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Quarterly Report - A Tailwind for 2021

Quarterly Report - A Tailwind for 2021

January 12, 2021
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“The pandemic has had some unexpected effects. Household savings rates reached
record highs across the OECD group of rich countries this year.”

 – Financial Times article, December 16, 2020

Overview

Following the third quarter’s strong equity performance, the fourth quarter rewarded investors who stayed the course and didn’t abandon ship when their account values recovered earlier losses from the first half of 2020.  This was evidenced during October and November, which exhibited some of the strongest monthly equity returns on record.  Interestingly, this was during a continued surge in coronavirus cases.  The last quarter of 2020 pushed all the major indexes into solid gains for the year.  We are only 8 to 9 months past some of the sharpest equity indexes' declines in recent memory and are now sitting near all-time equity market highs.

This strong equity performance wasn’t limited to just financial markets.  Low interest rates and supportive fiscal policy has also helped propelled real estate values in almost every major market to record highs.  This has made many investors or even passive news watchers ask, “what’s going on here, we have an unprecedented health care crisis and I’ve made a ton of money on my retirement account”.  It should be stressed that financial markets are often disconnected from current news flow and economic data.  Concurrently in 2020, we have experienced a slowdown in many areas of economic activity.  Industries like restaurants, hospitality, and travel related industries took a big hit, and have yet to recover.

But during the pandemic the US consumer has fared incredibly well.   This runs contrary to popular belief and may even be unpopular to discuss, but the consumer has record levels of wealth.  With all the doom and gloom seemingly the only story covered in mainstream media, it should be noted that there is an unprecedented level of cash on household balance sheets due both to external restrictions (lockdowns) and trillions of dollars pumped into the US economy via various government economic support measures.  This should be very supportive for the economy in 2021.

Economic Commentary

As mentioned briefly above, equity markets are at all time highs, this is while COVID-19 cases continue to rise.  This runs contrary to what many would expect from financial markets with death tolls mounting and lockdowns ratcheting up.  US equities bottomed in late March 2020 and bounced along a bottom for a few months while investors and market watchers tried to decipher where we were headed.  It should be noted that immediately preceding the COVID outbreak we had made new highs in equity market on February 19th, 2020.  As has happened many times before, the Fed came to the rescue of plummeting financial markets and acted as the lender of last resort. 

As dislocation began to spread in both equity and credit markets the Fed went to their standard playbook and cut interest rates 50 basis points (or .5%).  As credit markets froze up and equity indexes melted down the Fed quickly realized that it had to take extraordinary measures.  On March 15, 2020 the Fed cut rates to zero.  This decision was made on a Sunday night during an emergency meeting.  Later, markets continued to be jittery but the Fed had put in a floor under asset prices.

Currently, the Fed has come out publicly numerous times and reiterated their intention to keep rates at zero at least until 2023, or until inflation picks up for a sustained period.  To maintain credibility the Fed cannot deviate from their clearly telegraphed policy until there is substantial uptick in the inflation environment.  As has been said many times before, don’t fight the Fed.  This saying still rings true, and now has been augmented by don’t fight the Treasury.  Steven Mnuchin and the Treasury Department have been very out-front in advocating for very stimulative fiscal policy to combat damage done to the economy from the pandemic.

One has to wonder, what was said behind the scenes between Fed and Treasury officials during the depths of the financial market selloff in March and April.  The scale of the following coordinated response by both the Fed and Treasury is almost incomprehensible.  Previously the bailout of 2008, which was later widely criticized for reinforcing excessive risk-taking both on Wall Street and at big banks, was estimated to total $700 billion.  The current multiple stimulus measures are estimated to total about $4 trillion and will likely go higherThere is talk of an incoming Biden administration asking for another $2-$3 trillion in economic stimulus.

It is very safe to say that the current pandemic bailout packages dwarfs previous stimulus measures enacted back in 2008-2009.  The first CARES Act alone amounted to $2.2 trillion.  It is estimated that $1.5 trillion in “excess” savings had made its way to consumer balance sheets.  One reason we are sitting at new highs in financial markets is the sheer volume of money thrown at the pandemic’s fallout.  But, bailouts and asset appreciation have also raised the discussion of increased financial inequality, with the rich getting richer in the midst of a pandemic (more on this later).

For background context on past bailout efforts, please note that the market lost about 50% from October 2007 to March 2009.  Equity investors took much longer to recover from the 2008-2009 financial crisis versus 2020.  It should be stressed that the Fed also cut rates to zero during 2008-2009.  While the 2008 crisis was one borne out of internal excessive leverage, the current crisis was one borne of an existential threat from outside the financial system.  This also, may be one reason that the Fed and Treasury have been so successful at supporting financial markets.  For the most part, the financial system was healthy before the coronavirus breakout.  Due to the Fed and Treasury we are benefiting from reduced borrowing costs and witnessing an almost limitless money creation.

In many sectors like retail, travel, and restaurants, there is no doubt that individuals are experiencing fallout from lack of consumer spending.  But, an unintended outcome from this pandemic is that those with sizeable financial assets have grown much wealthier.  Employees with jobs that can be done remotely have fared far better versus employees faced with mandatory shutdowns.  Plus, knowledge-based workers who can work remotely typically have higher earnings.  This, coupled with forced savings induced by COVID-related shutdowns, has pushed up the personal savings rate to record highs.  Whether these outcomes are right or wrong can’t be analyzed here.  The goal of examining these outcomes is to hopefully help make sound capital allocation and investment decisions going forward.

Outlook

Recent political events in Washington bear discussion, but it should be stressed that they do not drive long-term financial market performance.  Actual policy decisions are much more important. The following paragraph is, word-for-word, a copy of last quarter’s outlook regarding potential election outcomes:  “The other major scenario is a Democratic “clean sweep” of the House, Senate, and White House.  With this outcome, we believe policy shifts could have very meaningful implications for investors.  Specifically, to the extent a Biden administration delivers on his plans for $2.5–$3 trillion of spending on infrastructure and clean energy, on top of stimulus measures directly related to the pandemic, we believe this fiscal impulse could fundamentally alter the underlying dynamics of interest rate and equity markets.  For several years, we have seen the market adapt to a consensus view that inflation will remain subdued for the foreseeable future and that rates will remain lower for longer.”

If we look back at recent events like the Trump/Clinton presidential election, coronavirus death toll, Democratic versus Republican control of the Senate, etc., these events are merely part of the overall landscape.  It could be argued, and history would largely support this outlook, that topics like Fed interest rate policy, credit conditions, overall financial leverage, and stimulative fiscal policy have a much larger impact on financial markets.  Or, as someone recently summed up, “2020 has been a very bad year for people, but a very good year for financial assets”.  The more quickly we can realize outcomes can be bad for people while simultaneously benefiting asset markets, the more easily we can make more effective decisions regarding capital allocation.  Right now conditions are very supportive for financial assets.  In our current scenario large-scale businesses have a huge advantage.

This “financialization” of our modern world is becoming a widely debated issue.  The pandemic has laid bare the advantage of being someone who controls capital versus someone who only controls his own labor.  Labor can be shut down and when not utilized it is uncompensated.  Capital can become more valuable by a variety of means.  One would be the ability to buy more assets after they go down in value (buying more stock after the market declines) or interest rates decline and make the present value of your cash flows larger because of a lower discount rate. 

This could be one reason that Jeff Bezos has benefited so greatly from the pandemic (Amazon controls both huge amounts of both capital and labor and is publicly traded).  A simple Google search will yield an illustration of just how powerful Amazon’s share price gains have been on Bezos’ personal net worth during the pandemic.  Bezos is making about $321 million a day, $13.4 million an hour, $222,884 a minute, and $3,715 a second this year. The largest single-day increase in Bezos's net worth is $13 billion, which he achieved on July 20, 2020.

This type of price appreciation for a tech company that basically distributes, sells and delivers products seems quite impossible if we are to take at face value the “economic destruction” being wielded by the coronavirus.  Which means that Amazon’s rise is much more nuanced.  It’s being driven by an advancing ecommerce-enabled sales model, tailwinds from stay-at-home orders, and the ubiquity of the iPhone, which has definitely softened the blow of many aspects of the coronavirus.  Many things we can now transact from our phone that up until a few years ago would have be impossible like ordering food, buying groceries, paying bills, and having goods and services from almost anywhere in the world shipped to our home.  

These are trends that were in play pre-pandemic but have evolved much faster due to COVID restrictions.  But, as many point to Tesla and Amazon as big winners, there have been many, many stocks that have gone unreported in the press and have had higher returns post-pandemic.  Tupperware is one.  Yes, Tupperware.  The stock was less than $2 per share in March and is now trading above $30 per share.

Summary

So where do we go from here?  In an era of so much noise around financial markets, coronavirus related issues, and politics we must go back to the basics and focus on some of the main drivers of equity valuations.  Are interest rates cheap?  We would propose they are insanely cheap and, maybe even a more powerful argument in favor of their “cheapness” is they are being held down by the Fed who has went on record that they will do whatever it takes to keep them low until the economy “runs hot”.  This seems to be an explicit backstop from the Federal Reserve.  We expect this policy stance to continue as the Fed has backed themselves into a corner.  And let’s not forget, every homeowner who refinanced their mortgage during this crisis has, in effect, been given a pay raise.

On the fiscal side we have a federal government who has thrown literally trillions of dollars at a public health crisis.  A large piece of this money has made its way on to consumer balance sheets, plus we have very high real estate and equity prices.  Further, we now have an incoming administration that has made it clear that they want to either continue or even increase direct payments to the general public via additional stimulus measures.  All of these factors should support consumer confidence and spending.  There are even some market strategists calling for a “spending boom” as we hopefully pull out of the coronavirus-induced malaise toward the middle of 2021.

At some point these economic policies may come back to haunt the US economy via inflation or some kind of debt boycott from our creditors.  But this is likely a couple years away; right now we see no other game in town than equities.  We continue to stay fully invested and believe there will of course be minor corrections along the way, but equities still have room to run given the fiscal and monetary backdrop illustrated above.