August 21, 2020
The Manley Macro Memo
July Market Review: July was another strong month for stocks as Q2 earnings came in better than expected (despite dropping by 36% from last year), and several vaccine trials announced positive results. The S&P 500 rallied by 5.6% to close in positive territory for the year, and the tech-heavy Nasdaq Composite closed at an all-time high. Despite this "risk-on" environment, the safe havens performed very well in July – gold appreciated by 11.1%, the long-term U.S. Treasury bond rose 4.4%, and the 10-year U.S. Treasury bond yield fell by 11bps to 0.54%.
Interestingly, the stock market seemed immune to any disappointing news. There was little adverse market reaction when the Coronavirus unexpectedly spiked in many Southern and Western states or when economic reopening plans were rolled back. Also, the market performed well despite many companies filing for bankruptcy (Brooks Brothers, Ann Taylor, Men's Warehouse, Jos. A. Banks, California Pizza Kitchen, and Lord & Taylor), and the rising tension between the U.S. and China. Additionally, stocks had no adverse reaction after Congress failed to extend the critical pandemic economic relief program that expired on July 31.
We believe the market's strength and incredible resiliency to bad news can best be explained by the Fed's unprecedented policy reaction to the Pandemic and the economic shutdown. To stabilize and stimulate the economy, the Fed cut short-term interest rates to zero and printed approximately $3 trillion in three months to buy bonds and inflate risk assets/stocks. This strategy of financial repression also drove real interest rates (nominal interest rates minus inflation) deeply into negative territory (see chart below).
By driving real interest rates to negative 1%, the Fed pushed the U.S. Dollar to a 2-year low, which inflated the price of most assets by reducing American's purchasing power (see chart below). For example, over the past 90 days, the dollar has had a -95% correlation with the S&P 500. Also, the dollar's correlation with gold and the CRB commodity index has been -89% and -85%, respectively. We believe that stocks (and other assets) are not rallying because the economy is improving or a vaccine is imminent, but because our purchasing power is declining. This loss of purchasing power explains why gold significantly outperformed stocks in July.
Portfolio Review: In July, we outperformed our benchmark, despite our defensive investment exposure that was underweight stocks and long the safe havens -- gold and long-term U.S. Treasuries. Year-to-date, we continue to outperform our benchmark with significantly less risk -- i.e., lower volatility, reduced equity correlation, and limited drawdowns.
Our equity portfolio remains invested in the defensive sectors of the market. We are long the Quality and Minimum Volatility Factors, and the Healthcare and Consumer Staples sectors. Our only economically sensitive exposure is to the Consumer Discretionary and Communications sectors. Also, we are invested in gold mining stocks (ASA, which is a closed-end fund) that should benefit from higher gold prices and an industry that is rapidly consolidating after a period of underinvestment.
We remain long the safe havens (gold and long-term U.S. Treasury bonds), and we recently added Treasury Inflation-Protected Securities (TIPS), which are bonds that provide protection from inflation. We believe that our high quality, defensive portfolio should continue to outperform our benchmark during this volatile period of considerable economic uncertainty.
As discussed last month, the market-based indicators that we monitor are signaling that the economic environment is changing from deflation (declining rate of growth and falling inflation rate) to stagflation (declining rate of growth and rising inflation). We believe that the aggressive fiscal and monetary policies that were used to battle the economic shutdown will continue for some time, which will weaken the dollar and inflate prices. As this trend continues, we will opportunistically invest in the sectors of the market that will benefit from a weak dollar and rising prices -- i.e., Gold, Energy, Materials, Commodities, TIPS, and Emerging Markets. Also, as inflation accelerates, we will reduce the duration of our bond exposure.
Market Outlook: As discussed earlier, the extreme monetary and fiscal policies that were used to stabilize the economy during the Corona Pandemic have created negative real interest rates and caused a loss of purchasing power for Americans. Given the historic debt burden in the U.S., we believe that economic growth will remain sluggish, and the Government will continue these financially repressive economic policies for the foreseeable future. We believe that these policies will have significant consequences for investors, especially those who rely on the traditional blend of 60% equities and 40% bonds.
In our view, the Fed's attempt to manage the business cycle over the past forty years has led to artificially low-interest rates, record stock valuations, a historic debt burden, low productivity, and wealth inequality. For decades, the Fed reduced short-term interest rates to stimulate the economy. Once interest rates finally hit 0% in 2009, the Fed created a new monetary policy tool (Quantitative Easing), which they believed would stimulate the economy by printing money to buy bonds and inflate stocks.
During recessions or severe economic slowdowns, the Fed would cut interest rates by 5.00%, on average, to stabilize the economy and stimulate growth. Lower short-term interest rates would increase stock market valuations and encourage corporate and consumer borrowing, which would fuel an economic recovery. This policy of cutting interest rates and encouraging debt accumulation drove interest rates lower, and the debt burden higher for the past forty years.
In May of 1981, the 3-month U.S. Treasury bill yielded 16.3% -- today it yields 0.10%. During each economic cycle, yields made lower highs and lower lows (see chart below).
While interest rates fell, corporate debt increased during every economic cycle. In 1981, corporate debt was 30% of GDP -- today it is a record 48.6% (see chart below).
Also, Federal debt increased from 30% of GDP in 1981 to a peacetime record of 108% today (see chart below).
During the Great Recession of 2008/2009, the Fed cut interest rates from 5% to 0% and then had to employ a new tool -- Quantitative Easing, which printed money to buy bonds in an attempt to inflate stocks and create a wealth effect that would stimulate the economy. Since QE lowered long-term interest rates and inflated stocks, corporations used financial engineering (borrowing to buy back their stock or make significant acquisitions) to grow earnings instead of making productive capital investments. In our view, QE is responsible for much of the enormous corporate debt burden and the decline in productivity.
The last recession ended in March of 2009, but the Fed never normalized their monetary policy. They waited nearly seven years to raise interest rates, and short-term rates ultimately peaked at only 2.4% in March of 2019. When the Pandemic struck, the Fed had a limited monetary tool kit since they could only cut interest rates by 2.4%, not the typical 5.0%. To stabilize the financial markets and stimulate the economy, the Fed cut interest rates to 0%, and in three months, printed a record $3 trillion to buy bonds (see chart below). In addition to monetary policy, the Federal Government passed the CARES Act, which at over $2 trillion (10.3% of GDP), was the largest fiscal rescue package in U.S. history.
Currently, we are in the worst recession since WWII, more than 22 million Americans lost their job, and America's debt burden has never been higher. We believe that the massive debt burden will lead to disappointing economic growth even once the virus is contained. Unfortunately, the Fed is out of tools -- interest rates are already 0%, and QE has not effectively stimulated economic growth. We believe that significant fiscal stimulus will be necessary to stimulate the economy. We expect that the Fed will maintain 0% interest rates for the foreseeable future, and they will use QE to finance the Federal budget deficit. We expect that these policies will gradually monetize (or inflate away) the enormous debt burden, but will also lead to stagflation – rising prices (a loss of purchasing power) and sluggish economic growth.
This economic environment will be treacherous for investors who use a 60% stock, 40% bond asset allocation. The 60/40 traditional blend has worked great since 1981 because bonds were very profitable (falling from 15.8% to 0.50%), and lower interest rates led to higher stock market valuations. Also, since the Fed always cut interest rates during economic slowdowns or recessions, bonds acted as an essential equity hedge during bear markets.
Currently, the 10-year U.S. Treasury bond yields only 0.60%, so it will provide limited protection if the economy falters, and it will provide a negative real return (after inflation) each year for the next decade. During periods of stagflation, it is essential to reduce the portfolio's bond exposure and invest in TIPS, gold, and commodities, which perform well during inflationary periods.
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Our short-term (three-months) outlook is neutral: Stocks are overbought, breadth is weak, and excessive speculation is evident. As the chart below indicates, the S&P 500 is at an all-time high, yet only 53% of stocks are above their 200-day moving average, and market breadth (McClellan Oscillator) is negative. Additionally, the 11-day Put-Call Ratio reached a 15-year low, which indicates extreme optimism and risk-taking. Our short-term market outlook is neutral, and we will become negative if the S&P 500 closes below 3200.
Our long-term (more than four years) outlook is negative: We believe that stocks offer a poor risk-reward, and we remain underweight equities relative to our benchmark. While the FANGM Stocks recently drove the S&P500 and the NASDAQ to all-time highs, most stocks are below their 200-day moving average and remain in a bear market. Central banks and not economic fundamentals drove shares far from their intrinsic value. The global economy was vulnerable before the Coronavirus, and now there is significant uncertainty about the magnitude and duration of the worst recession since the Great Depression. The S&P 500 is at an all-time high despite the deepest recession since WWII and a record corporate debt burden. We will remain defensively postured until the market offers a favorable risk-reward, i.e., valuations improve, and economic growth accelerates. Our Strategic Asset Allocation is underweight equities relative to our benchmark; we are invested in the defensive sectors of the S&P 500 and the safe havens (gold and the U.S. long-bond).
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Conclusion: Despite record market highs, there is incredible uncertainty because no one knows how the virus or the economy will progress in the future. As value investors, we deal with uncertainty by focusing on the market's risk-reward, which is currently very poor. The Fed's massive liquidity injection, coupled with investors flight to the safety of the mega-cap technology stocks (Facebook, Apple, Amazon, Google, and Microsoft) has driven the S&P 500 to an all-time high, despite the severe recession, 22 million jobs losses and little progress containing the virus.
If the best case occurs -- a vaccine is approved, the virus is contained, and the economy fully opens -- we don't expect much upside for the S&P 500. Instead, we believe there will be a significant rotation out of FANGM (mega-cap tech) and into the economically sensitive sectors of the market. There will be a great opportunity in these cyclical names, but we expect that the S&P 500 will remain range-bound. If the worst-case occurs (a significant spike in new cases this fall, a rollback in reopening's, and an increase in corporate defaults), we believe the market could drop by 30% or more.
We strongly believe that the key to growing wealth and compounding at an optimal rate is to avoid significant drawdowns, which typically appear in high-risk periods similar to today. We will continue to focus on preserving capital during this volatile and uncertain time. Preserving capital will ensure that we will have significant cash available to take advantage of the substantial opportunities available when the recession is over, and stocks offer a favorable risk-reward.
If there are any questions or comments, please do not hesitate to contact me directly.
All information disclosed in this statement is accurate and complete to the best of our knowledge. Past performance is no guarantee of future results, and there is no assurance that the firm or client's investment objectives will be achieved.
J. Lawrence Manley, Jr., CFA