It’s been a while since we issued an update on fundamentals, so we thought we’d roll up our sleeves and dig into the numbers for this quarter’s KnowRisk Report. The better we understand the exact mechanisms at play, the better we will understand the unfolding economy over the near term future.
As we all know, COVID19 and the ensuing government/health shut downs had a major negative impact on the economy. In economics terms, factory shutdowns lead to lower supply of many products, while at the same time, demand patterns shifted such as the shutdown of large portions of the travel and restaurant sectors. The net effect ended as a decrease to US GDP by $500 billion or 2.3% for the year which would have been considerably lower without government intervention. For reference, GDP growth was -2.75% in 2008. To avoid the risk of igniting a negative feedback cycle, the government took three major actions: Congress funded $5,335 billion of business and personal income (including the recent American Rescue Plan), the Federal Reserve financed $2,700 billion in purchases in the government and corporate bond market, and the fed lowered interest rates from 1.5% to zero.
So where are we now?
These actions were successful in the following areas: equity prices generally rebounded and continued rising, corporations raised a large amount of debt while debt to equity levels dropped (due to equity prices soaring higher than debt levels), and American households managed to stock away $1,600 billion of savings (source: Bloomberg and represented at the top of the Congressional Spending bar on the chart). Some government interventions are still in place. For example, the Fed continues to purchase an additional $120 billion worth of treasuries and mortgages a month. The latest round of stimulus is still making its way through the economy. Finally, segments of the economy remain restricted both by government and by slowly returning demand.
Normalization will have some predictable effects on the future economy. With the assumption of a certain amount of mean reversion, we can uncover some clues to the future. Continued vaccinations and natural immunities are leading to continued economic normalization. As government payments cease and businesses increase capacity, unemployment will continue to decrease. The American rescue plan will continue to impact spending, and Americans will spend down a portion of their excess savings. These three factors are all working in harmony to increase the “demand” side of the equation. Keep in mind, the size of consumer savings is currently 3x the size of the gap in GDP last year. On the “supply” side, while we are hopeful that the worst of the COVID shutdowns are over, we are worried that shutdowns due to shortages are on the increase. We see this currently with car factories shutdown over missing computer chips, which are predicted to last at least a year. With demand up and supply uncertain, the potential for price increases, otherwise known as inflation, is high.
The recovery has also been very uneven. Oxford Economics estimates that the top two income quintiles in the U.S. own all of the $1.6 trillion of extra savings. In terms of sectors of the economy, the US Real Estate index “FTSE NAREIT” has only just returned to levels from February 2020 as of April 2021, while the NASDAQ Tech index has gained over 80% in the same period. The price of lumber has increased even more dramatically. Government bonds, one of the most stable asset classes, lost -4% for the past year ending March 31 2021, with long duration debt hit worse down -16% for the same period. Worryingly, margin debt has increased dramatically which can be sign of speculation driving the market. Low interest rates contribute to speculation, as uncertain future payments are worth more in the present than they would be under higher interest rates.
Duration movement in bonds was particularly dramatic in the first quarter driving almost all of the loss. Despite the Fed again promising lower for longer, the market has decided to disagree by betting on rates moving higher more quickly. With rates this low, we are reminded of several KnowRisk reports we wrote in 2012 while rates were at this level, including one with the appropriate title “Return-Free Risk.” It’s available on our website (www.equitas-capital.com/research) and worth a reread. The Federal Reserve does have at least two separate tools to manage this. Their next step will be ending their open market purchases. When Ben Bernanke, then Federal Reserve Chair, mentioned ending these purchases in 2013 after the Financial Crisis, interest rates briefly spiked. After that, the Fed can also cool the economy (and presumably inflation) by raising interest rates. However, we must remember that they have promised not to do so for a while. Regardless of whether rate increases happen sooner or later, the change will hurt long duration bonds and equities anticipating future payouts, while shorter duration bonds and companies earning more today with slower growth will look more attractive. According to Jamie Dimon, CEO of JPMorgan/Chase Bank: “I have little doubt that with excess savings, new stimulus savings, huge deficit spending, more QE, a new potential infrastructure bill, a successful vaccine and euphoria around the end of the pandemic, the U.S. economy will likely boom. This boom could easily run into 2023 because all the spending could extend well into 2023. The permanent effect of this boom will be fully known only when we see the quality, effectiveness and sustainability of the infrastructure and other government investments.” This leaves the question of what happens after the effect of the economic stimulus “sugar high” wears off.
In 2002 Equitas Capital Advisors, LLC was established as a unique company that blends the resources of a large global corporation with the flexibility of a small boutique firm. The registered service mark of Equitas Capital Advisors is Engineering Financial Solutions® and the purpose of Equitas is to design, build, and deliver investment solutions to meet the goals and objectives of our investors. Equitas Capital Advisors, LLC located in New Orleans, has over 200 years of combined investment management consulting experience providing professional investment management services to investors such as foundations, endowments, insurance companies, oil companies, universities, corporate retirement plans, and high net worth family offices.
Disclosures and Disclaimers:
Above information is for illustrative purposes only and has been obtained from reliable sources but no guarantee is made with regard to accuracy or completeness. It is not an offer to sell or solicitation to buy any security. The specific securities used are for illustrative purposes only and not a recommendation or solicitation to purchase or sell any individual security.
Equitas Capital Advisors, LLC is registered as an investment advisor with the U.S. Securities and Exchange Commission (“SEC”) and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the advisor has attained a particular level of skill or ability.
Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the author on the date of publication and are subject to change. This publication does not involve the rendering of personalized investment advice.
Charts and references to returns do not represent the performance achieved by Equitas Capital Advisors, LLC, or any of its clients.
Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses.
All investment strategies have the potential for profit or loss. There can be no assurances that an investor’s portfolio will match or outperform any particular benchmark. Past performance does not guarantee future investment success.