All the leading equity indices rose Friday but that hardly defined the market. Huge gains by both Apple# and Facebook# dominated weakness in cyclical issues. The Dow rose by more than 100 points, but without Apple it would have declined by well over 100 points.
Thursday evening, after the market closed, Apple, Facebook, Amazon and Alphabet# all reported earnings. The headline was that all four exceeded forecasts on both the top and bottom lines. As noted, the gains at Apple and Facebook were so good that both moved to new record highs. As for Amazon, the results were sterling, but everyone knew they would be. The stock rallied on Friday but closed off its best levels of the day and well below its recent 52-week high. While Alphabet also exceeded forecasts, its absolute results were lower than last year. Obviously, Covid-19 had a dampening effect on advertising. No sense running ads when business is closed. But the Alphabet story, and to a lesser extent Facebook, has for years been about how the advertising world was shifting online. That is still happening but the pace is slowing. Search is becoming a mature business. There is growth left but nowhere near the pace of the past many years. Alphabet has other growth engines like YouTube and autonomous driving (Waymo), but its prominent profit driver is maturing. That is reflected in a stock price now sporting a P/E similar to that of the overall market.
The other big story last week was the economy. The Federal Reserve indicated through its Chairman Jerome Powell at the conclusion of a two-day FOMC meeting that it saw the pace of recovery slowing. Substantial additional economic support was needed. It implored Congress to act. Congress is talking about a Phase Four package, but expanded unemployment benefits expired on Friday. So far, talks haven’t reached an agreement on a new package. Both sides appear far from settlement. The finger pointing will start in earnest this week. It is logical to expect some compromise settlement, but it could be a week or two away. Mr. Powell suggested the Fed would be willing to err on the side of providing too much accommodation over the next year or so (maybe longer). Reducing stimulus in a robust economy is easier than trying to add additional thrust to pull the economy out of an even deeper hole than it is in today. Actual tactics will be better defined in September. But for now, the message is that interest rates will stay near zero for the foreseeable future. It is important to note that while low interest rates are an inducement for both spending and investment, the Fed doesn’t add to GDP directly with its actions. That is why fiscal stimulus is more impactful than simply setting rates low.
Of course, a key reason for the economic slowdown has been the uncoordinated governmental response to Covid-19. While President Trump likes to point out that we do more testing than any other country, testing per capita is not satisfactory, and the length of time to get results back often makes tracing problematic. Thus, hot spots are defined late. Remedial actions become less effective. President Trump, no fan of robust testing regimens, is unlikely to take action to improve testing efficiency. That suggests the negative economic impact of spreading infections is more attenuated here than in other countries.
That shows up in several ways. The first is the weakening value of the dollar. Think of a balance board. Money flows from weak to strong. As that happens the value of strong currencies go up. The resultant increase makes it more expensive to buy goods from an economy with a strong currency, and less expensive to buy goods from one with a weak one. Money then flows from strong to weak. Currency changes is the adjusting mechanism.
The dollar has been in persistent decline for several weeks, a realization that U.S. growth rates, relative to the rest of the world, are weakening. That doesn’t mean necessarily that we aren’t growing. But it does mean our advantage is less. The U.S. is less that 5% of the world population but accounts for roughly a quarter of Covid-19 infections and deaths. While the death rate in this country per 100,000 people is well below spring peaks, it remains one of the highest in the world. Of the major developed nations, only Great Britain is worse.
The high infection rate here is limiting travel and trade. Europe for now will not allow Americans to travel to the continent. It is limiting travel within the U.S. as well. Between March and June, the number of Americans who traveled by air rose by about 8-fold. But over the last eight weeks, the increase has been less than 5%. Similarly, restaurant headcounts, while still rising, are doing so now at a low single-digit rate.
Weekly unemployment claims had declined every week since the end of March, but they have risen the past two weeks. When summer fades and cool weather returns, the appeal of outdoor dining in Northern states will dissipate. It remains unclear in many states how in-restaurant dining can be restored to compensate.
So far the stock market has ignored the recent slowdown in growth/recovery as the move toward lower interest rates has been the key offset to slower possible earnings recovery. Indeed, last week the 10-year Treasury yield fell to its lowest level of the year, barely over 0.5%.
But the race to the bottom cannot be healthy in the long run. Low interest rates, negative if you adjust for inflation, may foster investment spending. But adding more capacity to a world already oversupplied is hardly good policy. In the 1980s, Japan tried to prop up its economy in exactly the same way. The end result was decades of stagnant growth, periodic deflation, and ultimately a collapsing stock market. Japanese stock prices are still well below peak levels of the 1980s almost four decades later. The Fed is right to support an economy in crisis. But once Covid-19 disappears and economic life normalizes, it should keep negative real rates in place. An efficient economy is one of supply/demand balance, not one mired in a world filled with zombie capacity added in weak times to prop up an ailing economy.
You have read for years in my notes that we were oversupplied with everything but labor even before the pandemic. Now we are oversupplied with labor as well. We certainly are oversupplied with money. Despite a GDP declining at an annual rate of over 30%, and despite record low interest rates, Americans are using credit cards less. Saving rates have climbed sharply. Look at the chart below of monetary velocity, the rate that money turns over. The Fed can keep flooding markets with money but it can’t make you spend it.
Yet the Fed still keeps adding to its balance sheet. With interest rates near zero, investors seek positive real returns. The beneficiaries of all this reallocation is asset prices. That includes stocks, bonds, real estate and gold. Housing starts are rising. Suburban homes are being snapped up within hours of listing. As for gold, it seems to go up when the market rises and when it falls. So far, investors worldwide have not lost faith in the dollar. It remains the world’s reserve currency. But if the Fed keeps buying assets and flooding markets with more money, there will come a point where faith erodes. When will that happen? No one knows. But if it happens, gold is likely to be the ultimate safe haven.
Until then, we live in an economy that is still improving. We will get a lot of July data this week, culminating in the employment report on Friday. While the rate of improvement is slowing, growth continues. Recent Covid-19 hotspots like Arizona, California and Texas show signs of improvement, although other hot spots are emerging. Schools will restart soon. Cooler weather come September will move people back indoors. And, of course, the election will come into greater focus as both parties hold their political conventions. Thus, risks are elevated.
August through mid-October can be a volatile time for stocks. I would expect more volatility this year. Virus counts are likely to rise. Economic data is going to remain uneven. The political winds will ebb and flow. The tech stocks may or may not continue to lead, but the cyclicals won’t take over unless investors are confident that growth is starting to accelerate once again and an end to the pandemic is within sight. Record low interest rates are not a sign of investor confidence. This is a time to be nimble and careful.
Today, Martha Stewart is 79. Martin Sheen is 80. Tony Bennett turns 94.
James M. Meyer, CFA 610-260-2220