"Unmasking" The Economy
We continue to be in the midst of a pandemic and an economic shutdown that most people would have never imagined. There are over 30 million people that have recently filed for unemployment. We have seen stimulus checks being sent to individuals. There have also been a couple of rounds of stimulus provided to small businesses and companies. We are in the middle of a recession, but we have seen the market rally 33% higher since March 23rd, after having dropped 33% from Feb 19th. There are huge food lines forming across the country and we are likely not going to see a vaccine until next year and there seems to be a low probability that we can conduct daily testing procedures in a large capacity. Across the country we are seeing citizens getting restless and who are experiencing financial difficulties demanding that the economy be reopened. The next GDP number we see for Q2 will be a negative double-digit figure. Welcome to the first part of 2020, which is a year that will go down in history and we will never stop talking about. Oh, and by the way, we have a Presidential election coming later this year.
This provides a quick summary of the daily chaos we are all experiencing on some level. A big portion of the country starting with the 20% of the country that is not employed and half of the total population of the country that is living paycheck to paycheck are extremely concerned. There is another portion of the economy that easily shifted to working from home, thanks to technology, and nothing has changed for them except for the fact that they wear sweatpants all day long. So, as we transitioned into the demand shock stage of this crisis and there was a complete shutdown of the economy in order to quarantine individuals and to lower the spread of the disease, it was shocking at first but came more quickly than one would imagine. Now we have reached a critical and difficult period where we have to balance two extremes. On one end we could continue the lockdown and self-quarantine for another 6-12 months to save lives and to give time for the development of a vaccine. In this case you would see a long deeper recession that will feel like the depression for many individuals that would create long term damage to our economy. This would wipe out most restaurants and retail stores. We did say extreme. On the other end if we were to completely reopen the economy, we would likely see a spike in new cases and deaths. No one can project the magnitude of this spike or if the weather might play a role. Obviously, we are trying to find the right balance which can be difficult, and it will take time. It will be a longer road to a complete reopening when compared to the days that it took to shut things down. Since the larger number of virus cases can be identified within a few groups of people it is more appropriate that we attempt a slow roll out of the economy but with safety measures in place. The safety precautions are critical if we are to buy time and limit cases until we get a vaccine. Yes, in the end, its all about the vaccine. We might also not get a vaccine for several years which would be troublesome.
Of course, the slow reopening is going to be very difficult as we are already seeing people pouring into parks or in public areas with no protection, feeling that they are not vulnerable. I do not think anyone can accurately predict what will happen, but there are several models pointing to a possible 2-3,000 average daily death level by this summer if we start to reopen. There is no way to say whether that is slightly too high or low as any death is horrible. We also do not want to turn this topic into a statistical analysis of reward versus death, as our role is always to evaluate risk and return scenarios for clients. During this week we are starting to see the market beginning to digest what the next 12 months might look like and there is a strange calm amidst this unsettling economic environment. But let us not forget that we would not be seeing a confident market without the trillions of monetary and fiscal stimuli that has poured into the economy in the last six weeks. On March 23rd, the $2.5 trillion stimulus bill was passed that included favorable terms for mortgage and rent liabilities, among other goodies. Then on April 9th the Fed stated they would be purchasing corporate bonds including high yield/junk, after this asset class saw a sharp drop in March, as the threat of an upward tick in defaults was gaining strength, not only due to the virus, but we have been seeing rating downgrades increasing for many months. Most of you, who know me well, are aware of my feelings here. Sure, it is a kind gesture to save companies but at what level do we ever let any company fail? So, let me understand, in today’s new world of capitalism any individual or entity seeking to take on a higher level of risk is not in danger as you can be bailed out. But if you seek to protect your wealth or to be conservative in a larger allocation of cash you will feel pain as your rate of return will remain extremely low for years. So. from that I guess we can deduce here is that the government is recommending all U.S. citizens, who invest, to take additional risk as there is a backstop. Obviously, this does not make sense. Here, I must quote Howard Marks from Oaktree Capital who speaks of this point and says: “capitalism without bankruptcy is like the Catholicism without hell”. We don’t mean to use a pandemic to criticize the policies of our Fed or the administration, but we have been languishing in a low rate environment for many years and increasing debt with no worries. Then we come upon this pandemic and we print money as we will never run out of ink. We will bring up a question that we have been asking the last several years, and that is, what will we do if we have another major crisis? We didn’t expect this recession to be sparked by a virus, but we can guarantee that we will see many more recessions and likely another pandemic in the next 100 years. Recessions are part of the economic cycle. And it makes the answer quite interesting because we literally shut down America to get our hands around this crisis and dropped rates to zero again. Can we ever raise rates again without the market getting flustered? We saw how the market reacted in Q4 of 2018, where it dropped like a sledgehammer -20%.
Now on the revenue side of the government spreadsheet we have seen a big drop since the tax cuts in 2017 and the deficit is about to balloon to $25 trillion and we are not done yet. So, a big question here is, can we just keep making monetary and fiscal mistakes and continue to print enough money to solve every future problem but at what cost. Even Warren Buffet in his annual meeting over the weekend questioned the future consequences of the same issues we bring up here. Another issue that comes to the forefront during a crisis is the global problem of separation of wealth that continues to create anger and feeds populism on the right and the left side of the political scale. During periods of crisis it is typical that people who are underprivileged suffer the most and the wealthy create more wealth. This might sound unusual from someone who manages wealth, but this global problem is spewing like an old volcano ready to erupt. Even though our role is to manage risk during all periods of an economy we have to address the underlying issues also. It is so evident during this crisis, as we see the long food lines on TV, while most people are working from home overstocked with food and toilet paper. It is an important topic that every country in the world knows that it needs to address but I am not sure anyone has the right solution. There are only two ways to provide wealth to an individual. You can create it through the growth of an economy or capitalism. The other path is that you hand out money. Of course, I favor the first over the last method, but even I see that someday we will have to address the idea of universal income or the annual payment of most citizens in a country. The point here is that we are not here to question the assistance of U.S. citizens during a pandemic. We are stating that our policies over the past 10 years have weakened our abilities to respond to a recession or crisis and we are hoping that a post-crisis strategy will be to consider these serious issues as we emerge with extreme levels of debt and with every indication that we are headed down the same road. Its obvious from both political parties that these longer-term issues are not going to be addressed as their thinking is very short term and only look to warm the hearts of voters. And this is especially true during a Presidential election year.
Now let us look at how the market benefits from the Fed stimulus and why we consider this like a “put option” that attempts to hedge losses. Because our role is to take advantage of this even as we question it. The chart below highlights the two support levels created by the stimulus that you can basically say if we tread near or below one of these levels we can expect more stimulus to roll in as its just a push of the button nowadays. We believe the market will trend sideways as we test the reopening of the economy. Obviously, as an active equity manager we favor a positive opening and the successful rebound of the economy by year-end or early 2021. Still though, the vaccine will weigh over our heads as we move forward with this experiment. Of course, we are not out of the woods here as this virus has been difficult and we could see a second wave that might create more pressure on the economy and markets. Also, its quite possible that people will be slow to react to a release from quarantine as the virus will be here for a long time and possibly forever. We try to consider all phases of the reopening as we did during the initial stages of the shutdown.
S&P 500: Levels of Monetary and Fiscal Support (Source: AETOLIA CAPITAL & KOYFIN)
Inflation or Deflation
A debate that will arise sharply as it does during any crisis followed by a period of quantitative easing (QE), will be whether inflation or deflation are ahead. The Fed has been monitoring inflation and has been waiting for this magic number to hit in order to raise rates. One may argue that we are just in a new normal range of low rates that we may never exit or possibly consider hiking maybe 3-5 years from now. We won’t do a long analysis as to whether QE capital floods the market causing inflation. A majority of the QE does not go into the public monetary flow, but other stimulus like the recent checks from the IRS do. We don’t expect there to be an inflationary surge in the near term. But to confuse things even more we don’t expect a Japan-like long deflationary period either, as some have been predicting for many years. It is a difficult and complicated debate and you could ask a dozen economists and you would likely get half on one side and the others arguing the other side. We hope to address this topic more as we flow towards to the back end of this crisis and enter into a real recovery period.
Oil: Too Much Supply and Low Demand
As the title states the world is flooded with oil and we have nowhere to put it as tankers filled with oil float off the coasts of most major countries that consume oil. But this crisis has slammed demand as everything is shut and the consumption of oil has dropped significantly. But the battle over oil began earlier this year and I am sure many have forgotten it due to the crisis. It wasn’t too long ago that we saw the outcome of an OPEC meeting where Russia refused to cut back production and in retaliation the Saudi’s decided to increase their production causing prices to fall sharply. This put immediate pressure on the shale producers in the U.S., as we have become one of the biggest producers of oil in the world. Most will agree that Russia and Saudi Arabia had exactly that intention as they would love to see the shale companies go bust as they are loaded up on debt and quite fragile. At this point one can argue that they also foresaw the lower demand coming which would be another nail in the coffin for the shale producers. In the mean time we saw prices fall sharply and we saw an entertaining TV spectacle one day as the May futures contracts closed at $-37.00 per barrel, which basically means you are being paid to receive a barrel of oil and will get paid for it. But we are not kidding when we saw dozens of tankers are sitting in the ocean off of the California coast and in most major waterways at this time as there is nowhere to store all of this oil. As a matter of fact, the tankers are now charging roughly $250K per day to store the oil which is a sharp rise from the usual $25K to ship the containers of oil. We will likely see low oil prices throughout the year as the economies of all countries start to recover. We don’t expect much higher oil prices in the short term, meaning in the next 12 months.
Beware of the Recovery
Even as we continue to see a nice recovery from March 23rd, we offer caution in that enthusiasm as we continue to live in an economy that is mostly shutdown. True, as we mentioned above, that the stimulus and low rates are a major stimulus for markets, but we are concerned that there are too many unknowns and surprises that can pop up at any time. There are more reasons to sell rather than to buy with full confidence. Even though we are minimizing our Treasury and Commodity hedges over the last two weeks, we still believe that the market will trend sideways until the end of June. At that point we will have to evaluate how the economy is doing. Remember we have some very bad earnings coming out for Q2 and most companies are avoiding any future guidance as they are unable make future projections during this unusual environment. Technology continues to lead the cyclicals, but we will continue to see occasional small spikes in Value stocks which deflate quickly. Whether it is the newer technology companies that are benefiting from the stay at home economy or the bigger tech names that have very strong balance sheets with tons of cash, they will continue to lead as we recover. It is likely that we see a short pullback soon as the big five tech companies have surged a lot lately but that is not an indication to sell in our opinion in these companies.
We recently began to track the following scenarios that we incepted on April 9th (FED bond buying day). Even though we seem to be tracking the Bull Case scenario, we still believe that there is a higher probability of the market ending up in the Base Case range by the end of June.
S&P 500 (Source: AETOLIA CAPITAL & KOYFIN)
We continue to see the VIX on its downward trajectory to a more normal range, which will take a long time to achieve. Even the short upticks in the VIX, recently, were short-lived.
VIX - Volatility Index (Source: AETOLIA CAPITAL & KOYFIN)
The 10-year yield has found a range, as shown below. We do not expect it to break out of this range as the 0.50% seems like a bottom for now. Of course, any sharp uptick in market volatility that will lead more investors into treasuries that might test the lower end of this range. But for now, there is more interest in equities versus treasuries, as equities continue to be the only game in town if you wish to achieve returns.
US10Y Yield (Source: AETOLIA CAPITAL & KOYFIN)
AETOLIA CAPITAL Portfolios
We are quite pleased with the performance of our strategies as we have been quite tactical since the earlier part of the year. We began to trim larger allocations in January, as the liquidity-driven rally led by the Fed purchases was quite evident since they began in October. As the virus news started to spread, we began to hedge our equity positions with treasuries and specific commodity exposure to limit our risk to the sharp increase in bad news and the economic shock that was obviously coming. But we also made some adjustments to take advantage of what would work during a stay at home economic surge. Now as the shift is leaning to a slow reopening of the economy, we continue to add to the strongest balance sheet companies that can weather a rough start that will take a long time. We are quite tactical and have the ability to manage these four buckets as appropriate to generate risk-adjusted returns. We favor active management over passive, even though our Multi-Asset portfolio has passive positions as it seeks to provide a globally diversified portfolio with less positions than you would find in our other active equity portfolios (typically 40-50).
-Growth portfolio utilizing quantitative screening, fundamentals, and technical analysis, that is actively managed. The portfolio favors momentum but will adjust, as needed, to capture alpha or to manage risk during extreme periods. Our benchmarks are the S&P 500 (SPX) and the All Country World Index (ACWI).
-This portfolio is driven by the trends and momentum of analyst earnings estimates and revisions. Its also supported by price momentum and valuation measures. The portfolio utilizes a quantitative and systematic process that favors lower volatility equities and employs equal-weight positions, within a range, to control risk exposure. The portfolio is meant to reflect the strength or weakness of corporate earnings and to present a lower beta exposure to the S&P 500. We utilize the S&P Equal-Weight Index (SPX EQ-WT) as a benchmark as we maintain a more balanced allocation to each position.
MULTI-ASSET TACTICAL ALPHA
-Tactical alpha is a globally diversified portfolio that utilizes passive investments, but is actively managed to capture alpha. Our goal is to tactically position sectors, factors, countries, and hedging strategies to achieve performance. This model will be adjusted to mitigate risk during more volatile periods. We utilize a Global Balanced index (GB) as a benchmark that blends 60% ACWI and 40% Barclays Aggregate Bond Index.