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“This is preeminently the time to speak the truth, the whole truth, frankly and boldly. Nor need we shrink from honestly facing conditions in our country today. This great Nation will endure as it has endured, will revive and will prosper. So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself—nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.”
-President Franklin D. Roosevelt during his 1st Inaugural Address in March 1934
The world has shifted dramatically since our last correspondence and, while our minds are filled with a number of questions, we believe the topics below are among the most important and timely. Feedback and follow-up questions are very much welcome.
In the short-run, we believe trends are deflationary with stay-at-home orders and social distancing measures pushing the unemployment rate to levels not seen since the Great Depression.[1] At the same time, we’re seeing falling global commodity prices[2] and a “demand shock” that has caused declining sales across nearly all U.S. business sectors but especially hospitality, travel, restaurants, and brick-and-mortar retail.[3] Some economists predict it might take until 2021 to see the unemployment rate drop back down below 10%,[4] and the Congressional Budget Office reported in May that it might take longer than that for real GDP to return to pre-COVID-19 levels.[5]
Once we find our footing in the recovery, though, we think trends could transition to be more inflationary in nature, particularly given the remarkable amount of debt being added to the balance sheets of the U.S. Government and the Federal Reserve in response to the COVID-19 crisis (see Question #2 below). Globalization has helped hold inflation lower in recent decades,[6] but now we’re seeing shifting sentiment away from globalization and towards nationalization and bringing more production back to the U.S. This trend may lead to greater job creation here at home, but it could also lead to higher production costs and pave the way for higher wage pressures down the road.
The trillions of dollars in fiscal stimulus being passed and implemented in response to the COVID-19 crisis has been both inspiring and seemingly necessary to support stay-at-home and lockdown orders across the country, but we believe it will come with constraints and unintended consequences which may hamper future growth as well as increase the risk of rising inflation in the coming decade (see Question #1 above). Our country’s rapidly swelling balance of debt will serve as an incentive to keep interest rates low so that our debts remain affordable, but it could also lead to higher tax rates or spending cuts[7] that might crowd out much-needed infrastructure spending.[8]
With the Federal Reserve cutting rates back to 0% in March, and suggestions they should subsequently move rates down further into negative territory coming from a number of public figures (including President Trump9), we can’t rule out the possibility of negative interest rates. In recent weeks, bets in the futures markets have suggested that negative rates may be within the realm of possibility later this year or next.[10] However, we don’t see negative rates as probable given the fact that they haven’t proven to be an overly effective solution for Europe nor Japan over the past 4+ years.[11] In fact, late last year Sweden’s central bank, the Riksbank, reversed its own negative interest rate policy and went back to a 0% rate after having been one of the pioneers in the global negative interest rate experiment this past decade.[12]
We also recognize that negative rates haven’t yet spelled doom for these economies. In an interview with Yahoo Finance back in March, Warren Buffett said this in regards to negative interest rates – “They puzzle me, but they don’t scare me,” and he went on to say, “Interest rates are important, but we don’t think they’re knowable.”[13] Instead, he suggests that investors should focus on “what is knowable and important.”[14] We tend to agree with Mr. Buffett.
The S&P 500 index is currently trading about 5% lower than where it started the year and 9% lower than its all-time high set on February 19th. Given today’s lower valuations, one might reasonably conclude that stocks are priced more attractively than they were five months ago, especially when you add in consideration that we’re now in a 0% interest rate environment (again). But we remain skeptical about current valuations and wonder if the market is not only ignoring falling revenues and very poor corporate earnings for the first half of 2020, but also not accounting for the longer-term structural economic damage that has been caused by the COVID-19 crisis and the subsequent global response (lockdowns across states and countries). We remain cautious and defensive in our equity positioning, and we believe stock market volatility may remain elevated through this summer and fall, particularly if there is a second wave of the virus.
Thank you for allowing us to serve you and steward your investment capital with great care.
Sources:
1. https://www.washingtonpost.com/business/2020/05/08/april-2020-jobs-report/
2. https://www.worldbank.org/en/news/feature/2020/04/23/coronavirus-shakes-commodity-markets
3. https://www.cnbc.com/2020/05/08/these-industries-suffered-the-biggest-job-losses-in-april-2020.html
5. https://www.cbo.gov/publication/56368
6. https://www.dbresearch.com/PROD/RPS_EN-PROD/PROD0000000000507962/The_case_for_inflation.pdf
8. https://blogs.worldbank.org/ppps/covid-19-and-infrastructure-very-tricky-opportunity
9. https://www.foxbusiness.com/markets/powell-trump-and-the-negative-interest-rate-tug-of-war
11. https://www.wsj.com/articles/do-negative-rates-work-yes-but-not-by-much-11577030400
14. https://finance.yahoo.com/news/warren-buffett-negative-interest-rates-224217645.html
Although the statements of fact and data in this report have been obtained from, and are based upon, sources that the firm believes to be reliable, we do not guarantee their accuracy, and any such information may be incomplete or condensed. All opinions included in this report constitutes the Firm’s judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Past performance is not a guarantee of future results.
