The markets resumed trading on Tuesday after closing for the observance of Memorial Day on Monday. The S&P 500 closed its second consecutive week of gains up 3%, and ended the month of May up 4%.
A report issued by the Bureau of Economic Analysis (BEA), an agency under the Department of Commerce, reported personal income had risen 10.5% in April versus March, while spending fell 13.6%. The increase in personal income was due to the transfer-payment program (stimulus checks) as well as the expanded unemployment benefits which added $600 per week on top of the regular weekly amount. These expanded benefits are due to expire at the end of July, along with the economic benefit they provide. Although spending will pick back up as businesses reopen in May, it will likely not reach its pre-covid levels as millions remain unemployed. The effect of the one-time stimulus checks is very temporary, and if the expanded unemployment benefits are not extended past their July expiration, we may even see a protracted decline in spending and an increase in savings.
In a bit of news that seems to be improving, weekly jobless claims came in at 2.1 million, down approximately 300,000 from last week’s figure of 2.4 million. This could be either because business is beginning to rebound, or more soberly, because companies hardest hit by the coronavirus are now operating under skeleton crews, i.e., there’s less employees left to lay off.
As for the performance in equities, it appears various factors are still at play regarding its rebound from its March lows. Optimism regarding potential covid-19 treatments and vaccines, coupled with businesses re-openings, and strong growth in the tech sector, are all contributing factors to gains in the major indices. Another factor is investors’ search for yield, as the S&P 500’s dividend yield outpaces that of the 10-year Treasury note which closed Friday at 0.650%.
Additionally, the S&P 500’s 12-month forward PE traded at 21.85 times on Wednesday. With the reported April unemployment rate of 14.7% and consumer spending down 13.6%, it’s hard to justify these price levels when the four most recent historical averages for the forward 12-month PE as of February 21, 2020, were as follows: five-year - 16.7, 10-year 14.9, 15-year - 14.6, and 20-year - 15.5. Additionally, this past week saw high grade corporate debt issuance surpass $1 trillion year-to-date, most of if for debt restructuring purposes, as well as paying down lines of credit and raising cash to weather the downturn.
At $10 trillion, non-financial corporate debt-to-GDP was 47% of GDP pre-crisis (13D Research)- “it has never been greater.” Decreased spending leads to decreased revenues for companies, while their debt servicing payments hold constant. S&P Global CEO Douglas Peterson told Yahoo Finance “We think there is going to be an increase in default levels up to potentially 10% of the high yield debt markets.”
All of this does not bode well for equities if the economic contraction proves to be more prolonged than anticipated as a result of the ongoing coronavirus pandemic. There are really two ways this can go:
Scenario 1 - Coronavirus persists, case counts increase, a slew of companies declare bankruptcy, and expanded unemployment benefits expire (worst case scenario)
Scenario 2 - Effective treatments and/or vaccines for covid are developed, life begins to normalize, and the economy and jobs numbers begin to recover
In scenario 1, we will see another draw-down in equities. In scenario 2, equities will continue their rally, mostly buoyed by the sectors hardest-hit by coronavirus as they will suddenly become value opportunities. Scenario 1 brings with it the specter of deflation, as prices and wages fall and the economy sputters. In this case, a diverse array of US Treasury bonds would be the preferred asset class as it would preserve your purchasing power, as well as gold as it is widely considered the best currency and safe-haven asset. You’d also want to limit the amount of cash you have (limit it to how much the FDIC insures).
Scenario 2 likely would not bring about inflation, as I believe economic expansion will be slow. The only way we’d see inflation is if the Fed actually started printing money (it can currently lend, not spend) and/or if they ramped-up the direct payments made to individuals. If inflation becomes more likely, then you would want to hold gold as an inflation hedge.
We’ll likely see a scenario somewhere in-between, and where on the spectrum between scenario 1 and scenario 2 reality lands will dictate your portfolio allocation.
16th Street Mall, Denver, CO
All of that being said, the weekend brought with it another variable- social unrest the level of which we have not seen in generations. Businesses in Central Business Districts across the nation were either boarded up or looted, and government property including police vehicles, city halls and state capitols were either destroyed or defaced as peaceful protests escalated into riots across the country. The catalyst was the death of George Floyd during an egregious case of police misconduct that brought decades of frustration toward racial injustice to a fever pitch.
What we clearly need now more than ever is judicial system reform. New York State Governor Cuomo called for the Attorney General to conduct investigations of police misconduct cases going forward (as opposed to local DA offices) and that may be a step in the right direction, as well as the elimination of qualified immunity which currently limits the ability of citizens to hold public officials accountable.
My hope is that, in the words of Killer Mike “we rise like a phoenix [out of these ashes].”