| In almost a tale of two cities, protests and looting have emerged in over 100 cities across America over the past week for George Floyd, a man who tragically died in Minneapolis police custody, on May 21. And yet despite the widespread civil unrest, this morning’s job market surprise of 2.5 million jobs created in May has capped a week with markets ticking higher throughout. This 50-day rally on the S&P 500 has outpaced any such prior period for the last 50 years. We are no doubt witnessing strong resilience of the U.S. economy. While this is proving to be a very painful period of adjustment in American history, and may yet drive an extended period of policy reform, Barron’s provided a succinct analysis this week as to why civil unrest has not been a detractor to market performance.[1] That lack of reaction isn’t surprising in one regard: Wall Street filters most news through the lens of share prices. It’s a voting machine on the future of corporate profits…The first thing Wall Street does when something new and unexpected happens is look to history for precedents. In this instance, that exercise sends analysts back to painful periods including President John F. Kennedy’s 1963 assassination, the 1965 civil rights march in Selma, Ala., the large 1967 Vietnam War protests in Washington, D.C., the 1968 assassination of Dr. King and the 1992 L.A. riots which broke out in the aftermath of the acquittal of several police officers put on trial for beating Rodney King. What does the reaction to these events show? Historically, the market looks past most civil unrest. Stocks aren’t significantly more volatile in the months following any of the events listed. What’s more, the S&P rose in each year under study. Annual gains, excluding dividends, ranged from about 4% to 20%. At the same time what started as a rally concentrated in a few technology and health care names, more recently has achieved broad-based participation, with 96.8% of S&P 500 companies now outperforming their 50-day moving average; and the equal weight S&P 500 index, which significantly lagged early on, is now since the beginning of the quarter in-line with the more widely-recognized, market cap weighted S&P 500 index. In addition, we are seeing small cap stocks outperform large cap stocks, with the Russell 2000 index up 26.2% versus the S&P 500, up 21.3% through the quarter. Finally, we are seeing a shift in leadership from growth to value companies, with the large cap value index (Russell 1000 Value) outperforming the large cap growth index (Russell 1000 Growth) nearly 2 to 1 for the month, led by the financial sector. As we noted last week, an earlier shift to small cap companies in client portfolios has added value. Maintaining a neutral weight between value and growth is similarly starting to add value within the portfolio. Fixed Income ReviewThe short end of the yield curve continues to remain fairly range bound set by the Fed Funds rate of about 5 basis points (0.05%), but further out on the curve you are starting to see steepening. There are a few factors that play into this. The curve is steepening as optimism builds as states reopen and public health concerns continue at a rate the health care system can handle. As the yield curve continues to build in future economic growth, it is also building in some additional inflation. Although inflation expectations continue to remain muted, the long end of the curve is starting to price in some drift upwards. Long-dated treasury bonds have also become slightly less desirable as the U.S. continues to borrow to fund the massive economic stimulus. The Federal Reserve recently began to openly discuss the concept of yield curve control, which it last used during World War II. This policy calls for the Fed to set targets for the treasury yields and buy as many bonds as necessary to maintain those levels. From initial Fed comments, it appears they will target the shorter end of the curve but leave the long end to float freely. The Fed has been pulling back as an active buyer of treasuries reducing their net purchases, which is also putting additional pressure on long treasuries. In the end, we believe a steeper yield curve is a healthy sign, if done in a gradual manner. If rates on the long end rise too quickly, it will tighten financial conditions, and we would expect the Fed to step back in. The Fed has various tools and has shown they are not afraid to adjust policy when market conditions warrant. In the meantime, we remain duration neutral to the benchmark, and continue to emphasize quality in the portfolio. |
Covid-19 Crisis: Economy & Markets (Chris Merker)
Much hay is being made this week regarding the April Consumer Confidence number, which compared to the monthly change in the S&P 500 index showed the widest-gulf on record since 1978, when the University of Michigan survey began. The explanation offered in the financial press is that this supports the “dislocation” theory of the stock market and the economy.[1] What has not been widely reported is the second part of that survey that covers Consumer Expectations, which have remained relatively strong and stable. Important to note is how this led the 2009 recovery.
We are monitoring the job market very closely to see whether consumer expectations are able to play out as the economy reopens.
The recent Memorial Day holiday weekend offers a very telling sign that consumers are responding favorably to the economy re-opening. Based on the significant and widespread jump in retail activity compared to the beginning of the month, we find some measure of optimism is warranted.
https://fingfx.thomsonreuters.com/gfx/editorcharts/xegpbymlzvq/eikon.png
And in the meantime, the path of the virus continues to head in the right direction with daily cases continuing to decline in the U.S., even with a number of areas of the country several weeks into their re-opening.
Fixed Income Review
For the last few years we have seen an uptick in headlines around debt-laden companies and municipalities. These concerns have once again come to the forefront during this crisis as future cash flows are more uncertain. Over the last two months the amount of debt classified in the U.S. as distressed has surged 161% and in April alone, corporate borrowers defaulted on $35.7 billion of bonds and loans, the fifth largest monthly volume increase on record according to J.P. Morgan.
Historically, the investment grade corporate sector has experienced a 3.6% default rate.[2] COVID-19 has super-charged and exposed many problems that pre-dated the pandemic. Many of these weaker firms facing challenges have struggled for years, and the recent economic turmoil has accelerated the reality of what was likely to play out over time, and compressed that into just a few months. In general, these companies are in challenged sectors, have weak balance sheets, questionable business models and / or poor management.
These at-risk companies are generally focused in a few sectors with approximately 33% of the defaults in consumer discretionary (majority coming from retail); followed by energy at 21%. Defaults include J. Crew, Neiman Marcus, J.C. Penny and the recent filing by Hertz.
Take Hertz as one example: A company that was poorly managed with high CEO turnover, four in just a few years. The company took on huge amounts of debt to finance its acquisition of Dollar Thrifty, and mismanaged its fleet (i.e., it emphasized sedans, only to have consumers demand SUVs, and then faced weak used car values when disposing of such inventory).
In the case of the Energy sector, most of the at-risk companies have been smaller players in the exploration and production space that had very weak balance sheets, and were structured for oil production at much higher prices.
So we find ourselves in a situation where, with the support of the Fed, market liquidity has started to improve the overall health of the market, while at the same time we have seen an uptick in challenged businesses.
The $3.9 trillion dollar municipal bond market remains a highly-rated market. Although defaults are headline-grabbing like Puerto Rico or Detroit, they are extremely rare. Investment grade municipals have defaulted at a rate of 0.28% since 1986.2 The areas most prone to default include specific project-financed bonds, and bonds focused around hospitals and healthcare. Data compiled by the Pew Charitable Trusts shows the vast number of states entered this crisis much stronger relative to 2007 (prior to the Global Financial Crisis) based on Rainy Day Fund levels, and they are now being supported by additional Fed assistance. This support has led to a strong rally in municipal bonds from the lows, even allowing for some of the more challenged credits to gain access to the market.
[1]https://www.wsj.com/articles/the-stock-market-and-consumer-sentiment-are-telling-different-stories-11590571805?mod=searchresults&page=1&pos=4
2 Source: S&P. For municipal defaults, S&P’s study period was Jan. 1, 1986, to Jan. 1, 2019. For corporate defaults, S&P’s study period was Jan. 1, 1981 to Jan. 1, 2019. The calculation represents a 15 year cumulative default rate.
3 Pew Charitable Trusts https://www.pewtrusts.org/en/research-and-analysis/articles/2018/08/29/states-make-more-progress-rebuilding-rainy-day-funds
A Framework for Sovereign ESG Risk Assessment (SAGE Advisory)
https://www.sageadvisory.com/media-assets/a-framework-for-sovereign-esg-risk-assessment/
Even though government debt represents approximately 41% of the $255 trillion global bond market, the level of vigor in Environmental, Social, and Governance (ESG) analysis that is applied to the issuer is not always the same as it is in the corporate space. Sovereign debt, which is issued by central governments, is particular- ly vulnerable to a lack of adequate ESG assessment. It is often passed off as a risk-free asset meant for capital preservation and stability, especially in the case of developed countries’ debt issuance, but events of the past two decades have showcased the need to rethink this notion. Greece struggled mightily after the 2008 fi- nancial crisis, requiring bailouts from the International Monetary Fund, European Central Bank, and the Euro- group, and lenders still took a huge hit on defaulted loans. And possibly even worse, Argentina (on the cusp of being classified as a developed country) has been engulfed in a debt crisis for the past 20 years, and creditors continue to get punished for holding its debt, with no real viable solutions moving forward.
Population-level COVID-19 mortality risk for non-elderly individuals overall and for non-elderly individuals without underlying diseases in pandemic epicenters (Yale and BMJ)
MAIN OUTCOME MEASURES: In people age <65 absolute COVID-19 death risk expressed as equivalent of death risk from driving a motor vehicle CONCLUSIONS: People <65 years old have very small risks of COVID-19 death even in pandemic epicenters and deaths for people <65 years without underlying predisposing conditions are remarkably uncommon. Strategies focusing specifically on protecting high-risk elderly individuals should be considered in managing the pandemic.
https://www.medrxiv.org/content/10.1101/2020.04.05.20054361v2
Covid-19 Crisis: Negativity Bias and the Markets (Chris Merker)
| 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. |
Covid-19 Crisis: Markets and Valuations (Chris Merker)
| COVID-19 Crisis – Week Ending May 15, 2020 How can stocks be trading at current levels when the economic data is so abysmal? That is the theme for this week and it is a fair question when looking at the data: GDP is expected to contract between 4 and 6 percent this year, and near-term unemployment rates may attain a level of 17%, a level not seen since the Great Depression. When you consider how much economic value will be lost from GDP contraction (what we define as a recession), the reality is quite staggering. A 5% contraction would result in an estimated $1.1 trillion in reduced GDP. In order to offset this, the Federal Government has provided about $2.7 trillion in direct support to households and businesses through the CARES Act and other programs. The offset to the loss ratio is 2.45 to 1. This does not include the additional monetary support provided to companies and municipalities by the Fed, which is now in excess of $6 trillion. In total, the combination of fiscal and monetary stimulus represents approximately 40% of GDP, or about $8 of stimulus for every dollar loss of GDP. Even with this offset ratio, the concern remains regarding how much dislocation will occur in the process due to business bankruptcies and unemployment. In other words, what job losses will be made permanent? If we accept that a large portion of the April layoffs were indeed temporary, then we should see those jobs come back relatively quickly. The Bureau of Labor Statistics in a recent survey found that 78% of respondents believe their job loss is temporary.[1] If we find that there is more structural damage from the shutdown, then this could prolong the recovery both in the economy and in corporate profits. It is forecast that 94% of the country will begin to emerge from shut-down by Memorial Day and each day that businesses are able to get back up and running will mitigate this permanent loss. But what about the path of virus and the effect this will have on consumption? Clearly, certain areas of the economy will lag as we come out of this. We don’t anticipate travel and leisure industries to rebound immediately. Restaurants, bars and theaters, for example, will only slowly come back due to social-distancing restrictions. We are watching closely as states such as Georgia, Texas and others re-open to get a gauge of these areas. For other sectors, it will depend on the speed and resumption of consumer activity, and if the housing market is any indication, a recovery is already clearly underway.[2] Finally, and as the Wall Street Journal recently noted, price to earnings measures only get you so far, but they do provide some guidance.[3] Strategas (a Baird company) forecasts that earnings on the S&P 500 could be around $110 by year-end, approximately a 31% decline since year-end 2019. Applying a simple price to earnings (P/E) ratio of 18 would suggest a level on the S&P 500 of just under 2000. The S&P in March bottomed around this level, suggesting that the damage to corporate profits was realized and priced in at the bottom end of the cycle. As markets undergo recoveries they tend to look out six months to a year. [4] Today the S&P is at 2,820. The Street consensus is that earnings will recover by the end of 2021 at around $170, and again, applying an 18 P/E multiple would have the S&P 500 pricing at 3060, still well below where the market peaked in February of this year at 3409.[5] Furthermore, as we noted last week, it’s been a lopsided recovery with a handful of very large tech stocks driving much of the recovery in the S&P 500 index. If we priced the S&P 500 on an equally weighted basis (where every stock in the index receives equal treatment, and not based on how the large the company is), the index would be down below 20%, still in technical bear market territory. This is why having proper positioning in the portfolio will be very important as we lead into the recovery, regardless of the path or speed. |
New assessments of risk and the new world order (Gillian Tett / Ian Bremmer)
This week Gillan Tett (Financial Times) describes how approach to risk is evolving under the crisis, and Ian Bremmer (Eurasia Group) calls what we are living through our first modern Depression. I find his view on how things will evolve on the geopolitical stage more interesting than trying to apply an old name to a new problem.
Is it safe to go to the shops, see a friend or get on a plane?
Gillian Tett on how to assess risk in the age of coronavirus
https://www.ft.com/content/a69afc14-904a-11ea-9b25-c36e3584cda8
Last month, Dayna Polehanki, a Michigan state senator, posted a tweet from the capitol building in Lansing that might have seemed unimaginable only recently. “Directly above me, men with rifles yelling at us,” it read, next to a picture of armed protesters standing in the building, demanding an end to the Covid-19 lockdown in the name of “freedom”. “Some of my colleagues who own bulletproof vests are wearing them.” It might be tempting to see this as just another sign of American political polarisation. But that would be a profound mistake. Over this bizarre and frightening scene hang questions that will affect us all in the coming months, be that in Lansing, London, Lagos or Lisbon: how do we define and measure risk? Who gets to do that? And who deals with the implications?
Ian Bremmer: Silver Linings in the COVID-19 Pandemic
Even though a lot of our institutions are structurally broken or eroded, the orientation and weighting of capital coming out of the COVID-19 crisis will be much more able to address and fix those problems, he said.
Bremmer also described how the crisis will affect the world’s three superpowers: the U.S., China and Europe. In the sense of the crisis, China has an advantage of being a surveillance state that can make huge, strategic investments to help the country recover economically much faster than the U.S. and Europe. But the caveat is that as China’s economy recovers, it is going to be dominant with all of the weak and poor-performing economies of the world while at the same time being decoupled from the U.S. and Europe, he said.
The Bearer of Good Coronavirus News (WSJ)
https://www.wsj.com/articles/the-bearer-of-good-coronavirus-news-11587746176?mod=opinion_lead_pos5
In a March article for Stat News, Dr. Ioannidis argued that Covid-19 is far less deadly than modelers were assuming. He considered the experience of the Diamond Princess cruise ship, which was quarantined Feb. 4 in Japan. Nine of 700 infected passengers and crew died. Based on the demographics of the ship’s population, Dr. Ioannidis estimated that the U.S. fatality rate could be as low as 0.025% to 0.625% and put the upper bound at 0.05% to 1%—comparable to that of seasonal flu.
Letter: Perhaps the New Mantra Should Be ESG Materiality (FT)
https://www.ft.com/content/7de1b83c-7752-11ea-af44-daa3def9ae03
David Stevenson, in “Are ESG and sustainability the new alpha mantra?” (FTfm, April 6), identifies an important paradigm shift: rather than using environmental, social and governance considerations as an “add-on” to a typical investment process, many are discovering that investors can use ESG concerns as a screen to avoid future poor-performing companies. But this suggests that ESG screens can also be used to find attractive companies to short. Indeed, as some past studies of mine and others show, negatively linked ESG can generate even greater alpha than positively linked ones. I liken this principle to the observation that we tend to like good companies but hate bad ones. In addition to avoiding bad companies, ESG screens can also help find excellent companies. For example, approximately 40 per cent of large US companies now explicitly compensate their top executives for various ESG outcomes. These executive contracts tend to increase both future ESG and financial performance.
Marquette Business Continues to Lead in Sustainable Finance and Investment Education (Marquette Business)
“Sustainable finance and investing are taking off- and the world’s top business schools are climbing on board” — Wall Street Journal, 6/10/2019
An article in the Wall Street Journal recently declared that sustainable finance and investment education is making its way into higher education curriculum. But at Marquette, that change happened over a decade ago.
In the 2005-2006 academic year, Dr. Sarah Peck developed and taught the course Investment Ethics. Dedicated to understanding the central role that ethical concepts and consequences play in the practice of finance and specifically investments,this course was one of the first of its kind across the country. Taken up and taught by Dr. David Krause, director of the Applied Investment Management program thereafter, the course eventually landed in the capable hands of Dr. Christopher Merker, Instructor of Practice for Marquette University who has taught the course since 2009.