- COVID-19 continues to have profound effects on the U.S. economy.
- Without material improvement in the labor market, the economy will continue to require
aggressive monetary and fiscal stimulus.
- With economic demand still weak, unless the U.S. Congress pushes through an aggressive
policy of fiscal stimulus, the U.S. could suffer an economic catastrophe.
The U.S. Congress leaving Washington for their August recess without a deal for a fifth coronavirus relief package doesn't augur well for the U.S. economy.
As the number of cases and deaths from COVID-19 continue to rise, the disease's effect on the
economy continues to be profound. The initial response to COVID-19 eliminated 22 million jobs in March and April, with only nine million recouped since. And it doesn’t feel like those jobs will come back anytime soon. Without material improvement in the labor market, the expected reduction in consumption will need to be offset by accommodative monetary and, especially, fiscal stimulus. Failing to push through an aggressive policy risks economic catastrophe.
Too pessimistic? Real interest rates, as measured by Treasury Inflation Protected Securities (TIPS), are at their lowest levels since January 1997. TIPS represent the yield on a U.S. Treasury security less the perceived inflation for its respective period. The equity market may be celebrating, but bond investors aren’t joining the party. The forward price-to-earnings (P/E) ratio for the S&P 500 Index has been steadily increasing to a level reminiscent of the Dotcom era since the end of 2018. Historically, real yields and forward P/E ratios tend to move in a similar fashion; a strong economy drives both higher.
Bond investors, through the lens of TIPS, have become increasingly pessimistic since the end of
2018. The current level of real yields shows that bond investors view the economic outlook as weak and uncertain.
Real yields should be low because we're in a liquidity trap. By this, I mean the Fed is pushing on a string. The Fed lowered interest rates from an already low level, but this hasn't affected lending
whatsoever. For the most part, companies are not borrowing money for capital investments.
Yet, there exists an unusual dynamic. Both the money supply and loan levels have increased. Firms are drawing down their lines of credit, but they're not using this money. They’re liquidating accounts to make sure that cash is available if they need it. Then they just hold the money and wait. If the money doesn’t circulate, job growth slows and overall growth potential is lost. Recent purchasing manager surveys do little to disprove this. During the second quarter, the metric measuring money circulation (known as the velocity of money) sank 23% from its already historically low level.
As if that wasn't enough, the pandemic is happening during an election year. One of the big things spooking corporations (and keeping us at Aware Asset Management up at night) is the fear that corporate taxes will rise if the Democrats gain control of the Senate. Adding costs to corporate balance sheets won't bode well for the bond nor the equity markets.
The economy will not recover until COVID-19 is under control and the election is over. Until then,
corporations will not aggressively hire more people. Yet, when unemployment remains high, demand remains low. It's a vicious cycle that the FED, by itself, can’t fix over the near term.
Businesses need to know that there is demand for their goods or services. And right now they just don't see it. There's not a lot of confidence about demand because no one knows what consumption levels will be with so many people out of work.
The current situation of weak lending, high unemployment, and a need for stimulus to support consumption, creates significant doubt that monetary policy alone can fix the problem. That’s why it's absolutely critical that Congress keeps spending. Fiscal stimulus is what's protecting us from economic calamity. Consumers need to keep spending until the COVID-19 overhang is removed.
The Fed explicitly stated that it wouldn’t even consider raising rates and would be content with allowing inflation to run hot. We don’t expect a highly inflationary environment until the unemployment rate falls. Yet, if the Fed does see an unexpected jump in inflation, will it continue to keep rates low or will rates rise to combat inflation? Will the Fed be able to maintain its independence after its balance sheet expansion stops?
With all this in mind, Aware Asset Management has been positioning portfolios based on two
themes. First, rates are too low for the long term. Their asymmetric return profile, specifically in the fixed-rate space, has led us to increase our exposure to floating-rate assets. This will enable us to produce higher current yields and provide downside mitigation when interest rates turn up. Second, we continue to utilize Inflation protection within our portfolios. We feel that the massive influx of stimulus in the market will eventually create a problem for the Fed. Since negative real interest rates are a harbinger for inflationary pressure, we continue to see opportunities in inflation-protected securities.
John E. Kaprich, CFA
Aware Asset Management
Investing involves risk, including the loss of principal.
Real Rates (10 Year) Relative to Forward S&P 500 Price-to-Earnings Ratio
Past performance does not guarantee future results. It is not possible to invest directly in an index.