March Investment Comments
It is quite clear that as COVID-19 goes, so goes economic activity, which leads political response and tests the remarkable ability of people to adapt.
The path of the virus over the past few months is evident when examining what is surprisingly fairly solid economic data. Fourth quarter GDP grew 4%, capping a year that saw GDP fall 3.5% as large sectors of the economy, particularly travel and hospitality, were off limits to consumers. After COVID-19 case counts declined during the summer, a resurgence of the virus in the late fall and through the holidays spurred the reimposition of stay-at-home orders and retail closures for restaurants, gyms, and other gathering places. With less opportunity to move about, consumers still boosted their spending a respectable 2.5%, but this was short of what economists expected during the critical holiday season.
The employment market, a lagging indicator of activity, saw weakness to start the year as employers added only 49,000 jobs in January. Further, December’s previously reported job loss of 140,000 was revised down another 87,000 for a total decline of 227,000. The path of the virus is again evident as the leisure and hospitality sector shed 61,000 jobs in January and a whopping 536,000 in December. Even so, the unemployment rate in January declined to 6.3% from 6.7%; the virus also impacted this statistic as the decline was due to a lower percentage of workers in the labor force for various reasons, such as fear of contracting the virus and/or increased child-care responsibilities for students learning at home.
Very recently the path of the virus has taken a turn in the right direction. After positive COVID-19 test cases peaked at over 300,000 on January 7th, positive cases have declined sharply to a mid-February rate of around 65,000 per day. The decline can likely be explained by a variety of factors such as fewer post-holiday gatherings, the increasing numbers of those that have previously had COVID-19, and the accelerating pace of vaccination. These later two reasons place us closer to “herd immunity.”
The stock market has taken notice of this better COVID-19 news, hitting new recent highs as returning to normal economic activity becomes more likely. However, this doesn’t mean COVID-19 risk is behind us, especially as virus strains from the U.K. and South Africa look to be more contagious and possibly more severe.
Assuming the path of the virus can be brought under control, the economy is poised for rapid growth and recovery. The extraordinary amount of fiscal and monetary stimulus injected into the economy since March 2020 has left households with $2.2 trillion of additional cash at the end of 2020 compared to the start of the year. The inability of consumers to spend on travel, movies, and other services has led to a jump in the personal savings rate to 13.7% in December, about double the pre-pandemic rate, and this is even before Congress passed another $900 billion in COVID-19 relief before year end. Some of this savings is already being spent, as January retail sales rose 5.3%, a sharp turnaround from the three previous monthly declines recorded from October to December.
While this liquidity provides ready resources for the spending needed to boost future economic growth, some of it is being put to work in ways that are introducing risks to the economy. The wild speculative ride in GameStop stock was juiced by individual investors using social media to band together and artificially bid up the price of a company with a brick-and-mortar business model that can no longer compete in the digital age. In addition to GameStop, investors have bid to the moon companies supporting electric cars, clean power, Bitcoin, and cannabis. Time and time again investors have been burned by this type of speculation—think tulip bulbs in 17th century Holland or pre-revenue dot-com stocks from the early 2000s.
Businesses have also noticed the abundance of liquidity. In January, U.S. listed companies conducted 80 follow-on stock offerings that raised $16.35 billion, both records to start any year since Dealogic began tracking this data in 1995. The Federal Reserve’s plan to keep interest rates at zero for a long period of time has left investors searching for yield and supported the riskiest companies’ ability to borrow all they want at rates that not long ago were reserved for the safest credit. As an example, the average yield on the ICE BofA U.S. High Yield Index—a group that includes embattled retailers and fracking companies—was recently just 3.97%. Contrast this rate with the U.S. 10-Year Treasury yield of 3.23% just a little less than three years ago.
This combination of households flush with cash and risky companies borrowing significant sums could create a dilemma for the Federal Reserve if inflation jumps unexpectantly and bond defaults cause significant job loss. The Fed’s primary tool for fighting inflation, higher interest rates, seems to have been taken off the table given recent emphasis on returning the employment market to the pre-pandemic unemployment rate of 3.5%. But even if the Fed won’t raise rates, the market likely will, as evidenced by the recent jump of the U.S. 10-Year Treasury yield to about 1.3%, up 0.5% since November, on prospects for stronger growth as the economy reopens.
The stock market normally doesn’t react well to increasing rates, but this recent rise hasn’t had much of an impact. This is probably because the U.S. 10-year rate is still lower than inflation, which registered 1.4% in January compared to one year ago, a slightly negative real yield that supports higher asset values. Companies also expect a better economy to boost earnings, and comparisons with the pandemic-induced recession results should be easy.
As always, investors need to be careful when selecting companies, particularly avoiding those that are highly valued today on speculation of robust future results that are many years away. When investing in bonds, the same caution is warranted as today’s ultra-low yields don’t support taking default risk.
Daniel J. Boyle, CFA