The summer rally and fiscal impasse
This year's powerful summer rally came on the back of an unprecedented surge in monetary policy support along with better-than-expected economic data. While the nascent economic resurgence has not been record-breaking, overall results continue to surprise to the upside and that's keeping markets satisfied despite intense political wrangling in Washington.
Reports this month showed upside in the US manufacturing and services sectors in addition to solid employment gains. With 1.8 million jobs added in July, many economists believe the worst of the recession is behind us. In the second quarter, 82 per cent of S&P 500 companies exceeded analysts' estimates — much higher than the historical average.
While the bounce off the March bottom has been fast and furious, we are likely to see a slow and grinding path forward from here. A noted strategist claims the global economy can only operate at about 80 per cent of its full potential without a Covid-19 vaccine.
In June, the International Monetary Fund projected global economic growth to contract at an annual rate of -4.9 per cent for 2020 followed by a +5.4 per cent GDP expansion in 2021. The June forecast is lower than April's due to the pandemic and associated government response. Overall, the 2021 GDP forecast is 6.5 per cent lower than the pre-pandemic projections made in January 2020. Growth in the advanced economy group is projected at -8 per cent in 2020, but expected to rebound to +4.8 per cent in 2021.
Despite improving data points this summer, the world remains in a technical recession for now with some countries faring better than others. China and Europe appear to be recovering first as they had to deal with the virus earlier. In the US, a second broad lockdown is not likely to happen as this would cause permanent closing of many small businesses from restaurants to physical retailers.
Aggressive monetary policy has catalysed the rally. The US Federal Reserve increased the M2 money supply by a whopping 23 per cent on a year-over-year basis — more than twice the increase seen during the Great Financial Crisis 12 years ago. Money printed through quantitative easing in the three months after the Covid-19 outbreak is more than the total amount added during the year of the Great Recession.
Even though the stock market just hit a new high, as measured by the S&P 500, the majority of the newly minted funds have been pouring into short-term securities. Equity funds, for example, have seen net cash outflows on a year-to-date basis and bond funds have seen only modest inflows. Money market funds, on the other hand, have seen massive net inflows to the tune of almost a trillion dollars this year. Funds sitting in money markets earning next to nothing may provide fodder for further rallies in other asset classes.
The full impact of this year's transformative Fed policies became clearer this month as risk markets forged higher despite elevated unemployment levels and large parts of the economy operating well below potential due to heightened restrictions and reduced mobility. Last week, the S&P 500 stock index touched a new all-time high even as political squabbling caused an impasse in implementing the next round of government stimulus.
While an eventual compromise is likely, the US economy is fast approaching a fiscal cliff if additional stimulus is not provided. Investors must contend with the near-term possibility of waning government financial support prior to an effective Covid-19 vaccine being approved and distributed.
While President Trump and his administration are not averse to running up the Budget deficit by cutting taxes, the White House seems to be taking a more traditional Republican approach on the second tranche of stimulus.
US Treasury Secretary, Steven Mnuchin recently stated that the Democrats in Congress and the White House may not reach an extension deal while House Speaker Nancy Pelosi has described the two parties as “miles apart.”
In order to prevent an imminent spending cliff, President Trump issued an executive order last week which provides additional unemployment payments of $400 a week. At the beginning of the pandemic, Congress had approved payments of $600 a week, but those benefits expired at the beginning of this month.
The last time I wrote about a fiscal cliff was in October 2013, “America's Fiscal Follies and the Road Ahead.” At the time, the US was forced to endure a government shutdown due to political wrangling over the Budget. History repeats itself today with the Democrats looking to increase America's debt load faster by advocating for a $2 trillion-dollar package, although that's been dialled back from an initial $3.4 trillion ask. Republicans stand firm on a smaller package.
As with the 2013 scenario, we will likely see a resolution in the near future. Political careers are at stake in an election year and no one really wants a dissatisfied populace looking for their slice of the pie. Besides, the hit to small businesses and service workers was hardly their own fault.
In this environment look for dividend-paying stocks and disruptive innovators to perform well. Both sides of the aisle are geared towards policies which will keep interest rates lower for longer. As we have seen in both Europe and Japan, zero interest rate policy and slow growth is the logical outcome to unrestrained government largesse. In periods of secular stagnation, disruptive growth companies tend to shine. Income investors who can withstand some volatility should be more interested in sustainable dividends than shrinking bond coupons.
• Bryan Dooley, CFA is Head of Portfolio Management at LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority