May We Live in Interesting Times - Private Client Letter
/To say that we are living in “interesting times” would not do justice to what we all have experienced since the COVID-19 outbreak made headlines in February. What began as a serious health crisis quickly turned into an economic collapse as government leaders issued lockdown orders and essentially brought large parts of our economy to a standstill. Never before has the United States shut off its economy by proclamation. Interesting times indeed!!
To blunt this downturn, the Federal Reserve and Congress put together the largest rescue package in U.S. history. Even so, unemployment numbers skyrocketed as the longest running period of economic expansion (a record 128 months) gave way to the sharpest recession this country has ever experienced.
Throughout this extraordinary period of upheaval, Clearwater Capital has concentrated on two fundamentals: key trends of the virus outbreak and high frequency economic data. We believed this would provide us with the greatest possible insight relative to the “flattening of the virus curve” and the reopening of the economy. Remaining steadfast in our focus on data also would help us avoid a panicked response to the historic collapse in equity markets worldwide.
All along our view was that the COVID pandemic was best understood as a “shock” to our system, rather than a systemic breakdown within our economy. This shock is paramount to a natural disaster which strikes suddenly and produces a lot of damage. History would suggest that the economic impact stemming from a shock is transitory in nature. Our conclusion throughout this crisis was the downturn would likely be the steepest, but also the shortest, of our lifetimes.
As the months have passed, this perspective appears to have been quite accurate. The recession that began earlier this year, and officially declared by the National Bureau of Economic Research just last week, is now likely over. In other words, the recovery is already underway as evidenced by very strong employment numbers and post-pandemic rebounds in retail sales and industrial production.
Retail sales surged a record 17.7% in May, more than double the consensus forecast of just 7.7%. Headline industrial production and its manufacturing subcomponent rose 1.4% and 3.8%, respectively in May, a welcome reprieve after April had the largest monthly declines for both series on record. Within manufacturing, auto production surged 120.9%, by far the largest monthly gain on record, as car and truck factories began resuming operations (First Trust).
After setting new record highs in late February, U.S. equities experienced a freefall that would take stock prices down by about 35% in less than six weeks. In the time that followed, markets produced a stunning rally and by June 8th the S&P 500 had recovered all the COVID-19 losses.
Just 53 days after bottoming with $10 trillion in value destroyed, the S&P turned green for the year, capping a 47% rally from the intraday low on March 23rd (Bloomberg). As of June 17th, the S&P was astonishingly less than 9% away from its all-time high. Few market participants expected a rally of this magnitude and not surprisingly the S&P 500 now trades at levels above most of Wall Street analyst’s year-end price targets – including our own.
After such a dramatic rally off the lows, investors are now reassessing where the markets stand relative to the pace of economic growth and fears of a “second wave” COVID outbreak across the country. Social unrest involving race issues and widespread protest demonstrations have cast a shadow over the economic recovery. Consequently, a renewed spike in volatility emerged last week with the U.S. stock market enduring its worst daily decline since March. Going forward, the lingering uncertainties, along with a national election less than five months off, would likely suggest more volatility to come.
Narratives abound, but given how overbought equities had become, we are hesitant to push an explanation for recent volatility beyond an overdue round of profit taking. At this point, we are increasingly confident COVID-19 is not the health threat feared a couple of months ago. While some are skeptical about the pace of true economic progress, we are focused on an unprecedented stance of monetary policy and the enormous liquidity that has been pumped into the system.
So where are we as we move into the second half of this historic year?
First, we are encouraged by the current COVID-19 data. Hospitalization and death rates have not spiked as the country loosens restrictions on business and social activities. While the number of known infections has risen, we believe this is the result of higher levels of testing. The nation’s medical response to COVID also continues to advance with better treatment protocols, and a wide range of therapeutics and potential vaccines are progressing rapidly through the research process. The nation appears to be getting the pandemic under control.
Second, the government’s monetary response to the crisis has been extraordinary. From last week’s meeting of the Federal Reserve, we now know policymakers do not expect to raise short-term interest rates until at least 2023. They see the unemployment rate dropping steadily as an above-trend recovery takes shape. Over the past three months, the M2 money supply has exploded by an annual rate of 86% creating an unprecedented level of liquidity in the U.S. economy. This liquidity will help fuel a steady rebound in economic activity while serving to support prices within the capital markets.
The downside to this flood of liquidity is, of course, the inflationary pressures it produces. We expect higher rates of inflation, but not right away. As the economic recovery gains traction and the desire to hold precautionary levels of cash fades, this liquidity will begin to exert upward pressure on general prices. Future monetary policy adjustments will ultimately determine how much inflation becomes an issue over the next several years.
And third, the economy is on the mend. We have a long way to go before we will have a full recovery, but it appears consumers and businesses are eager to re-engage. Restaurant bookings, rail car traffic, an initial jobless claims data have turned favorable along with many other real-time economic indicators. The “animal spirits” are stirring. People are itching to return to normal and there is considerable pent-up demand throughout the system.
Even still, we must brace ourselves for more troubling reports on the economy as the recovery takes shape. These reports will be the traditional backward-looking measures of activity, such as second quarter earnings reports - which we know will be very bad. We must continue to monitor the forward-looking “green sprouts” to gauge the pace and ultimate strength of the rebound.
In the coming days we will be updating our year-end target for equity prices. Originally, we believed the S&P 500 could reach 3,575 in 2020. With the COVID-19 outbreak, this target was adjusted to 3,100, which has already been achieved. This said, we do expect further gains from here, along with additional volatility in the second half of the year. Inflation, interest rates, and equity prices will all be higher a year from now. We look forward to sharing with you our new targets for 2020, along with our preliminary expectations for 2021.
As always, thank you for your continued confidence, especially during these “interesting times”. From the very inception of our firm nearly 15 years ago, our goal has been to bring clarity to a complex world. We hope our Thought Leadership communications have been helpful to you as together, we navigate unchartered waters.
