If you visit our local Smith Reynolds airport (KINT) in Winston Salem, you will see over 27 American and United 737 and 757 jets parked on Runway 4 – 22. These aircraft are just a tiny portion of all commercial jets “mothballed” at airports around our country resulting from the extraordinary drop in commercial aviation due to COVID-19. In each of our cities and towns, notable businesses and favorite restaurants have restructured or closed. The economic impact of shelter in place has been quite severe in certain sectors of the economy.
If one combines local anecdotes of economic damage with the blaring headlines in the press and social media describing additional fiscal stimulus as the final “firebreak” preventing recessionary collapse in the economy, it becomes very easy to adopt a bearish outlook towards investing.
This has been a year like no other, certainly in our everyday lives as well as the financial markets. However, a closer examination of key financial data produces contrarian observations of economic strength which are critical when making asset allocation decisions. In other words, your favorite restaurant may be no more, but the economy and corporate profits in certain sectors are surprisingly healthy at this point in the recovery.
First, the annualized estimated rebound in 3Q GDP looks to be up +33.4%. In quarterly terms, 3Q 2020 GDP appears to only be down -2.9% versus prior period 3Q 2019 GDP. Certain economists see this sharp rebound in 3Q GDP as an indication of substantial underlying strength in the economy. In other words, without strong supportive foundations in the economy, this scale and speed of rebound could not occur. What are some of the supportive foundations in the economy?
Car and light truck sales rose +246% in 3Q while retail sales were up +50%. Home building is forecast to continue rising at +15% per annum. These are three sectors driving economic recovery impacted by the sharp rise in savings and liquidity in the economy. In addition, recent innovations in technology have been a tremendous catalyst in this regard, and the banking sector, in contrast to the 2008 financial crash, has strong balance sheets and the ability to provide credit in the current environment.
Forecasts for 2021 corporate profit growth and margin improvement remain strong across many sectors with hospitality, travel, and energy being notable exceptions. Business inventories are dropping, and production is falling behind demand in many sectors as the economy reopens. While defaults have risen significantly, some economists estimate that credit losses have already peaked.
The Federal Reserve has been clear regarding its intention to keep interest rates low for the foreseeable future. Perhaps the most notable development in terms of Fed policy is the intentional coordination between fiscal policy (federal stimulus spending) and monetary policy (monetization of federal debt through bond purchases). While this will likely create significant future challenges for both fiscal and monetary policy, it is providing a tailwind to the current economic recovery underway.
Therefore, with low interest rates, tame inflation, and abundant liquidity as the backdrop against economic recovery and corporate profit growth, current sobering equity valuations may not be as alarming as historical trends suggest.
What could derail this underappreciated positive macro-economic landscape? Several important unknowns.
First, we continue to battle both the health and economic challenges of a coronavirus pandemic with Europe, the U.S., and Latin America now recording surging infection rates. Already Italy, the United Kingdom, and France are announcing new measures which could further impact local economies. The politization of pandemic policies has muddied the waters when it comes to a careful examination of alternative public health policies such as Focused Protection (https://gbdeclaration.org/). Our unwillingness, as a nation, to engage in non-politized, meaningful discussions of economic and population health friendly alternatives to battling the coronavirus has the risk of thwarting the current economic rebound.
Second, the upcoming election portends to change the policy landscape in the U.S. as well as inject electoral uncertainty after election day. Markets dislike uncertainty so a fresh burst of market volatility could be in store following the November 3rd election. However, if one surveys market performance over multiple investment cycles, it appears that election results have not been a determining factor with respect to longer term performance. Also, a policy reversal related to taxes and government regulations will take time to emerge.
Third, debt monetization is financing a U.S. budget deficit estimated to reach 20% of GDP this year. Currently, the low level of interest rates is protecting the U.S. economy from the traditional crowding out effect of government borrowing. In fact, much of the fiscal stimulus provided by the government has been left to the private sector to determine its best usage. Depending upon next month’s election, government may take back decision making on where stimulus dollars are to be spent. Stimulus dollars allocated to non-productive purposes can pave the path toward accelerated inflation.
Where does the current macro-economic landscape leave us at Cassia Capital Partners?
First, we are mindful that overall volatility or risk, as measured by the standard deviation of return, has increased. Therefore, we have rebalanced our models to take increasing trailing 3-year risk into account.
Second, the record low level of interest rates has meaningfully changed the role of fixed income in our asset allocation decisions. Bonds are likely to provide less risk mitigation going forward. Low interest rates extend the duration of many bonds thereby increasing interest rate risk once rates move back toward a longer-term averages.
Third, equity valuations appear high compared to most historical measures; therefore, expected returns over the next investment cycle are expected to be modest. However, the low level of real rates and continued value creation through growth and margin expansion in technology and other sectors do offer support for continued and increasing exposure to equities over time.
Finally, it is difficult to assess the speed and breadth that digital transformation and post-COVID changes may bring to various sectors. In this regard, we believe our risk based diversified asset allocation within an active/passive approach provides both the discipline and flexibility to adapt to market conditions over the coming investment cycle.