February Investment Comments
In 2020 governments around the world responded to COVID-induced economic shock with fiscal rescue policies that injected trillions of dollars into their economies and added similar amounts to sovereign debts. The Department of the Treasury’s Data Lab (datalab.usaspending.gov) recently estimated the total bill for U.S. fiscal relief at $2.6 trillion of stimulus plus $900 billion of tax relief, for a total of $3.5 trillion. That total grows closer to $4 trillion including the stimulus that President Trump signed in December.
On January 5, a surprise result in the Georgia Senate runoff turned what initially looked like a mixed U.S. election result into a “blue wave.” With a willing Congress behind him, President-Elect Joe Biden has promised to make more fiscal stimulus his top priority, proposing a $3 trillion stimulus and infrastructure plan.
According to thebalance.com, the U.S. national debt stood at $22 trillion at the end of 2019, a little over one-year’s GDP. Recently measured at $27 trillion, the debt could rise as high as $30 trillion if the stimulus package proceeds as planned. This would catapult the United States ahead of most other developed countries in terms of debt/GDP, although Japan remains the world leader at over 200%.
It may not be knowable whether a new wave of stimulus will change the economy’s near-term trajectory. Underlying fundamentals already look encouraging. December’s unemployment rate held steady at 6.7%. As long as lockdowns ease as expected in 2021 that number should come down under 5% by year-end. Consensus GDP estimates show the U.S. economy contracting about 3.5% in 2020, not bad considering the circumstances. 2021 growth estimates average 4.5%-5%. These estimates already reflect some potential expected lift from further stimulus, but there may be some incremental upside potential if the stimulus package passes as currently proposed.
The S&P 500 finished the year up 18.4%. Whether this price appreciation has more to do with strong fundamentals or with abundant money creation is debatable. Both forces are at work. Central banks responded to COVID-induced financial instability by purchasing bonds, both safe and speculative. Junk-rated bonds have been some of the greatest beneficiaries. The interest rate premium paid for risky debt is currently at an all-time low. The assets of the U.S. Federal Reserve’s balance sheet are currently $7.3 trillion, up $3.2 trillion since early 2020. This activity suppresses yields on bonds and supports higher stock values.
Every major government has embarked on deficit spending to smooth the disruptions caused by the pandemic. The United States has been especially generous, to the detriment of our currency. The U.S. dollar was strong in late February and early March, living up to its reputation as a safe-haven when panicked investors fled risky assets. However, since that time it has steadily melted down against foreign currencies and hard assets alike. It is down 5% compared to the British pound and Japanese Yen over the past twelve months and down 10% against the Euro. In dollar terms, most listed commodity prices have appreciated by double digits over the past year. Oil is the exception, down 12% owing to reduced travel demand, but its less economically sensitive cousin natural gas is up 26%. Gold increased 25% in 2020, following a 19% rise in 2019.
Rising commodity input costs and a declining dollar should pressure interest rates upward. The 10-year Treasury now yields just over 1.1%, low by historical standards but up sharply from 0.9% just one month ago. One can’t help but wonder where yields would be if not for central bank bond-buying? As the Fed looks ahead and attempts to taper its balance sheet, the bond market could get very interesting.
For now, with short-term rates stuck at zero, any change in longer-term yields causes the yield curve to steepen. Bank stocks have been hot lately, juiced by that steeper yield curve and a Federal Reserve decision to permit share buybacks. Deposits have been streaming in faster than banks can lend or invest. With travel curtailed, entertainment venues closed, and money practically falling from the sky, consumers cannot help but save money. The personal savings rate has skyrocketed. It reached 34% in April and has eased back down to 13% in November, which is still nearly double its pre-COVID average.
We can only assume that most of this money will find its way back into the economy eventually. One early beneficiary of lower interest rates and higher bank balances has been housing. The Case-Shiller Home Price Index measured 8% year-over-year appreciation as of October. Rising home prices make homeowners richer, adding further to consumers’ fortress balance sheets. Commercial real estate is not nearly as robust. According to FinViz.com, among 21 U.S. residential apartment real estate investment trusts (REITs), the median 1-year return is -10%. Among 27 REITs that own office buildings, the median 1-year return is -27%. This weakness could start to affect the residential market as condominium conversions and other redevelopment opportunities add to housing supply. Combined with upward pressure on interest rates, we would expect the housing market’s rapid growth to moderate as the overall economy normalizes.
Outside of imperiled commercial real estate, almost no asset class looks cheap right now. Bonds certainly do not impress, with safe yields still near zero while inflation knocks on the door. Equities look better. The Wall Street Journal estimates the S&P 500’s forward P/E ratio at 25, almost exactly where it stood one year ago at this time. Investors will need to be selective. Corners of the market are clearly in bubble territory. This doesn’t have to end badly for earnest investors as the 2000-01 “tech wreck” left many stocks unscathed even as speculative stocks fell sharply.
Some of the stories we are witness to right now can scarcely be believed. The CEO of a fashionable growth company with a P/E over 1,000 and a market cap of almost a trillion dollars recently tweeted his support for a social media upstart called Signal. Investors responded by blasting money into an unrelated penny stock called Signal Advance, which saw its share price increase from $0.60 per share to a high of $70.85. Again, this is a totally unrelated company with a similar name. The stock cooled off somewhat, but as of this writing, Signal Advance remains up more than 1000% from its unaffected price. The market is littered with similar stories of rampant, uninformed speculation.
Investors who stick to reliable companies backed by solid fundamentals still have a good chance to grow their purchasing power over time, even in an elevated market. Investors who throw their money into the wind will lose it. It is as simple as that.
Miles Putnam, CFA