10 observations and themes of the economy

Air Date: May 22nd, 2020
  1. The Fed provided a dire forecast for the economy, indicating monetary policy will remain very easy for some time. In particular, Chairman Powell noted, “the path ahead is both highly uncertain and subject to significant downside risks.” He also highlighted the ways a deep and long recession could harm long-term growth considerably even after the actual recession ends.
  2. We do not expect negative interest rates in the U.S. Chairman Powell said as much last week. The Fed will engage in continued quantitative easing, buying more corporate bonds to narrow credit spreads and increase market liquidity.
  3. The coronavirus pandemic is disproportionately affecting those of retirement age, which could influence how parts of the economy are re-opened. According to the CDC, the average age of those who have died is 76, with 80% of all deaths in America coming from those over 65.
  4. Even if infections rise, it will be politically very difficult to “re-lock down” the economy. The original case for economic closing was not to wait for the virus to be eradicated, but rather to slow down the pressure on the health care system and buy time to develop more testing and treatment. Americans seem increasingly determined to re-open the economy.
  5. We continue to think April will mark the low point for the recession.Retail sales collapsed a record 16.4% last month, with only online retails avoiding the pain. We expect to see economic data start to improve in May as parts of the economy begin to re-open.
  6. Credit markets remain stressed, but are improving.Since the Fed announced support for credit markets in late March, absolute yields have declined and credit spreads have narrowed. Spreads still remain wide by historic standards, but conditions are slowly getting better.
  7. The next fiscal stimulus package is likely weeks or months away.The $3 trillion package passed by the House has virtually no chance of passing in the Senate, although there is a consensus in Washington that more stimulus is needed. We expect a final package in the neighborhood of $1 trillion that could include state and local government support, additional health care funding, some business liability protections, additional unemployment insurance and possibly additional direct payments to individuals.
  8. U.S./China relations will likely continue worsening in advance of the November elections.The follow-through on the Phase-One trade deal seems in jeopardy, and U.S. animosity toward China is growing as politicians on both sides of the aisle are blaming China for an insufficient response to the virus.
  9. Corporate earnings will continue struggling in the near term.Close to 150 of the S&P 500 companies have suspended earnings guidance, approximately 100 have stopped stock buybacks and approximately 50 have cut dividends.
  10. Inflation could start to rise by 2022.The aggressive and coordinated expansion of monetary and fiscal policy is designed to be reflationary. Depending on how long this stimulus continues, it could disrupt the long-term disinflationary forces such as technological and productivity improvements that have taken hold over the last decade. We may start to see signs of inflation next year.


When markets bottomed on March 23, we believed that point could be the low for the cycle. When stocks subsequently climbed 25%, we started arguing that markets were ahead of themselves. Equities have since climbed another 10% and subsequently pulled back 5%. So where are markets heading from here?

Upside and downside risks appear fairly well balanced. The bull case: 1) The Fed is easing aggressively. 2) More fiscal stimulus is likely. 3) The infection rate is falling and test capabilities are rising. 4) We expect better or at least less bad economic data from here. 5) Investors have few alternatives to stocks. And the bear case: 1) The magnitude of economic damage will take years to fix. 2) More earnings disappointments are likely. 3) Valuations are less attractive than they were three months ago. 4) An additional surge in infections is very possible. 5) Bear markets associated with a recession usually last longer than four weeks.

Over the next several months investors may overlook a long list of negatives, driving markets higher and expanding P/E multiples.  On the contrary, stocks could be quite vulnerable to headlines and earnings in the short-term.  Volatility is likely to remain high and downside risk seems above average.  Over the long-term, however, we believe the positives will outweigh the negatives. Stock prices could gain ground when we have more clarity around the state of the economy. At that point, we expect investors will begin to price in prospects for a sharper economic recovery at the same time the Fed remains committed to promoting growth. This could cause a rotation away from the more defensive areas of the market that have been outperforming and into more economically sensitive cyclical areas.

The out performance of U.S. equities so far this year is largely a function of strong gains by a handful of mega-cap technology stocks continuing a multi-year trend. The five companies with the largest market value in the S&P 500 Index account for over 20% of the index’s total market capitalization. This is the highest since the tech bubble in 2000 –and potentially a warning sign. Yet these market leaders –with businesses in e-commerce and online search –are poised for better earnings as they have strong long-term growth prospects, robust financial metrics, and business models benefiting from pandemic-spurred behavioral shifts. In contrast, cyclical sectors such as energy, financials, consumer discretionary and industrials, have reported poor earnings –and challenging outlooks.

Washington in response to the pandemic – speed, size and monetary-fiscal coordination has been remarkable. Effective execution, however, is the real measuring stick.  Adding to this conundrum, poor near-term earnings prospects mean that further equity market gains are dependent on outsized P/E expansion. This tilts the scale towards downside risk.  A re-flaring of tensions between the U.S. and China is another reason for caution.

The bottom line: We view equities as a better value than bonds. More specifically, we prefer the U.S. market’s relatively high concentration of quality companies and sectors set to ride long-term structural growth trends. We likely remain under-weight in areas like the euro and Japan – they are more dependent on foreign trade and have less willingness or capacity to engage in policy stimulus.