Barnett and Company

“This Too Shall Pass:” Notes on the Investment Environment Going Forward

After five weeks of quarantine, many people are wondering when, if ever, life will return to normal.  The short investment answer is that it won’t.

Even after a vaccine is found, the ramifications of the Coronavirus pandemic will persist.  The event has exposed fault lines in society that will not easily be papered over.  It has also revealed the extent of how both the Federal Government and private entities have relied on debt to keep economic good times going.  It is surmised that credit will not flow so quickly or so cheaply going forward when compared to the past twelve years.

One would have to go back to 1912, to the sinking of the RMS Titanic, to find an equivalent social movement born out of a disaster.  The Titanic was considered an engineering marvel, an example of maritime progress.  However, after it sunk and inquiries were conducted, it was noted that of the 1,500 people who perished, almost all were below deck in the steerage compartments.  Of the 600 people who survived, most were first-class passengers.  It seemed the ship had only enough lifeboats for the upper deck and none for below.  The ensuing public furor over this marked the end of the Edwardian Era.  Up to that time, the life of a commoner was considered of less value than the upper class.  The Titanic’s discriminating loss of life was reinforced with the prosecution of World War I.  Commoners were conscripted to march into a meat grinder of trench warfare, while upper-class members were enlisted as officers who often directed the carnage from a distance.  By the 1920s, Britain was taxing estates at a rate up to 120 percent; such was the contempt of the commoners for the elites.

Something similar is happening now, with African Americans dying from the Coronavirus at 2.5 times greater than their share of the population.  The number of workers without masks, protection, health insurance, paid time off, or a living wage has been laid out for all to see.  These conditions are expected to find a political outlet. For some, it will not be pretty when it does. 

The propensity of government to raise funds it does not have to offset the mass quarantine is staggering.  So far, $4 Trillion has been committed.  Before it is over, another $2-4 Trillion may be raised.  For a country with a $24 Trillion economy, but $20 Trillion in government debt, this is a significant number.  Any attempt to pay this debt down by raising taxes or running a surplus will be a drag on the economy.  Even before the virus came along, the government was running a deficit of $1 Trillion per year.  In this sense, the Coronavirus did not so much change the fiscal course of the US as to accelerate it.

The consequences of these trends would seem to be: first, higher interest rates, as the US taps into a shrinking pool of international assets for investment.  Second will be higher inflation, as the income inequalities exposed by the Coronavirus is addressed by a higher minimum wage, expanded healthcare benefits, etc.  Third will be more subdued financial markets, where investments will have to be benchmarked to a higher interest rate and lower earnings per share growth to evaluate their value.  Hedge funds that have enjoyed a privileged tax status will have it rescinded.  Private equity will no longer have borrowed money plentiful at low rates, impacting the ability of an investment to pay both the managers and the investors.  Stock buybacks with borrowed funds will be a thing of the past.

Superimposed on this environment is the ongoing decline in population growth due to our stringent anti-immigration laws.  Without population growth, an economy can only get bigger through either borrowing or exporting.  Until the US dollar materially weakens, and other countries are willing to overlook various policy differences and insults by the US, it is not expected that exports will be a material source of growth going forward.

This is not to say there will not be any investment opportunity. Healthcare will continue to grow, although the more political parts may be leveled by government edict.  The growing retired segment of the population will, in time, go back to taking cruises, trips, eating in restaurants, etc.  In fact, such activity will probably be considered a private sector stimulus to an economy that will be contending with reduced government spending in the form of lower deficits or even surpluses.

The issue is whether the entire stock market will advance.  The answer is probably not at the rate of the past decade.  The loss of stock buybacks will take away a material source of stock demand.  Rising dividends in time will take up the slack, especially as the cash return on stocks is compared to the return on short-term debt.

The world going forward will look different from the world of even a few months ago.  Out of such changes, investment opportunities are formed, and threats to the established order are created.  Thus investing resembles nothing so much as a chess game that never ends.  Play a long game, and play well.
The Economy
The economy is in a state of induced coma.  The consumer, who makes up 70 percent of the economic activity, has been dispatched to dwell in self-isolation with the exception of those considered essential to the community.  In all areas, hospitals and first responders are considered essential, as are grocery stores.  Beyond this, the list gets murky.  Liquor stores in most localities are considered essential, whereas seating in a restaurant is not.  The idea is to avoid congregating unless necessary.  The result is an unemployment rate north of 15 percent. 

Reviving the economy will take some finesse.  There is already some debate over which areas should be opened first, with manufacturing and transportation to be early candidates.  Schools, churches, and the like will probably come second.  A concern is a potential for the Coronavirus to flare up again, prompting a second lockdown.  It may be the second half or even 2021 before the economy and social life is restored.
Inflation
The most immediate effect of the Coronavirus is deflation, as lower demand responds to supply that has not adjusted.  A key example is the price of oil, where demand has dropped by over 10 million barrels per day, and almost all storage tanks are full. Yesterday the price of oil went negative, as owners of contracts could not find a place to accept delivery.  A contract is for 1,000 barrels, or 42,000 gallons.   

Looking ahead, a resumption of normal activity should restore both demand and prices for oil.  In addition, higher wages and health insurance costs will drive the cost of services higher, and in time the cost of goods. 
Interest Rates
One of the great disservices by parts of the economics profession has been the idea that deficits do not matter in terms of a country’s finances.  This idea was first promulgated by John Maynard Keynes, who, to his credit, said that deficits in recessions needed to be paid off with surpluses in times of prosperity.

From there, we had Arthur Laffer, whose curve was supposed to demonstrate that a country could grow by cutting taxes and without concern for deficits.  This was embraced as a tenant of Modern Portfolio Theory (MPT), which has driven so much of the financial market for the past decade. 

The trillions spent addressing the Coronavirus should help put MPT into the dustbin of history.  At some point, financial markets will demand higher interest rates to hold a security that there are so many of, even if the security in question is United States Treasury bonds and notes. 
The Stock Market
After riding along on a sea of cheap money, the stock market hit its own iceberg in February.  Since then, it has rolled over, retracing most of its decline.  It appears to be rolling over again. 

This is to be expected.  Usually, when a market drops as suddenly as this one has, some investors, using the peak as a reference point, “by on the dip.”  This creates the demand we have seen of late.  There is then a second decline that washes out those who ran into a burning building, so to speak.  From here, a base will be formed to lead the next advance. 

Recall that there is a one in five chance that the leaders of one market advance will lead the next.  This rotation of industries will need to be watched.

Warren M. Barnett, CFA

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