Stocks continued to surge yesterday, with the leading averages up another 2%. But who would have thought such a gain would happen while share prices for Apple#, Facebook#, Amazon, and Microsoft# all fell. The obvious answer is rotation. With economies now starting to open in all 50 states, stocks of companies in businesses virtually shut down during the pandemic are starting to rise. Should they? Let’s take a look.
But before I do that, just the fact the stocks are soaring at a time when GDP and employment numbers are collapsing is mind jarring. Add on top of that the fact that Covid-19 is still with us. There is little question that in the weeks ahead we will see the number of hospitalizations related to Covid-19 rise. It’s inevitable that as we all leave quarantine and begin to interact, even with care associated with social distancing and masks, infection is going to spread. But that isn’t the question. The question is, will it spread far enough to force the government that has let the proverbial cat out of the bag, to go back to quarantine status? The answer is clearly no, unless the surge in hospitalizations simply overwhelms our health care system’s ability to cope. For now at least, markets are voting that won’t happen.
So, let me go back to the earlier question of whether stocks of retail chains, airlines, cruise ships, theme park operators, movie theater chains, etc. will surge based on the reopenings? The answer, of course, is maybe. It is different for each company and each industry. The first question is whether survival is still in doubt. Obviously, it is for several of these companies, particularly if there is a virus resurgence in the fall and no protective vaccine until later in 2021. It’s one thing to allow everyone to fly or take a cruise. It’s another to expect sufficient numbers to buy tickets. Not everyone will stay in a hotel room under current conditions. But most probably will if they are convinced that their rooms are virus clean. I am not sure whether airlines offer the same risk profile. Operators can clean the planes, but they can’t guarantee that the person sitting next to you is virus free. Thus, airline traffic will rise rapidly in the months ahead, but still may not get to levels that allow operators to be cash flow positive any time soon. We can argue with each other about the odds of that happening or not, but we can all agree it remains a real risk. So, is buying airline stocks today an investment or a gamble? It depends on how you define the two words. With that said, stocks are long-lived investments. We hold stocks that are proven winners for years. I can’t tell you if six months from now a particular airline will be solvent or not. It depends on non-economic facts that no one can predict accurately.
At the other end of the spectrum, Disney# is making plans for staged openings of its theme parks. Just a couple of weeks ago, it was thought by many that Disneyland and Disney World would not reopen in 2020. The two parks are different but, most importantly, they are in different states. Disney World is in Florida, a state that is reopening quicker than most. Disneyland is in California and is likely to remain closed until experience at Disney World suggests otherwise.
Clearly, reopening is a positive. The economy can start to grow again, albeit from very low levels, and jobs will be restored. How far back and how soon are obvious open questions, but the direction is indisputable. We also see for ourselves that many will pay little or no attention to the public health sector’s warnings of social distancing, masks, or hand washing. They either think they won’t get sick or they feel the freedom to move around as they wish is worth the risk of a brief illness. With that said, there is a sizable sector of our population that is fearful and will avoid crowded spaces and other avenues of risk. They aren’t the ones you see on the TV news clustered at the beach. They are the ones still sitting inside watching others having a good time and shaking their heads. Economically, the first group, the one with less fear, will drive the economy forward in the months ahead. The second, those still scared, will cap how fast we return to normal before there is a vaccine or herd immunity.
There is another factor pushing asset prices higher. That is the almost $3 trillion of money the Federal Reserve has already pumped into financial markets over the last 10 weeks. And judging from Fed Chair Jerome Powell’s economic concerns, the Fed is going to keep the spigots open for some time to come.
It is hard to come to grips with what $7 trillion means. Total non-financial corporate debt issued by U.S. businesses totals less than $7 trillion. It is more than 30% of Treasury borrowings. With all the Covid-19 spending surge already passed by Congress, the U.S. budget deficit could top $2 trillion this year. That is less than what the Fed has purchased in 10 weeks! In other words, despite our huge deficits and debt, the amount of debt held by non-government entities will actually decline this year. That leads to an obvious question. Why doesn’t the government spend whatever it wants and let the Fed effectively fund all the deficits, adding more and more to its own balance sheet?
That sounds too good to be true and it is. The process works when interest rates are near zero. But they are near zero in part because the Fed is buying $3-5 trillion of bonds this year. $3-5 trillion isn’t a trivial amount. The total of all U.S. debt, government, private, mortgage backed securities, and stock and local borrowings is roughly $60 trillion. Thus, incremental buying of something approaching $5 trillion is going to jack up prices and drive down yields.
Thus, in the near term, a rising economy and buckets of money to buy financial assets leads to very happy times. So, what are the risks? Let’s remember the following before we get too far out over our skis.
1. The Fed cannot buy $3 trillion of bonds every 10 weeks. At some point, there are no bonds left to buy! At some point, once the economy is back on its feet, it will stop. When that happens, asset prices will find their natural equilibrium. For bonds, that almost certainly means higher rates. I don’t know whether the 10-year Treasury gets back to 1%, 2% or more. Certainly, over the past decade, without Fed intervention, it traded between 1.5% and 3.0% most of the time. That seems like a good place to start.
2. Higher interest rates mean borrowing won’t be free. One of our economy’s problems for the past decade is that we have lived in a world with too much of everything. There are many companies that are struggling to survive, choking on too much debt. Higher rates will tip them over the edge to bankruptcy. Neiman Marcus is a perfect example. There will be many more.
3. Higher rates mean governments will have to pay higher debt service costs, crowding out other needed investments. The same applies to corporations. Stock buyback programs won’t resume until balance sheet strength is restored.
4. Covid-19 didn’t disappear. It may take a breather over the summer as we spend more time outdoors and less in crowded offices or classrooms. But unless there is a vaccine a lot sooner than expected, cases will rise as temperatures fall. It is almost a guarantee. What we don’t know is how large a surge there will be, and whether we have learned enough the first time around to handle the surge. History of other pandemics doesn’t paint an optimistic picture.
5. We don’t yet know how many businesses simply won’t reopen or reopen to volumes that can’t support underlying costs and subsequently close. It is simply too soon to make that judgment. Nowhere is that question more important than in the restaurant industry.
6. There are important sectors of the economy still in limbo. How do sports leagues operate in a pandemic? Will fans still be enthusiastic watching sports without any fans in attendance? Personally, I found watching German soccer league games without anyone in the stands rather boring. But hopefully there will be creative ways to attract my interest. Sports isn’t the only category at issue. I mentioned theme parks earlier. What about movie theatres or concert venues? Can Broadway reopen? Its audience clearly skews older.
7. Stocks are fully priced, based on 2021 expectations, by any historic basis.
The bottom line is that we are now moving forward, and central banks are showering markets with money. It is a beautiful short-term fix for financial markets. President Trump will use his bully pulpit to keep that going as long as he can, at least until November. But the Fed can’t buy at its present pace for long. Moreover, early optimism about reopening at some point will be replaced by a sober reality, the early spike suggesting a V-shaped recovery can’t last. Airlines went from 80%+ capacity to 5% in less than 4 weeks. They could triple current load factors and still not be back to 50%. There will be few large weddings or corporate events anytime soon. Unemployment isn’t returning to 3-4% for a very long time. I understand the stock market’s enthusiasm, just as I understand everyone’s excitement about getting out of the house and back to normal. But normal tomorrow isn’t going to be quite the same as it was before we were quarantined. We will adapt and that’s important. But getting everyone and every business back to normal won’t be a smooth road. There will be failures, a lot of people aren’t going to get their job back, and the virus uncertainties remain. It may not be time to sell, but this probably isn’t the time to chase if you aren’t invested yet.
Today, former Senator Christopher Dodd is 76. Former Secretary of State Henry Kissinger turns 97.
James M. Meyer, CFA 610-260-2220