By Kevin M. Harris, CFA®, President & Chief Investment Officer of Aspireon Wealth
Some Shoots Of Hope…But Not Yet A Time For Bold Action
WHAT WILL IT TAKE TO FIND A MARKET BOTTOM?
We’ve been discussing with clients that the recent market strain originated as a structural problem rather than a financial one. The key distinction between the two is that structural problems typically occur abruptly and are followed by quick recoveries once the issue is corrected. Financial crises, on the other hand, have longer-lasting impacts and ramifications spread wider the longer they are left unaddressed. There’s little question that significant structural problems serve to develop financial issues as an effect, but the efforts required to combat the two differ greatly. Namely, structural issues require more immediate fiscal policy decisions and other forms of government action, while financial ones demand greater emphasis on monetary policy and stimulus.
We believe there are three key efforts necessary for finding a bottom in the markets and starting a recovery process in the economy.
Briefly, these are:
- Maintain Market Liquidity. Immediately the Federal Reserve must deploy its arsenal of tools. The Fed can provide two key things in times like this: (1) They can serve to stabilize markets that have seen liquidity (or lack thereof) disrupt order and lead to panicked or technical (forced) selling. This is basically what the Fed is seeking to defend against with ‘Quantitative Easing’. (2) The Fed can use policy tools to stimulate the economy by lowering the cost of capital while increasing the availability of it. They accomplish this by reducing the Fed Funds interest rate – the discount window at which banks can borrow money – and/or by limiting the reserve requirement that distinguishes how much cash banks must keep on hand. In a structural problem, the first action is significantly more important as the market can’t become incented by stimulus until the acute problem (uncertainty) is remedied.
- Revive the Economy. The root of the structural problem is the COVID-19 coronavirus. The virus emerged with a pace on the global scene never witnessed before in modern times. There have been approximately 5 stages of the regional spread: (1) China; (2) South Korea and Taiwan; (3) Italy and Iran; (4) Western Europe & Australia; and finally, (5) the United States. Fortunately, several countries before us have taken aggressive steps to contain the spread and have even begun reviving their economies by allowing citizens to return to work and school. Evidence supports the United States’ ability to “flatten the curve” and slow the spread as quickly as cases have spiked. What is required, however, is that communities take severe actions with the goal of stopping the spread and providing a path to containment. Our need for a 15- to 20-day stay-at-home response is by far the most important thing to watch. Again, if you solve the structural problem, you can limit the effects of the financial problem. A successful ‘flattening of the curve’ would work to remove the cause of uncertainty, get people back to work, re-open businesses and squash the fears prevalent. Once this occurs, we will be more capable of assessing how much damage was done to the economy and therefore corporate earnings and consumer health; these would in turn aide in determining the market’s fair value and ultimately lead to a stabilization of market conditions.
- Backstop Those Impacted and Stimulate Forward. The government’s fiscal policy response has been watched closely for the last few days. In short, there are several items in the forthcoming bill that will help to offset the financial inconveniences suffered by individuals and small businesses. These groups have limited safety nets in place and maybe more permanently impacted if they don’t receive meaningful and immediate support. Additionally, larger corporations (the airline, cruise, lodging, energy, etc.) that have been disproportionately impacted are also due to receive support. While some controversy and disagreement are present surrounding the size and suitability of the proposed stimulus, it has paled in comparison to the moral issues brought forth by the government bailout during the Great Recession of 2008-09. The bill under consideration is already the third to address this structural problem and it likely won’t be the last. While this package will likely provide over $2 trillion in support, there will not only be a need to replace lost wages and missing revenue caused by the work stoppage and stay-at-home efforts but to also begin to look forward and stimulate activity when life returns to normal.
Of these three elements, the most important is that we find the path to containment of the virus. With proper efforts, the ensuing results will send people back to work and revive the economy. This will mark the restart of activity and therefore allow markets to draw conclusions around where the floor resides. Working in concert with fixing the structural issue is how much stability, support, and stimulus the Fed and government will provide. Their actions will determine the speed of recovery and normalization.
WHAT IS OUR OUTLOOK REGARDING THE ACCOMPLISHMENT OF THESE EFFORTS?
Our feeling is that the Federal Reserve has already succeeded in providing stability and future stimulus to the markets. The Fed had already reduced funds rate to 0% and committed to more than $700 billion in security purchases, but as we eluded earlier, their more important function was to stabilize other parts of the market that were becoming disorderly. Monday, the Fed launched a new suite of programs aimed at keeping credit flowing to businesses and individuals. The highlights of these initiatives were as follows:
- Unlimited Quantitative Easing (QE), Unlike the Past. The Fed will purchase Treasury securities and agency mortgage-backed securities—now including commercial MBS—in amounts needed to support smooth market function and effective transmission of monetary policy to broader financial conditions and the economy.
- Support for the Corporate Bond Market. The Fed established two facilities to provide credit to large employers – the Primary Market Corporate Credit Facility (PMCCF) for new bond and loan issuance, and the Secondary Market Corporate Credit Facility (SMCCF) to provide liquidity for outstanding corporate bonds.
- Encourage Consumer Spending. The Fed also established a new Term Asset-Backed Securities Loan Facility (TALF). The TALF will enable the issuance of asset-backed securities (ABS) backed by student loans, auto loans, credit card loans, and loans guaranteed by the Small Business Administration (SBA).
- Backstop the Country’s Municipalities. The Fed will facilitate the flow of credit to municipalities by expanding the Money Market Mutual Fund Liquidity Facility (MMLF) to include a wider range of securities, including municipal variable rate demand notes (VRDNs) and bank certificates of deposit. They will also facilitate the flow of credit to municipalities by expanding the Commercial Paper Funding Facility (CPFF) to include high-quality, tax-exempt commercial paper as eligible securities.
This is an all-out effort to ensure that the business sector can continue to exist even as economic activity temporarily collapses. The Fed is now effectively the direct lender of last resort to the real economy, not just the financial system. Open-ended QE—this always looked inevitable—plus purchases of both primary and secondary market corporate bonds, and bond ETFs, for investment-grade businesses (BBB/Baa3 or above) represents a huge easing. We believe this removes one key element of the uncertainty facing investors, though the other two—the extent and duration of the spread of the virus, and the ultimate fiscal response—are still unknown. The Fed’s balance sheet is now set to re-expand rapidly and substantially—especially if the fiscal package initially is financed by the Fed, as we expect—but that’s nothing to worry about; the near-term threat to the economy is structural. We can fret about inflation risks later because right now the threat is a deflationary collapse.
Regarding the efforts to stem the spread of the virus, citizens, largely at the direction of state and local government, have begun to shelter in place and we believe the next 7-10 days will be very telling on whether we have made the necessary progress to begin to get back to work.
Lastly, we are going to receive a large package on the fiscal front by the middle of this week, even if there are the common political considerations stuffed in-between what should be the bill’s only focus. We also believe the message with this bill is that the government is not done, and more importantly remains willing to offer more support as needed.
In our base case, if Congress acts aggressively—$2T+, including serious support for the self-employed and gig workers—and the disease is under control by the end of late April to mid-May, the economy will rebound very strongly in the third quarter, with only a modest loss of capacity from businesses going under. The second quarter is anyone’s guess, but a huge double-digit decline is inevitable even if activity rebounds strongly in June. In this case, we believe today’s market levels closely reflect the pending economic damage which entails a temporary spike in unemployment and a very difficult second quarter for business activity. It is likely we will see a recession for 2-3 quarters, and markets starting to look beyond in the next few weeks. If the disease fails to be contained, lasting into June or later, we should expect an additional decline in the markets to the tune of 20% or greater, and a more permanent impact of employment and businesses. This will stretch the recessionary conditions out likely into 2021, also suggesting continued market volatility in general for longer. While not our base case, this still respectfully has a probability in our minds of 15-25%.
WHAT CAN INVESTORS BE DOING WITH THEIR INVESTMENT PORTFOLIOS?
Given today, the community spread chain is not yet broken and there is not enough data available yet to make the decision on precisely when to send people back to work. It remains important that investors actively manage their risk levels, and we suggest this entails working to dynamically maintain a portfolios’ risk levels similar to where they were before markets began to drop. In times like the present, it's important to pair back investments that have done their jobs and held up well from a defensive standpoint and to reallocate proceeds from this activity back towards wealth accumulating strategies which have been more victimized for their offensive stance. This allows a portfolio to recapture the inevitable turnaround in market performance. Additionally, for investors who maintained cash in reserve for future opportunities, the time is growing increasingly attractive for putting some to work. Talk with your advisors for guidance and direction or contact Aspireon Wealth Advisors if you need advice or a second opinion.
DISCLOSURES: This commentary provides general information for illustrative purposes only and is compiled by Aspireon Wealth Advisors, LLC. This commentary constitutes an opinion as of the date published, and is subject to change without notice and therefore it may not be accurate or current. This material is not financial advice and it should not be considered a recommendation to purchase or sell any particular security and does not purport to show actual results. Information contained in this document is based on data obtained from third party sources, while this information has been obtained from sources believed to be reliable, Aspireon does not guarantee, nor is it responsible for, the accuracy, completeness, or timeliness of the information provided. Investments in securities or other financial instruments involve risk. Past results do not guarantee future performance. Aspireon Wealth Advisors, LLC does not provide tax or legal advice; please consult your tax advisor, CPA or attorney. Aspireon is a wholly-owned subsidiary of The Bank of San Antonio, Inc, and is a Registered Investment Advisor. Additional information about Aspireon is also available on the SEC’s website at www.adviserinfo.sec.gov. You can search this site by a unique identifying number, known as a CRD number. The CRD number for Aspireon Wealth Advisors, LLC is 150508.
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