Stocks tumbled both Thursday and Friday as coronavirus fears escalated once again. Bond prices soared as the 10-year Treasury marched towards its record low of 1.36%. The bond market is sending a signal that either the economy is ready to roll over or central bank liquidity is so great that the rush by investors to get any yield at all is pushing rates lower.
Right now, there are three issues facing investors. The first, which I just stated, is trying to decipher the message of falling yields. Clearly there isn’t any inflation despite near record unemployment. In fact, wage growth, which is above overall inflation, is moderating. This is a sign that we are not close to full employment yet. But with central banks increasingly accommodative and governments around the world spending without any thought of deficit containment, the entire world is awash with money seeking a home. Some, obviously, has gone into equities. With the S&P 500 now yielding 1.74% against bond yields ranging from 1.4-1.6%, stocks are actually viewed by many as a yield substitute, a place to get maximum current return. Stocks don’t tend to underperform when they return a higher dividend yield than Treasuries.
The second issue is the coronavirus. I have no more insight than any of our readers. But the signals are obvious. Even if there are signs within China that the rate of increase in numbers testing positive for the virus may be nearing a peak, it has begun to spread around the world and there are clear pockets of concern as far away as Italy. The death rate still isn’t as high as SARS, but it is high enough to scare us all and is rising. Over the past several days a few big companies, notably Apple# and Procter & Gamble# have said Q1 earnings would be impacted meaningfully. You don’t have to be a rocket scientist to presume that every multi-national company will experience some negative impact this quarter.
The obvious question is not how bad Q1 will be, but how long lasting will the pain become. It will vary both by geography and industry. We have seen cruise ships quarantined with scary results. Some cruises are already canceled. But the real question is whether those now booked on cruises and those thinking about taking cruises will pull back and seek some other type of vacation. Obviously, that is happening right now. The key question is how long will that continue. I would be very reluctant to book a cruise today, and if I did, say for next winter or summer, I would want assurances that I could get any deposit back no questions asked. I am sure cruise lines will do whatever they can to accommodate these fears. But that may not be enough. Cruise ships are closed environments and cruising is virtually 100% discretionary. I suspect this is one industry that will be feeling the pain well into 2021. And that assumes the coronavirus is contained within the next few months. Airlines face the same dilemma, although at least a healthy share of air travel isn’t discretionary. What both industries share, however, is a very high fixed-cost base. The way to entice users is through price. Price discounting may fill cabins or seats, but at a cost to profits. We will see how this plays out. It may be the right time to buy into either cruise lines or airlines at the peak of the epidemic, but buying too soon may be painful. At best, investments in these or similar industries are higher risk than they were a month ago. You can extend these thoughts throughout the entire leisure travel world, including hotels.
But it isn’t just discretionary travel that will take a hit. Plants remain shut down or understaffed. Inventory shortages will become more prevalent, particularly if the virus remains an acute event for several more weeks. Commodities will see a stock piling of inventory as demand falters. This ranges from grains to oil. Hopefully this virus will run its course as weather warms and winter ends. But we don’t know for sure and it remains an overhang to stock prices.
The third concern is political, specifically the rapid rise of Bernie Sanders to the top of the Democratic ticket. In many ways, Sanders’ campaign resembles that of four years ago by Donald Trump. He has a core of enthusiastic supporters while his opponents stumble to gain traction. Today, there are six viable Democrats. Soon there will be just two or three. Elizabeth Warren had a good debate last week but isn’t gaining ground. Bernie appears to be the progressive’s choice. Buttigieg, Klobuchar, Biden and Bloomberg are all stumbling along. Their collective hope is that they can collectively siphon off enough delegates to keep the nomination away from Sanders on the first ballot. What might happen from there is an open question.
Obviously, a Sanders nomination scares investors just as a Trump nomination did four years ago. Most think that if Sanders were nominated, he would lose big to Trump. Four years ago at this time, the conventional wisdom was that Hilary Clinton would beat Donald Trump easily. We as investors look at the election through a lens that suggests a logic that makes a Sanders victory implausible. The U.S. government is expected to spend $60 trillion over the next decade. Just totaling the cost of the Sanders programs for health care, higher education, climate change and housing (e.g. canceling student debt) would cost an additional $50 trillion.
It is easy to argue that such spending levels will never happen. Congress won’t pass them. That is probably quite true. Indeed, one could argue that all Presidents have a lot less impact on the economy than central bank policy and other economic factors. President Trump’s tax cuts helped corporate profits for a year, but otherwise have had little economic impact. GDP growth in 2019 may have been over 2%, but corporate profits actually declined. President Obama’s signature health care plan barely made a dent on economic growth or even on the profitability of the health care system. Indeed, perhaps the biggest beneficiaries turned out to be the health insurance industry.
But that may not directly address the market’s concerns. Fear can be more important than reality, especially over the short term. While a Sanders win doesn’t mean taxes will double, but it may, depending on the makeup of Congress, mean somewhat higher taxes and increased deficit spending. The former would be bad for investors, the latter might actually be a positive in the short run. Voting to raise taxes isn’t something any elected official wants to do. If voters don’t see immediate benefits from the higher taxes, they will take it out on members of Congress in the next election. Moreover, despite the campaign rhetoric that only the rich will pay for all these programs, any notion that the rich, however one wants to define rich, are going to come up with $50 trillion while the rest pay the same or less than they pay now is sheer nonsense.
But with all this logic, what is clear is that those who feel left behind are ready to speak out, and it makes those who have benefited, namely the investor class, nervous. In the stock market, nervousness is expressed by selling and lower prices. Mr. Sanders isn’t about to change his message. Mr. Trump never changed his four years ago. We have been seeing populism rise around the world. Look at Germany today, for instance. Clearly, I am not a political analyst, but the presumption that Mr. Sanders won’t get the nomination or won’t win if he does, doesn’t look like the sure bet it might have looked like a month ago. To effect policies, we will need solid working majorities in both chambers of Congress. Even then, remember that both Obama and Trump only got one major bill passed each. Thus, the worst fears almost certainly won’t be realized. But rising concerns might be enough to keep stocks on a rocky path for the next several months.
Today, Nike founder Phil Knight is 82.
James M. Meyer, CFA 610-260-2220