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“We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.” Fed Chair Jerome Powell
“We’re just guessing. We are prepared for the worst case. We simply don’t know.”
Jamie Dimon, CEO, JP Morgan
The coronavirus pandemic is a deep human tragedy. We are extremely grateful for the healthcare workers who are devoted to caring for patients and for scientists who are working diligently to find a vaccine and a treatment. We hope you and your loved ones are staying safe and healthy. The virus and global lockdown have resulted in a deep global recession. The United States clearly is having difficulty controlling the spread of COVID-19, and we are concerned that our economic recovery will take longer, and securities will remain volatile, as a result. Much uncertainty remains regarding the economic outlook, including the reopening of schools over the next few months, a prerequisite for many workers to return to their jobs. The improvement in the employment picture is encouraging (7.5 million Americans returned to work in May & June) but getting the remaining sidelined workers back to their jobs may be slower than the initial burst of hiring we saw when many businesses initially reopened. Indeed, the Wall Street Journal reports that over 15,000 restaurants nationally have permanently closed and the Independent Restaurant Coalition, which represents some 500,000 small businesses, found that up to 85% of independent restaurants are at risk of closing by the end of the year. U.S. retailers are on track to close as many as 25,000 stores this year as the pandemic upends shopping habits. We are also wary of rising tensions with other nations, China in particular, and the impact they might have on economic recovery as well as the social unrest across our own country.
On the positive side, Bloomberg reports that European regulators could approve the first vaccine against Covid-19 this year, after a flurry of trials by drug makers leading the race showed promising results. About 160 vaccines are in development, including about 20 that have started human testing, according to the World Health Organization. With a clutch of front-runners now having reported positive early results, attention is rapidly turning to larger, later-stage trials that would prove the efficacy of the shots in tens of thousands of volunteers and potentially lead to the treatments’ approval for use. Last week, experimental vaccines from Moderna and Pfizer entered their pivotal phase 3 trials.
There is a dichotomy between the troubles on Main Street and the exuberance on Wall Street. 2020 global per capita GDP is registering one of the largest declines in the last century and a half and the largest decline since 1945. And with over 90% of the world’s economies contracting, the present global recession has no precedent in terms of synchronization. There have been 14 global recessions from 1871 to 2020 and the percentage of the world’s economies in recession averaged 54%; the previous high was 84% during the Great Depression. Either the realities of Main Street will have to catch up with Wall Street’s expectations or Wall Street will have to catch up with Main Street’s experiences.
Indeed, GDP and earnings will remain below peak levels until the virus is behind us. However, all signs are that if the virus can be better contained, the economy can continue to recover through the end of the year. Science and technology are the disciplines that will eventually end the social and economic consequences we are experiencing from Covid-19. The pandemic has accelerated technology disruption. It has changed the game in terms of how businesses reach their customers, handle supply chains, deal with employees, and build their brands. Winning stocks will continue to be found in tech, health care, and communication sectors and other companies that continue to show cash-flow gains. And since stock prices ultimately represent the present discounting of future cash flows, stocks of those companies should perform well over time.
Second quarter earnings have been better than the pessimistic forecasts. With over half of the S&P 1500 now reporting, earnings have been 31% higher than expected although still down 12% from a year ago. There has been positive earnings growth in the healthcare, utility, consumer discretionary (due to Amazon) and real estate sectors. Perhaps the most telling aspect of earnings reports were from the banks which raised their loan loss reserves by billions of dollars as they feared a rash of delinquencies and loan defaults.
Once earnings season is behind us, the market will focus more closely on the November election and any potential changes in tax policy.
Based on valuation, the S&P 500 is expensive even when looking at estimated earnings for 2021 and 2022. However, above average valuations are to be expected in an era of historically low interest rates. On two key relative valuation metrics, the S&P 500 dividend yield looks attractive relative to Treasury yields and the S&P 500 earnings yield looks attractive relative to the BBB corporate credit rates.
We continue to believe the best course of action for investors is to stick with an appropriate asset allocation and a long-term investment strategy which focuses on shares of high-quality companies with durable business models and sustainable competitive advantages that will survive this temporary threat. Companies with good free-cash-flow yields and a history of rising dividends should perform well over a market cycle. Stocks can keep rising, particularly if the Federal Reserve plans to keep rates near zero for an extended period. Governments around the world are spending massively on simulative fiscal policies to offset the recessionary forces unleashed by the virus contraction.
Most of those contractionary forces have been driven by the government lockdown policies adopted to impose social distancing to slow the spread of the virus. So far, all the government stimulus has provided some support for the global economy. But the virus is still out there, and so are the recessionary forces. This week, the Fed reiterated its pledge to take aggressive action to support an eventual recovery. That approach does have negative longer-term consequences, however. With the Fed pushing out trillions of new cash, some companies that should have gone out of business remained solvent. Efficient free markets do not have Fed bail outs saving poorly run companies. It is bad for the economy long term as it means a misallocation of capital to inefficient uses. But ultimately, earnings matter. They are the growth engine for the stock market. Right now, in a choppy world with unknown virus implications, discipline is important.
We worked remotely for 8 weeks and were able to carry on with our work fully. We have been back in the office since mid-June and are pleased to report that the transition has been smooth. We have had some in-person meetings and many virtual meetings and are readily available by phone or email.
The LVM Team