The Fed shifts on inflation – What does it mean?
The Fed unveiled a revision to its monetary policy, allowing for higher inflation to help support the labor market. We believe this action could keep interest rates low for years.
Dan Hanson, CFA
Mr. Hanson is Senior Vice President and Chief Investment Officer at Ivy Investments. He is responsible for leading the company's investment management division and has more than 25 years of investment and leadership experience.
Mr. Hamilton is Senior Vice President and Global Economist at Ivy Investments. He has more than 23 years of investment experience.
Dan Hanson: We just experienced the best April since 1938. The market has rallied off the March 23 lows as a result of record stimulus. The depth and breadth of the U.S. Federal Reserve’s (Fed) policy action has led to a record amount of issuance in the investment-grade bond market. Companies have been able to refinance and shore up their balance sheets. Energy hit new lows in April and remains a very challenged sector. There's very little demand for oil right now, but there's plenty of supply. There's been a shift to a risk-on environment and that's caused small cap and value stocks to perform well. We think the market is behaving rationally in this risk-on environment.
Derek Hamilton: Broadly, the COVID-19 curves continue to flatten. New cases have continued to accelerate at a less rapid rate, and continue to slow in places like Europe and New York. While containment of the virus continues to be positive, we're still seeing relatively weak overall activity levels, but we are moving off the bottom. Data from Google shows increasing trips to places like restaurants and retail stores. Some of the data around small business is also relatively weak, but it's also moving off the bottom.
In China, we've begun to see a bit of a stall in the pace of recovery in aggregate. We're seeing overall activity levels stall out at about 90% of pre-virus levels. Last week was a holiday week which usually results in a jump in travel and shopping. Travel and consumer spending were down quite a bit but less so than pre-virus trends. In aggregate, the data is showing a move in the right direction. As we've been saying for a while now, second quarter data should be the weak point for the broad economy. From a policy standpoint, there have been some notable updates.
Fed Chairman Jerome Powell stated the Fed is willing to do more, and he's pushing hard for more fiscal stimulus. Negotiations on the next round of fiscal stimulus will begin soon. The second tranche of Paycheck Protection Program (PPP) loans for small businesses was released last week. In just five days, over half of the capital was committed. We think there will likely be a third round of stimulus that includes more funding for PPP loans and could make it easier for small businesses to take these loans.
We'll probably get some state and local aid. Given pushback from Republicans, there may be some restrictions on this. Basically, Republicans don't want to bail out pension plans that have been poorly managed.
There's talk of another stimulus for consumers. We're not sure if this will come in the form of a payroll tax cut, or if it will be another stimulus check. It's unclear what the amount of this stimulus might be.
In Europe, the European Central Bank (ECB) made some changes to liquidity provisions for banks. Banks can now borrow from the ECB at -100 basis points (bps). The ECB is essentially paying banks 1% to borrow money, making sure there's plenty of liquidity in the system. However, the ECB continues to lag what the Fed has done, and even though they've said they would do more, they do seem more hesitant and have a few more constraints than the Fed.
With regards to the U.S. and China, new export controls have been put in place. This means that more U.S. companies need a license to export goods to China. There's been an increase in U.S. naval activity in the South China Sea. China is using the virus as a reason to expand activity there, but the U.S. is pushing back. President Trump has threatened additional tariffs, and wants accountability for the spread of the virus. This could be the start of a prolonged escalation between the U.S. and China. Trump's goal for reelection was a strong economy, and that obviously hasn't been the case given the effect of COVID-19. Recent polls show all-time levels of skepticism regarding China. If Trump can't rely on the strength of the economy, then he may pivot to a more hawkish position against China.
Dan Hanson: The S&P 500 Index is just past the halfway mark in terms of numbers of constituents that have reported earnings for the first quarter of 2020. Relative to market cap, about 2/3 of the index has reported earnings. Broadly, we're seeing about one-fifth of companies missing earnings expectations, but we wouldn't want to make too much of that because forecasts are very cloudy right now. Big tech continues to lead and follow through. While it's a narrow market, we continue to observe the haves and have-nots. There continues to be plenty of uncertainty in this market, and it's important to have multiple shots on goal so to speak. We don't think it's time to overweight cyclicals and laggards right now. We think it's best to have balanced exposures in this environment.
With regards to infrastructure spending, how do you see this playing out in the current environment?
Derek Hamilton: It will be very difficult to get an infrastructure bill passed this year. Policymakers in Washington want to address the people and businesses impacted by the virus, and that includes the state and local governments mentioned earlier. With that said, infrastructure is likely going to stay on the back burner for now. Both Republicans and Democrats want infrastructure, but they don't agree on how to pay for it. Historically, infrastructure bills involve some coordination with state and local governments, and that's difficult given the current state. This will more likely be a 2021 issue.
Dan Hanson: A couple of the large cap names that would typically benefit from more spending like this are still down nearly 35%. They are in the category of very limited clarity around future earnings power.
What do you think aid to state and local governments will look like? Will it be in the form of direct aid, or will it be in the form of increased liquidity in the bond market?
Derek Hamilton: It will likely be both. Congress is focused on direct aid right now. The Fed just expanded their muni bond buying program by increasing the number of eligible cities and states, and they've increased duration limits as well. The Fed still has plenty to offer, but the focus right now is on direct aid from Congress.
What are your thoughts on the outlook for the oil market?
Derek Hamilton: Broadly, we have a pretty significant supply/demand imbalance. Looking at miles driven or jet fuel consumption, these things have been decimated as one would expect. However, if we do see a recovery in the back half of 2020, we expect to see more driving, but travel and tourism will continue to be pressured.
Dan Hanson: : If you look at long-term, multi-decade trends, $20-$30 per barrel of oil in real terms is pretty similar to where it's been priced over the last century. We think all commodities ought to ultimately trade at the marginal cost of production. The supply imbalance is exacerbated by the willful production of Saudi Arabia and Russia. They can change that on a dime if they choose to do so from a geopolitical standpoint. The demand side will come back more slowly whether it's with regards to jet fuel consumption, miles driven or just broader economic activity. That will take some time, and it would be imprudent to expect a bold, dramatic resurgence in oil.
Are there concerns of rising inflation given the large amount of stimulus?
Derek Hamilton: We've seen an extreme shock to the market, which is deflationary. That headwind will lessen, but it isn't likely to go away. The monetary stimulus is really just filling the hole left by businesses and households retrenching. I wouldn't get too concerned about inflation until we start to something like robust demand for credit, and we think that environment is still quite unlikely for the foreseeable future.
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