 million new cases per day. 

The Institute for Health Metrics and Evaluation (IMHE) current projection of daily infections at current levels of social distancing projects daily infection rates of 115,000 (the seven-day average is closer to 66,700), a number they forecast declining into October. In contrast, the worst-case, upper end of their projections, assuming continued easing of restrictions, is 317,000 per day, or less than a third of our estimated maximum daily threshold. Short of a complete abandonment of any social distancing policies or practices, this level of new daily cases is unlikely to be realized.^[3]

Why is this important? Business restrictions and consumer activity will remain sensitive to these factors, and so as long as the medical sector can handle caseloads and the need for further shutdowns or greater restrictions lessens, the path of the economic recovery will continue. To the extent that hospitalization and mortality metrics improve through better treatments, the sharper the “V”, as shown in the figure below. The steeper the recovery, the better performance from equities, particularly across the many sectors that have lagged information technology this year. 

Markets and the Next Stimulus Package

For now, equity markets appear to be in a period of consolidation, although still up since the end of the quarter, as Congress determines the next fiscal stimulus package. With the additional $600 per week unemployment benefits set to expire today, Congress has been pushing forward on a plan to extend those benefits, albeit at potentially reduced levels.

The municipal market is anticipating that some portion of the bill will bring relief to current budget shorfalls. Since the May 12 HEROES act, the municipal market AAA scale has rallied by almost 50 basis points (0.50%). Democrats have proposed an additional $1 trillion of support, and the Republican side has proposed no support. Wall Street is estimating that they will compromise and settle around $400-500 billion of support for states and cities.

The NY transportation system, one of the largest municipal issuers, recently stated that they need an additional $3.9 billion to keep operating through the end of the year or it will be forced to implement severe cuts in order to meet the transportation needs of the city. In the meantime, numerous states have enacted temporary spending plans with the belief they will receive additional government support.

The Fed met this week and announced no adjustments to current interest rate policy beyond their intention to remain extremely supportive through 2022. The Fed also announced they will extend emergency lending programs by three months until year end. All but one of the nine programs was set to expire. These programs serve as a lender-of-last-resort and help support the lending function of the corporate and municipal markets.

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^[1] https://www.nih.gov/news-events/news-releases/phase-3-clinical-trial-investigational-vaccine-covid-19-begins

^[2] As of most recent data available, July 13, 2020 https://www.cdc.gov/nhsn/covid19/report-patient-impact.html

^[3] Sources: IMHE, Center for Disease Control (CDC), Worldometer

Education and the reopening of schools came into focus this week. Approximately 40% of households have at least one minor child at home, which has ramifications for the labor market and consumers.^[1] The path to mobilizing 56 million students back to schools is not clear cut, and a number of school districts are in the midst of announcing plans that run the gamut. Earlier this week, Los Angeles announced the decision to remain virtual despite the fact that a third of their students never logged on during the shutdown last spring (Baird-Strategas). The implications for students and families that remain at home are significant, and the pressure has been on to find ways to make education in the classroom a safe reality. The CDC is currently working on a set of new guidelines to help school districts accomplish this in the coming days. About 65% of universities and colleges have already announced their decision to bring students back in the fall, albeit with adjustments and cautionary measures in place.^[2]

In the meantime, cases continue to surge, but mortality rates have remained flat over the past seven days. It is interesting to note that Miami-Dade County, which has been described as the new Wuhan or epicenter of the pandemic, never re-opened its restaurants and bars. California, the first state to shut down, has sought to reinstate a limited lockdown, which will have implications for its local economy. Recent data shows that states that emerged from lockdown earlier have consistently seen lower unemployment rates and faster recoveries.^[3]

The stock market continued its rally this week, as economic data continued to show signs of improvement. At the close of the market on Wednesday, the S&P 500’s year to date return was flat for the first time since the crash in March. The NFIB survey of small business revenue expectations came out this week, showing the fastest snap-back on record, and a near complete recovery since first quarter of this year (see figure).^[4] While it was highlighted recently in the press that 20,000 to 30,000 small businesses have experienced closure this year, it’s important to note that this is a fraction of the nearly 30 million American small businesses.^[5]

Equity

As the sentiment among smaller companies improves, our rebalance in mid-May from large cap equities to the small cap sector is paying off. With Wednesday’s big move in small cap, our small cap sleeve has pulled ahead of both the large cap growth and value indexes, up 19.54% versus 15.27%, respectively, over this time period. Large cap technology enjoyed a strong rally from mid-May before correcting in the second week of June. Since that time, small caps have steadily gained traction as supportive economic data from the re-opening of the economy has rolled in. Of note, the Russell 2000 (small cap index) still has a good bit of room to run here as the index is still down nearly 12% YTD versus the Russell 1000 (large cap index) , which is nearly even for the year.

Fixed Income

The Fed owns $4.2 trillion of U.S. government debt, roughly 22% of the total outstanding. Since March it has purchased about $1.7 trillion in treasuries with the aim to improve market function primarily focused on the short end of the yield curve. With the short rates anchored near zero, the curve experienced some steepening YTD (2s/10s) of around 45 basis points currently. The yield curve flattened a little in June with COVID-19 cases increasing, but we expect that steepening to continue at a very gradual pace. 

• Real yields remain in negative territory showing the easy monetary conditions
• The Copper/Gold ratio shows rates should be heading higher
• 10-year breakeven has been climbing off the lows of March – a sign that inflation is expected to increase, but still at a low level of only 1.4%

^[1] https://www.statista.com/statistics/242074/percentages-of-us-family-households-with-children-by-type/ 

^[1] https://www.cnbc.com/2020/06/23/65percent-of-colleges-are-preparing-for-in-person-classes-this-fall.html 

^[1] https://www.wsj.com/articles/californias-second-shutdown-11594770566?mod=searchresults&page=1&pos=1 

^[1] Source: Baird-Strategas

^[1] https://www.oberlo.com/blog/small-business-statistics

We begin this newsletter with research conducted by Baird Private Asset Management in response to the recent focus in the media regarding pressure on ICU capacity limits in states that have seen an upsurge in the virus.[1] One fact that has not been widely reported in these stories is that under normal conditions, ICUs at hospitals tend to run at higher levels of capacity, in the range of 55% to 82%. We examined the top 10 states by GDP contribution (cumulatively about 60% of total US GDP), and found that ICUs are actually running within or even below normal ranges.[2] This includes the Sunbelt states, Florida, Texas and California, which have been held out among the leading states experiencing case surges. Remarkably, over the last seven days total estimated ICU admissions have increased by a fractional 635 cases as compared to approximately 375,000 new cases, or 0.17% (Arizona saw a mere increase of 65 cases, and California was actually flat). This compares to peak ICU occupancy due to COVID back on April 17th of 18,000 compared to 6,396 today, when new daily case rates were half of what they are currently.[3]  Equities. With the ongoing rally in stocks, investors continue to question whether current valuations are justified or disconnected from reality. A review of year-to-date industry sector performance suggests that recent valuations remain in-line and fairly priced, and that – with only two of eleven sectors significantly positive for the year – what appears to be disconnected are the indices themselves. Take the S&P 500 index for example, which is now down a mere -2.65% on the year, compared to the underlying sectors that comprise it. This is due to the market-cap weighted structure of this index and many others like it, i.e. larger stocks by market value make up a greater percentage of the index. With the run up in technology stocks, this one sector alone now comprises nearly 30% of the index. The valuations are not at a level that is concerning to us, but the concentration of this sector within the index is at a level we haven’t seen since the “Dot Com” bubble of the late 1990’s.   What this means is that there are segments of the market that remain undervalued and attractive, and there are abundant opportunities in strategies away from the index.

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^[1] https://www.cnn.com/2020/07/07/health/us-coronavirus-tuesday/index.html

^[2] Source: States’ departments of health

^[3] Source: Institute for Health Metrics and Evaluation

Today we provide a brief update in advance of the Fourth of July holiday weekend, with the markets closed today. The second quarter that ended on Tuesday was the best quarter for the stock market in more than 20 years. This, of course, came on the heels of one of the worst quarters in recent memory, with the stock market falling 35% in less than six weeks due to the shutdown of the global economy at the start of the coronavirus pandemic. The recovery in the markets has been spurred by strong resumption of economic activity combined with unprecedented government stimulus. The S&P 500 finished the second quarter up 20%, its biggest gain since the final quarter of 1998. The rally has cut losses for the year on the S&P 500 and Dow Jones Industrial indexes to -4% and -9.6%, respectively.

The market has looked past the – especially recent – rising number of coronavirus cases considering improving therapies, falling mortality rates and strong prospects for an effective vaccine.  There are over 100 vaccines in development, a handful of which are already at Stage 3 testing. Some lingering concerns remain at the prospect of resumption of shutdown policies in certain hotspots like California and Florida, but for now, the current trend is mitigation through masks and continued social-distancing, with some renewed restrictions on bars and restaurants.  

We had another blow-out jobs number this morning with 4.8 million jobs added in June; well above the 3.7 million anticipated. The unemployment rate now stands at 11.1%. The U.S. had lost more than 22 million jobs at the height of the shutdown in April and has since added back 7.5 million. In addition, new claims for unemployment fell this past week to 430,000; the lowest level since February.  

Investments

While stocks continue to move higher, bond yields remain low and spreads continue to tighten. Credit and municipals have largely recovered from steep losses in Q1. The general tone of the market remains constructive and firm, and demand continues to outstrip supply. The Fed remains a significant portion of that support by purchasing ETFs and individual bonds through its Corporate Credit Facility, which opened on June 29. 

We are also seeing stabilization in the commercial mortgage-backed securities (CMBS) markets after dropping in May. The weakest segments in the BB and BBB- segments have stabilized to some degree over the last few weeks. While we don’t invest directly in the CMBS markets, this is an important indicator for the real estate market. We expect to see a negative Q2 return for real estate; however, most of the impacts have been concentrated in the hotel and retail sectors, where our managers do not heavily invest.  As shown in the table below, these two sectors make up the majority share of CMBS that have transferred into special servicing (i.e., workout, both pre- and post-Covid-19).^[1]

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^[1] https://www.fitchratings.com/research/structured-finance/coronavirus-pushes-20-billion-of-cmbs-into-special-servicing-17-06-2020

https://www.retireguide.com/guides/covid-19-retirement/

The COVID-19 pandemic and accompanying financial crisis leaves uncertainty for the 18 million Americans expected to retire in the next five years. At the same time, research suggests that millions of U.S. workers are retiring early — a move that could jeopardize their long-term retirement goals.

Asked last month about when fatalities and hospitalizations would meet state thresholds for reopening, Mr. Cuomo responded: “All the early national experts, ‘Here’s my projection model.’ . . . They were all wrong. They were all wrong. . . . There are a lot of variables. I understand that. We didn’t know what the social distancing would actually amount to. I get it, but we were all wrong.”  The Wall Street Journal, “What Covid Models Get Wrong” June 18, 2020  The U.S. policy emphasis for the pandemic appears to be shifting from economic shut-down to crisis management. On Monday, Mr. Gavin Newsome, the governor of California, said “We have to recognize you can’t be in a permanent state where people are locked away—for months and months and months and months on end—to see lives and livelihoods completely destroyed, without considering the health impact of those decisions as well.”  And while the University of Washington’s Institute for Health Metrics and Evaluation[1] has issued a new forecast that Covid fatalities could increase over the summer and see a resurgence in the fall, Stanford epidemiologist, John Ioannidis explains in a new paper that most models have overshot by making incorrect assumptions on virus reproduction rates and equal susceptibility across populations.[2] For example, a Massachusetts General Hospital model predicted 23,000 deaths in Georgia, the first state to reopen, but Georgia has had only 896. Forecasting errors like this have tended to be in the 10 to 20 times multiple range. For example, early estimates in the U.S. were for 2 million deaths, as compared to current projections, which have ranged recently from 140,000 to 200,000.  Even in the face of rising infection rates, policymakers may now shift their attention to hospital utilization and mortality rates. We noted last week, in states where there have been rising rates, lower utilization and mortality rates suggest that the crisis can continue to be managed without another lockdown (see below chart). Hospital utilization has remained relatively flat, even with the uptrend in cases, in states such as California. Continued development in therapies is supporting this trend in declining mortality rates with this week’s announcement of an application of a readily available steroidal drug, dexamethasone, as only the most recent example.  In the meantime, a wash of new studies is finding that in addition to the models not accurately forecasting the impacts of the pandemic, the shutdown itself was only marginally beneficial. A recent paper by the University of California at Berkeley found that, while social distancing reduced person-to-person contact by 50%, more stringent shelter-in-place rules only further reduced contact by another 5%.[4] A USAToday analysis found that over 40% of the mortalities have come from nursing homes, suggesting that despite whatever shelter-in-place directives may have accomplished, it failed to protect some of the disease’s most vulnerable populations.[5]  Markets Why do we continue to focus on the pandemic each week in our analysis? Because market performance will be driven by the pandemic and how it impacts corporate earnings, at least for the near term. As we await second quarter earnings over the next couple of weeks, we have been encouraged by leading indicators, which in large part have exceeded earlier estimates. One chart from yesterday morning’s update from Baird-Strategas provides additional support to a V-shaped recovery, with the Citi Economic Surprise Index resting at an all-time high.  This week’s retail sales number of 17% vastly exceeded the 8% expected by economists and, while yesterday’s first time unemployment claims number was somewhat above estimate, other indicators like airline traffic and restaurant reservations provide a sign that the economy continues to rebound.  Both the corporate and municipal bond markets continue to see strong demand backed by Fed support. For example, a recent JFK airport bond backed by American Airlines/British Airways was 10 times oversubscribed, allowing them to increase the size of the deal. We have also seen universities and New York bonds come to market and receive strong interest. While we would not invest in these higher risk issues, it does demonstrate significant support to the overall market. The downside of this positive stabilization in credit is that yields have dropped to all-time lows, and it appears will stay there for quite some time.  In light of this low-yield environment, our research team is diligently working to develop investment options for supplementary income in dividend-oriented investments, and we will be reporting on this more in the days to come.

On Thursday, the market sold off nearly 6 percent in one day, after rallying for several weeks. The sudden drop seemed to follow investors expressing concerns around two issues: 1) What’s the risk of a second wave of the virus? and 2) What about the slow path to recovery?  Let’s take each in turn:  The Path of the VirusThe news is reporting this week that coronavirus infection rates have been rising in 12 states despite the overall numbers continuing to fall. States like Arizona, Florida and Texas have received a fair amount of attention. Arizona’s daily case rates have increased 125% since reopening on May 6. However, a deeper dive into the numbers being reported by the Arizona Department of Health reveals a mixed picture.    What has not been a point of focus in reporting on the case rates in Arizona is that hospitalization and death rates have plummeted from one month ago, down 64% and 73% respectively.[1] Accordingly, these increases have not disrupted hospitalization utilization rates, which have remained relatively stable over the last few weeks in the 73-78% range. Texas, the second most populous state in the U.S. with nearly 30 million people, has seen the level of hospitalizations since the reopening on May 11 increase by 280 cases. These numbers are consistent with Florida’s recent increases. There are other states that were among the first to reopen, like Georgia, which have not seen any real pick up in new rates of infection. Absolute numbers could, of course, increase if the topline infection rates further accelerate, so we will continue to carefully monitor this trend. In the meantime, the overall picture continues to improve for the nation, with both declining daily new infections and deaths since the states began reopening in late April:[2]                         The Path of the Recovery Last Friday’s positive surprise on the 2.5 million jobs in the month of May capped the market’s recent achievement of the fastest market recovery on record, but volatility re-entered the market this week following Fed Chairman Jerome Powell’s comments from the Federal Open Market Committee (FOMC) meeting on Wednesday. The FOMC announced holding the target rate low in the range of 0% to 0.25% with a unanimous 10 to 0 vote. Overall the statement was fairly uneventful, but there are interesting takeaways from some of the projections and commentary. Almost all of the policy members expect the Fed funds rate to remain near 0% through the end of 2022. Only two members out of the 17 are in favor of raising rates even in 2022. Regarding the timing and size of future adjustments to rates, the Fed reiterated that it will take into account labor market conditions, inflation pressures (which continue to be muted) as well as financial and international developments. For bond investments this means that our emphasis on quality will continue to serve as an important source of liquidity and stability in the portfolio. As rates eventually begin to normalize we will be able to buy into issues at higher rate levels, just as we did following the 2008 crisis. The Fed plans to keep rates low, adjust as needed and continue to support the economy as necessary. Powell cited an “unbalanced nature” of the recession and reiterated a few times that they want the markets to be working. The Fed-provided liquidity has been a powerful mix for stocks, but Powell did make it clear that once the crisis has passed, the Fed “will put these emergency tools back in the tool box.” The Fed’s projection of 9.3% unemployment by year-end was also very much in line with our earlier estimate of 8-10%. Yesterday’s new claims for unemployment (1.54 million) were approximately 23% below the consensus estimate, providing further evidence of an improving labor market. This bodes well for stocks over the long run. The pullback on Thursday was a reminder of the volatile nature of stock investing, but on balance we view the pull back as invoking important discipline in the market. Consolidation at this stage allows for a more stable and consistent pace of growth as corporate earnings recover and eventually catch up to valuations.   [1] Comparison of COVID daily statistics from opening (May 6) to most recent (June 4).While these looked at single day comparisons, it’s important to note that the three and seven day moving averages were similar. Arizona Department of Health COVID-19 Dashboard https://azdhs.gov/preparedness/epidemiology-disease-control/infectious-disease-epidemiology/covid-19/dashboards/index.php    [2]  https://www.worldometers.info/coronavirus/country/us/