The US has been alone among advanced economies in attempting a return to “normal” before quelling Covid-19. It shows in the data. New daily cases soared above 70,000 in the US last week, with a majority of states showing a rise rather than a decline in new infections over the week. So far, deaths have not risen in tandem. An unexpected drop in consumer sentiment in early July suggests that workers and families are worried. Governors and local officials are too, with some reviving lockdown orders. Debate is now raging about whether schools can safely reopen this fall. California – with over 6 million students in public schools – announced last Friday that remote learning will continue for many after the summer. But the S&P 500 continued to climb, up another 1.25% last week for a rise of 3.3% so far in July.
Listen to Finance Forward: In the latest episode of RockCreek’s podcast Afsaneh Beschloss and Caroline Atkinson talk with Fed insider, Dr Nellie Liang, about how financial reforms after the last recession left US banks – who often argued against reform – better able to withstand today’s crisis.
The Covid-19 recession hit world-wide. Thanks mainly to extraordinary government stimulus, financial markets have suffered little, after an initial panic in late March. Investors have looked past the dismal Q2 picture for output, jobs and earnings, hoping for a quick turnaround as economies wake up after lockdown. Last week, China showed this is possible. First into recession, in Q1, China notched positive GDP growth in the second quarter. In Europe, countries across the region have reopened gradually in recent weeks as daily infections and deaths have come down, and stayed down. Outbreaks of Covid-19 remain a concern, but governments have acted quickly to test, track, trace and then isolate these outbreaks – as in Spain last week.
The picture could hardly be more different in the US. Last week saw an uptick in American deaths, following the rise in hospitalizations that followed the renewed surge in infections that began in mid-June. The difference is not just in the health numbers. It is also about the path forward. There is no debate in Europe about children returning to schools. That means parents can return to work more easily. Offices are open, albeit with new rules on distancing, wearing masks, and cleaning procedures. Tourism is down, but not out.
The summer lull may obscure these differences. And the news is not all bad. The recent – and shocking – number of close to 1000 daily deaths from Covid-19 is still well below the daily toll in April. Treatment is improving. Vaccine trials are continuing apace. Moreover, the US economy, and financial system, were strong and resilient going into this crisis. Other recent data, notably for housing and construction, show that record low interest rates are doing their bit to boost the economy, unlike after the last crisis which, after all, was triggered by an implosion of mortgages. More broadly, equity valuations suggest investors remain hopeful about the future, even as some look now to 2022 rather than 2021 to justify current prices.
Three issues to consider, and the take away for investors.
By now we know that the workers hit hardest by the pandemic-induced recession were women, in contrast to the experience after 2008-09 when unemployment rose more among men – a more usual cyclical pattern. Women – especially those at the lower end of the income scale – lost jobs at a greater rate this spring, as firms in service industries that rely on female labor, whether restaurants, hotel and office cleaning companies, or hair salons and beauty parlors, have been closed. At the same time, many of those women who have continued to work, have done so in dangerous circumstances, as nurses, staff in care homes, and other “essential workers”.
Now attention is being drawn to the career hit that women further up the income scale are likely to suffer as many schools stay closed and working from home continues, at least for some parents who have little choice with children at home. As former Australian Prime Minister Julia Gillard and London Business School professor Herminia Ibarra note in a Harvard Business Review piece, working from home is especially tough for women, who typically do more childcare than their partners. Looking ahead, if women stay home more than men in a new “hybrid” working environment, will this exacerbate the problems of better-connected men who go into the office more often rising more readily to the top?
2. Where is fiscal stimulus when you need it?
We are now just two weeks from the US fiscal cliff, when temporary unemployment benefits are due to expire. Congress has seen the deadline approaching. So far, Democrats and Republicans have stuck to their very different plans. But as the House and Senate return today for the stretch before August recess, pressure to agree is rising. House Democrats passed a $3 trillion package in May that would continue the unemployment benefits, among a host of new and additional programs. These included, most importantly, a big increase in federal money for hard-pressed state and local governments, for the health system and for infrastructure. Senate Republicans pinned their hopes on a continued summer recovery in the job market that would make an extension of the expanded coverage and higher benefits under the CARES Act unnecessary. They also heard complaints from some businesses that the extra $600 a week for the jobless enacted in March was enough to make some workers reluctant to go back to low paid jobs. Liability protections for businesses whose workers catch Covid-19 have been rejected by Democrats but are high on the Senate and Administration list. The buoyant stock market has eased pressure for action although President Trump now says he would like to see a $1 trillion stimulus bill that he can sign this summer. He wants it to include a payroll tax cut. Democrats quickly rejected that. Compromise is possible. But there is not much time.
In Europe, leaders fought all weekend over the EU proposal to raise EU-wide funding in capital markets for the first time. Strongly backed by German Chancellor Angela Merkel and French President Emmanuel Macron, the recovery fund would support fiscal spending in individual nations with a mixture of loans and grants, After tentative agreement overnight on the amount of grant funding, €390 billion, leaders extended the summit into a fourth day and will reconvene later Monday to haggle over the governance of the fund. The Netherlands and other Northern European countries have been the main hold-outs. They are pressing for a smaller fund, as well as conditions on the money and unanimous consent, so that any single country can exercise a veto. That governance approach would backtrack from the “Hamiltonian moment” that Europe was approaching, of joint liability and EU-wide decisions. Insistence on conditions and on national veto power for support to needy countries, as the Dutch now want, undermined the euro during the 2011 to 2013 crisis. For a crisp attack on this position, see Lisbon Council Chief Economist Alessandro Leipold’s, “‘To Persist in Error is Diabolical’ How Intergovernmentalism Could Torpedo the Next Generation European Union Plan.” As with all things EU, a fudged compromise is likely, maybe even as soon as today, Monday. The details will matter.
3. Is distress coming, for borrowers and their creditors?
Many are predicting a wave – or even a tsunami – of bankruptcies to come as shuttered businesses and unemployed workers cannot pay their bills and repay loans. Banks in the US are well-capitalized, and last week reported soaring second quarter revenues even as the economy collapsed. But banks also built up their reserves, expecting worse times ahead. The Fed recently ordered limits on dividends and share repurchases to preserve capital until the shape of recovery, and the costs of the recession, become clearer. Many obligations were halted during lockdown, making it hard to know how bad the damage will be, or where opportunities may lie for distressed asset investors. Corporate default rates are climbing, reaching 5-6% so far this year compared to their 4% long-run average. Some predict that this could rise as high as 10 or 15%. But the rewards for taking this risk remain meager, with high yield spreads only 300-500 basis points above Treasuries.
4. The take-away for investors?
Equity markets continue to show resilience in the face of rising Covid-19 cases in the US and across developed markets. Moving into the second half of the year, we think institutional investors will be focused on scenario planning and ensuring even greater flexibility and cash in their portfolio so they can quickly pivot depending on the outcome of US elections and the path of the virus.
Nearer term, the focus will be on earnings reports. Q2 earnings season kicked off on a positive note with banks reporting better than expected earnings despite lower interest rates depressing profit margins. The coming weeks will see more earnings news that could introduce another level of volatility – even shorter-term or intraday – into the markets. Many believe that valuations today are not necessarily reaching bubble level despite an economic slowdown. The current 17% premium in the US market is similar to the start of the year and significantly less than the 65% premiums priced into markets at the peak of the dot com bubble. Today’s depressed earnings are also elevating P/E ratios, unsurprisingly. The S&P 500 trades at a 22x forward P/E ratio today but given such a low level of interest rates the implied equity risk premium is still attractive at over 3.5%. This is in sharp contrast to the negative equity risk premiums that were seen during the tech bubble.
To this end, interest rates rising are a potential long term risk to markets even if investors are able to ignore the downside of rising interest rates in the short term. While difficult to see given the current state of economic indicators, if an economic recovery does gain traction and interest rates rise, we would expect to see higher valuations and lower equity risk premiums as earnings rise. Despite equity returns lacking any sort of foreseeable upside, a combination of a potential economic recovery, low rates, and technicals argues against meaningfully underweight equity positions at this time. Another reason for investors to remain vigilant, patient and cash rich as we monitor the upside downside case for the US equity market.
US Fixed income markets on the other hand continue to be the puzzling piece of institutional portfolios that used to rely on the “40%” of the 60/40 model. How does one continue to earn sufficient returns from fixed income and who are the new players in the market? One interesting issue relates to who is buying the huge issuance of US treasury bills and bonds. Bonds are being bought by the Fed and T-bills by US money market funds (which have seen huge inflows until recently). Foreign buyers (Japan, Europe and China) have noticeably reduced purchases. One reason is that on a hedged basis US yields are no longer attractive relative to local currency yields in those countries. We wonder how long does this lack of interest last? If US investors feel more confident will they move out of US T-bills, in which case yields on T-bills and US bonds will have to become more attractive to entice foreign buyers. Especially given the heavy issuance by the Fed.
Related to the question of inflation, TIPS is another part of fixed income markets that investors have commonly considered good inflation protection. TIPs buying has continued to be strong as many investors fear that the Fed will allow an overshoot of its inflation target of 2% to ensure better employment. 30 year TIPs are now being offered at negative yields of around -25bps. The question remains whether they are a good buy at these real yields.
Emerging markets is another exciting, albeit volatile area of opportunity. In public markets, selling activity this past week in the China A-shares market from State backed shareholders such as NSSF and National IC Fund triggered cautiousness among investors – A-share indices corrected by 6.5% from its peak along with three consecutive days of net selling. Given increasing retail participation in the A-shares market, Chinese regulators are increasingly monitoring OTC margin financing and released a list of 258 platforms that are involved in illegal margin financing, showing the determination from regulators to avoid the leverage bubble in the A-shares market like in 2015. As the Securities Daily put it, “the market pullback this week has left the A-share market healthier and more balanced.”
China reported better than expected second quarter growth this week, indicating that the world’s second largest economy grew at an annual rate of 3.2% – outpacing analyst expectations of 2% – with the usual caveats about the reliability of Chinese official data. This was welcome news given the 6.8% contraction seen during Q1. Industrial production and a better than expected increase in exports led the recovery, while retail sales were still down on the quarter. Classic brick and mortar consumption has yet to recover to pre-crisis levels and we believe it may never do so. Similar to global trends, consumption patterns in China have shifted to e-commerce and online services.
In private markets, investors have picked up on these changes in behavior and are directing capital accordingly. Venture capital deals in China have seen a significant uptick recently, with edtech and software companies taking the lion’s share of funds deployed. Zuoyebang, a Chinese online tutoring startup for students, and Chinese online education startup Yuanfudao raised $1 billion and $750 million respectively in their most recent funding rounds. Just this week, Google announced its intention to invest $4.5 billion in India’s broadband and streaming business Jio Platforms. Jio Platforms has an array of media and service operations including music streaming service JioSaavn, broadband, on-demand live television service JioTV, and payments service JioPay. Jio Platforms and Google have agreed to jointly develop an entry level affordable smartphone with optimization to the Android operating system and the Google Play store.
We expect these types of investment to continue across emerging markets for the foreseeable future even once viable vaccines are administered and the pandemic abates. Consumer habits are generally hard to break especially if rooted in convenience and many of these tech driven business models provide exactly that, convenience. Scalability will be key however, which is why we also expect the larger incumbents in areas like e-commerce and online entertainment to dominate in the short term. In other sectors such as online medicine, education and banking, the dispersion of players is still wide and investors will have to do their homework to pick future winners.
Over the past few weeks, the RockCreek team has hosted a few guests on our daily investment calls to share insights on their areas of expertise. We recently hosted Owl Ventures Director Malvika Bhagwat to discuss education technology, and RockCreek Senior Managing Director Ken Lay to discuss innovations in climate and sustainable investing. We look forward to sharing highlight clips of more discussions in the coming weeks.
We hope you, your families and teams continue to stay safe and healthy throughout these uncertain times. We are always eager to learn of more ways in which we can help uplift communities during the crisis, please let us know if you are aware of any opportunities and ways in which we can get involved.