COVID-related closures and global lockdowns have instigated the most dramatic economic plunge in modern history. The lights went out on the economy in mid-March and the blowback since then has been stunning. More than 30 million Americans, or roughly 20 per cent of the workforce, have filed for unemployment benefits. The April jobs report was the single worst monthly showing on record: in excess of 20 million jobs have been eliminated, including 6.4 million “Accommodations and Food Service” jobs, wiping out 45 per cent of that sector.
Consumer spending suffered a similar slide. Outlays on travel, both international and domestic, plunged more than 60 per cent in Q1, according to the Bureau of Economic Analysis. Movies and live entertainment deteriorated similarly, cratering 62 per cent and 58 per cent, respectively. Clothing stores witnessed a 50 per cent pullback in retail activity in March, according to the US Census Bureau. But grocery store registers rang up 27 per cent higher sales vs February.
Commodity prices – which are real-time indicators of global economic activity – also retrenched. The price of a barrel of West Texas Intermediate crude oil has slid 60 per cent to date, after spending a couple of ugly days in April in negative territory for the first time in history. US electricity consumption is 8.6 per cent lower year over year, roughly in tandem with economists’ forecasts for our nation’s growth outlook.
Since hitting its low on March 23, about one week after the national lockdown took effect, US equity markets have surged nearly 30 per cent. Why, in the face of the toll taken on our nation in both human and economic terms, are equity markets trending higher? Last Friday’s 455-point Dow rally, on the same day as the devastating jobs report was released, exemplified this divergence between Wall Street and Main Street.
Accommodative monetary policy – central banks’ willingness to provide liquidity through bond purchases – represents a good portion of the rally’s fuel. The Federal Reserve is taking a page from former European Central Bank President Mario Draghi’s “whatever it takes” playbook: Chairman Powell’s monetary pledges currently amount to about 30 per cent of US GDP. Other central banks around the world aren’t far behind. Much of the divergence in equity market performance this year can be explained by the degree of central bank intervention in respective countries. China is an outlier in this regard, probably because they’re further along their economic road to recovery. Central banks’ liquidity largess has eased capital market concerns. However, monetary stimulus benefits large, mostly public, companies with access to capital markets, leaving smaller, Main Street businesses to rely on Congress’s awkwardly administered lending programs. While small businesses struggle to access relief funds, more than $68 billion of corporate bonds were issued in Q1, according to Federal Reserve data.
The COVID-19 crisis has bifurcated the corporate world into those firms that will survive the lockdown, and those that won’t. Investors are reevaluating their holdings, making the distinction between companies that have temporary liquidity challenges and companies that have serious solvency concerns. Access to capital will alleviate liquidity problems, but current circumstances punish insolvency. Balance sheet quality is paramount in today’s uncertainty, as credit quality explains a large share of equity market divergences.
The last, and least understood, source of divergence is the mechanism by which stock prices are derived. In its purest sense, a stock’s price is the present value of all future cash flows, assuming the stock will be held indefinitely. Here is a simple example: Suppose a company pays out its entire 2020 earnings stream of $4/share as a dividend to shareholders and grows earnings at 2 per cent annually thereafter. Using a 5 per cent discount rate, the share price would be $100. Suddenly, a global pandemic shutdown wipes away 2020 and 2021 earnings. Although earnings resume in 2022, they are at 2020 levels, in essence meaning the company has been in a coma for two years. Despite this setback, the present value of the revised cash flow stream – using the same 5 per cent discount rate but with an earnings stream that is two years shorter – declines by only 11 per cent, meaning the share is still worth $89. Investing is a long-term endeavor; though missing two years of cash flow is devastating while you’re living through it, any given year represents just a small fraction of a company’s equity value.
Notwithstanding the positive factors, we see several risks to equities. The first is the path of the virus. COVID-19 is an insidious enemy that won’t disappear until most of the world’s population is immune either through exposure or immunization. Social distancing can slow the infection rate, but it won’t eradicate the virus’s threat. Increased interactions as lawmakers ease stay-at-home orders could usher in a second wave of infections, prompting expanded lockdowns and renewed social distancing. We do not believe equity markets are pricing in this realistic threat which has the potential to push prices lower, although not necessarily to their March 23 low.
The second risk, although longer-term in nature, is related to the policy response to the crisis. Unprecedented government support is projected to push government debt and deficits to their highest levels relative to GDP since World War II. The Committee for a Responsible Federal Budget (CRFB) expects the federal debt held by the public will exceed the size of the economy by the end of this year; by 2023 it will eclipse the record set after World War II. Higher tax rates will surely follow. Corporate tax collection as a share of GDP has been steadily declining. By the end of 2019 it sat at 1.1 per cent, nearing its lowest point in history. The last time government debt exceeded the size of the economy, the corporate tax collected represented 6.9% of GDP. Higher corporate taxes would undoubtedly have an impact on share prices.
Implications for Investment Strategy
Investment sensibility during this period of uncertainty should mirror our own personal sensibility: maintain as much as possible while avoiding unnecessary risks. Most quality companies, with the help of central bank liquidity, will likely reemerge from the lockdown. Unfortunately, the same can’t be said for their highly leveraged, lower-quality counterparts. We suggest investors maintain their long-term equity allocation target, but emphasize markets, sectors and companies that are insulated from the vagaries of COVID-19.
We also know that as the world economy attempts to reopen, the course of the pathogen will remain uncertain. As a result, business leaders, lawmakers and investors must prepare to balance two risk scenarios. In the first, an overly enthusiastic population, tired of isolation, reengages too quickly and triggers a reescalation of infections. In the second, a general unwillingness of fearful consumers or workers to engage in a reopened economy turns what was expected to be a “U-shaped” recovery into an “L-shaped” malaise. Either scenario would pose near-term risks for equity markets, although economically sensitive and highly leveraged stocks would be the ones most at risk.
Longer term, we believe investors should plan for higher taxes as lawmakers grapple with government debt levels not seen in a generation. While it’s too early to tell where policymakers will look to raise revenue, corporate and personal income tax rates are likely candidates. This suggests carefully selected, intermediate-term municipal bonds would be a good place for investors to generate income, as the value of their tax exemption increases with higher marginal tax rates. Growth-oriented equities offer the best opportunity in navigating a higher tax environment, since a greater share of their return is derived by capital appreciation and not income-generating dividends.
COVID-19 reminds us that near-term investment risks abound. However, equity investing requires a longer-term time horizon to ensure success. We can’t promise that reopening the economy won’t suffer setbacks, but we’re confident that, several years from now, COVID-19 will be a bad memory that shaped public policy and business strategy and inspired movies, songs and books. Equity markets, meanwhile, will carry on.