2nd Quarter 2020: It’s the Fed

It’s the Fed

One of our more communicative clients has emailed me numerous times over the last four months. More of a running commentary, his messages are always brief, sometimes sarcastic and often humorous. Below is a sampling of his messages sent during the volatility of February and March.

Feb 24: Dow -1032 points: “Nice market today! You could feel it coming…Coronavirus…”
Feb 27: Dow -1191 points: “Pretty big hit to Mkt for week—which ain’t over yet!”
Mar 3: Dow -786: “Here we go again!”
Mar 5: Dow -970: “And again.”
Mar 9: Dow -2014: “So, don’t trim? You have a point where you worry about our strategy?”
Mar 10: Dow +1167: “Ahhhh”
Mar 13: Dow +1985: “+2000 ain’t bad.”
Mar 18: Dow -1338: “Gonna be ugly today.”
Mar 16: Dow -2997: “Nice start to day!” and later, “Even better end.”
Mar 23: Dow -582: “Strap up tight. Looks like futures portend sorry day. This ain’t no ordinary times…”

And so forth. Obviously he is one who follows the market pretty closely, checking the futures before the open and following the trading action during the day. As the market began its rapid recovery from the lows of March, this client, continuing his trademark communication method, repeatedly expressed amazement and puzzlement about how well the market was doing given the horrific economic news. He was not alone in his puzzlement. Many investors have expressed the same. In a few of his latest messages, our client has shared that he wonders if the market is being manipulated by certain large, powerful investors. In his words, “You may think I’m whacky but I’ve come to the conclusion that [the market] is driven by a few very powerful forces.”

I’m here to tell you that our client is right. But before revealing the “powerful forces” driving the market, I should remind you that the stock market has recovered much of the ground it lost during February and March. Including dividends, the S&P 500 was down just 3.1% for the first half of the year. Take a peek at the peak-to-trough and trough-to-6/30 returns in the table of market index returns. Both the decline and the recovery were dramatic. In our view, the market decline makes sense given the immediate and expected impact of the pandemic on the economy. It is the market recovery that leaves us scratching our heads. How could the market be up this much when the economy is in such a deep hole? As Matt DeVries points out in his update on the Market and Economy, economic output (GDP) is expected to have declined by 35% (seasonally adjusted annual rate) during the second quarter. Full year S&P 500 earnings are expected to be down 21% from 2019 levels. Unemployment is still north of 10%. And while the worst of the economic and earnings news is (we hope) behind us given that the economy is re-opening, we have a long way to go just to get back to where we were in February before things fell apart. So why the exuberance?

As we see it, there are three reasons the market has recovered:

First, the market is looking past the virus. The market is forward-looking. Right or wrong, the market sees the virus as a temporary phenomenon and the self-imposed economic damage is likewise temporary. Specifically, investors are counting on effective treatments, a vaccine or herd immunity to get us past the virus. As for the efficacy of those treatments, the timeline for a vaccine or the possibility of herd immunity, the market is doing its best to estimate those unknowns and to put numbers to paper to justify a price for which stocks should trade. And high valuations notwithstanding, the market mechanism is working. As we’ve described in prior letters, some sectors (technology, consumer stocks, communications, healthcare) have done exceedingly well during the pandemic while other sectors (industrials, financials and energy) have floundered. According to Yardeni Research, there is a 51 percentage point performance spread between the best-performing sector (Technology +14% YTD) and the worst-performing sector (Energy -37% YTD). We’re encouraged by this differentiation as it demonstrates that the market is doing its job.

Then there is spending by the Federal government, also known as fiscal stimulus. Congress has authorized Coronavirus relief spending of $2.4 trillion this year so far. How much money is that? A lot! Prior to the virus crisis, the US was expected to run a federal budget deficit of $1.1 trillion this fiscal year. The new spending will more than triple the deficit to $3.5 trillion and push total US debt as a percentage of GDP to levels not seen since the end of World War II. This subject deserves an article to itself but we’ll save that for another day.

And finally to the “powerful forces” moving the market. It is the Fed. Also known as the Federal Reserve System, it is the central bank of the United States. Among other activities, the Fed 1) conducts the nation’s monetary policy to promote maximum employment, stable prices, and moderate long-term interest rates in the US economy, and 2) promotes the stability of the financial system and seeks to minimize and contain systemic risks through active monitoring and engagement in the US and abroad.

On March 11 the World Health Organization declared a global pandemic. Here are the steps the Fed has taken since then:

1. March 15: The Fed lowered the Fed Funds rate by 100 basis points to zero and announced another round of bond buying called QE4 (quantitative easing, round 4) which planned to purchase $700 billion in Treasury and Agency bonds.
2. March 23: The Fed removed the cap on the amount of Treasury and Agency bonds it will purchase and eliminated any reference to an end date for this program. In addition, the Fed established two new facilities to provide up to $750 billion to support credit to large companies—the Primary Market Corporate Credit Facility to purchase new bonds and loans from corporations and the Secondary Market Corporate Credit Facility to provide liquidity for outstanding corporate bonds. For the first time in its history, the Fed would buy corporate bonds.
3. April 9: The Fed announced additional support for existing and new programs totaling $2.3 trillion! Recipients include banks providing government-backed loans to individuals and corporations, corporate borrowers, and municipalities. The Fed also committed to providing liquidity to the commercial paper market, the investment-grade bond market, money market funds and the short-term municipal market. Remarkably, the Fed even committed to buying bonds of companies rated less than investment grade (junk bonds) as long as those companies were rated BBB or higher (investment grade) prior to March 23.

These moves are unprecedented in many ways. For starters, the Fed has never before said it would make unlimited purchases of Treasuries and Agency bonds. It has never purchased corporate bonds, corporate loans, bond ETFs, or municipal bonds. The dollar amount is simply staggering. The Fed’s balance sheet has ballooned from $4 trillion at the end of February to $7 trillion at the end of June. For comparison, after the financial crisis of 2008, the Fed’s balance sheet peaked at $4.5 trillion and it took six years to reach that point. Fed Chair Jerome Powell has made it clear that more support is available and likely to be deployed.

Within days of these announcements by the Fed, prices on bonds and loans from all types of issuers absolutely soared. Stock prices did too. When investors believe that companies will be able to easily borrow money, refinance debt and enjoy low interest costs, it makes the stock of those same companies far more attractive. Don’t underestimate the benefit of low interest rates. The year began with the 10-year Treasury yield at 1.88%. It finished the second quarter at 0.65%. The cost of debt is a critical component in the valuation of risk assets like stocks. Indications are that rates will remain low for the foreseeable future given the weakness in the economy.

So the Fed is the “powerful force” about which our client wrote. Too powerful you might ask? Don’t these actions distort the market and create a moral hazard? Is there no longer a penalty for taking risk? How does this end? These are great questions. We think you’ll hear and read much more about this subject. Look for our additional thoughts in an upcoming article.

A Pat on the Back

Changing gears a bit, let me take a moment to offer a word of congratulations. With just a handful of exceptions, Bragg clients kept the discipline during the roller coaster ride that was the first half of 2020. It’s true. We manage money for about seven hundred families and institutions and I can count on two or three fingers the number who went to cash during the dark days of March when the Dow was plummeting. A slightly higher number raised some cash or tweaked their allocation but even those can be counted on two hands. As you can see in the table to the left, the Dow was giving up seven percent, ten percent, even thirteen percent (March 16) in one session! These declines were compressed into an extraordinarily short period of time. Those were very difficult days—I would be guilty of being less than truthful (translation: I’d be lying) if I told you that I didn’t struggle mightily during that time. So I must ask, how did you do it? Granted, Bragg always recommends staying the course and thinking long-term but admittedly, with that much volatility and with that many dire headlines, I am surprised that you kept the discipline. I guess there are those of you who would say that you are a long-term investor and it didn’t cross your mind to make a change—something along the lines of, “Declines are normal. This was par for the course. What’s the big deal?” and so on. But I’d wager that a larger number of you were watching the market like hawks, tracking the spread of the virus, alarmed by the declines, greatly disturbed by the headlines, pessimistic about future returns and perhaps considering making a move, but simply didn’t get around to it before the market turned up on March 24. And then there are those of you who weren’t following the market closely and are looking at the returns in the nearby table and asking, “Did the market really go down that much in one day? Did it really do that? Did I actually endure that? What was I thinking? I should pay closer attention!”

Regardless of which of those describe you, congratulations for staying the course! You certainly were rewarded for doing so, as shown in the table of the Dow’s ten best days and in the simple fact that the market regained most of its losses by the end of the second quarter.

Looking Ahead, The Coast Is Not Clear

While the market has recovered most of its losses from earlier in the year, the bears may turn out to be right. It’s true that right now the market is looking past the virus and it’s true that fiscal stimulus has been enormous and unprecedented and that we may see more of it. And finally, as detailed here, it’s true that the Fed is a powerful force. But the market could be wrong about the virus. While the vaccines under development look very promising, we can’t be certain they’ll be effective and we don’t know when they’ll be available. As for Congress and the Fed, history demonstrates, and basic common sense tells us, that there are limits to fiscal and monetary stimulus. We should tell ourselves that the volatility of the last few months is likely to continue at least through the election and possibly beyond. The market’s nice run has given us the opportunity to take a breather here, and even pat ourselves on the back a bit. But rebalancing is in order and portfolio discipline remains the priority. Please let us know if you would like to discuss your portfolio or your financial planning. Thank you for trusting Bragg Financial Advisors.