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: The big economic headline is about the jobs number. If there was any question about the shape of the recovery and whether a "V" is likely, then that should be put to rest with the abrupt reversal of the unemployment trend. Any inflection after such a dramatic decline for the past three months will look like a “V in the initial stage. The bounce is certainly positive, but questions remain about the durability of the recovery. Will we have a second wave and a corresponding second lockdown? That remains to be seen.
Markets are responding favorably to the new data, and sentiment is being buoyed by the reopening. Six states are reporting notable declines in COVID‐19 cases, including some of the previous hotspot areas like New York City, New Jersey and California. The simple math shows the worst hotspots have stopped getting worse.
Investors have also been reminded: don't fight the Federal Reserve (Fed). We've had more stimulus and the spigots have remained wide open. At the peak, the Fed was buying roughly $75 billion of securities per day, which has been tapered to $4 billion per day, but the backstop remains and has helped investor confidence. The market recoils from uncertainty, which is best illustrated by the spike in the VIX a couple months ago. That uncertainty creates market volatility and downside, but recently the data has been improving.
We're in the midst of the second quarter, and while earnings reports are still a ways away, we believe investors are likely to give companies a pass regarding second quarter results and turn their focus to the third quarter. Meantime, we believe sitting on the sidelines is a dangerous thing to do in terms of capital. The recent surge in small caps, value‐oriented businesses and cyclical companies supports the belief that we are recovering. The most dramatic returns have been in this area over the past few weeks, but the large cap and growth stalwarts continue to participate. Our view is to maintain a balanced exposure, including small caps, value, and international coupled with some of the stronger U.S. large cap businesses.
DEREK HAMILTON: Most of the world continues to see improvement in controlling the spread of COVID‐ 19, with most of the outliers coming from emerging markets. But overall, trends continue to move in the right direction from a global perspective.
Data supports our view that April was likely the low point in economic activity. We have previously outlined our belief that, in the short run, our economy will experience a rapid recovery from the lows, but more challenging medium‐term environment where unemployment and bankruptcies likely take some of the focus. This continues to be our base case. We believe the back half of the year for much of the world will show that sharp recovery.
Source: Bloomberg. Data calculated: 01/01/15 – 06/01/20.
May employment numbers were very strong, beating expectations by a wide margin. The snapback was strongest in hardest hit areas like restaurants and retail. The unemployment rate was reported at 13.3%, which is obviously high but much better than expected. The true unemployment number is about 3 percentage points higher than that figure. The way the survey is constructed tends to skew the number of unemployed toward the low side in this environment, but even 16.5% is still well below than the market‐predicted 19%. We think by year‐end the unemployment number will be 8‐9%, which is consistent with historical recessions. The pace of the recovery, with unemployment dropping from the mid‐teens to 8‐9%, speaks to the cyclical snapback versus a more structural breakdown.
State and local governments continue to be under pressure. We had a second month of aggressive layoffs in these areas of employment, one of the few spaces that didn't experience a strong recovery in employment. This may lead to more stimulus, specifically targeting state and local governments.
Congress included an additional unemployment insurance benefit of $600 per week, which is scheduled to end on July 31. That deadline will likely provide the motivation to extend additional benefits in one form or another. Republicans and Democrats are debating how to address this – Democrats want to extend it through year‐end, while Republicans want to pare it back, incenting people to go back to work. Very few Republicans want to drop the additional unemployment benefit to zero, so we expect something to get done.
More household stimulus and medical funding is also possible. Republicans want another payroll tax cut, but that seems less likely if the economy continues to improve. Small businesses still have access to Paycheck Protection Program (PPP) loans, so stimulus is not likely to focus here. Also, the Fed continues to do whatever it takes, including asking for fiscal stimulus. We believe the Fed is likely to make it very clear that short‐term rates will remain close to 0% for years to come. We have been below the 2% inflation target for years, so the Fed believes it needs to have a "catch up" by letting inflation running above 2% for a while.
In terms of Europe, its monetary and fiscal stimulus is catching up to U.S. The European Central bank announced additional stimulus last week, as did Germany with a notable focus on consumption. France is also likely to announce a stimulus package this week. Overall, we continue to get more stimulus in the financial system around the world.
Lastly, the U.S.‐China trade conflict continues to accelerate. As we get closer to the election, markets will be more focused on this issue, while President Trump will push hard on this topic. It's a popular topic in the U.S. as Americans view the relationship with China more negatively than ever before.
What securities have the Fed been purchasing?
The vast majority of what is being purchased is U.S. Treasuries. The reason is because it’s easiest to get liquidity in the system to drive down the cost of capital. U.S. Treasury purchases dwarf the Fed’s purchase of corporate credit, municipal bonds and high yield credit. The purchases in the corporate and high yield space were delegated to ETFs, so we haven't seen them participate in specific issues.
How much faith do we put in unemployment number, i.e. was this month’s number skewed by the PPP loans and will there be an uptick in the future?
Our confidence in the accuracy of people unemployed is low. When surveys are done, the number of responses is less than typical because the businesses aren't open. In terms of PPP loan impact, that absolutely had an impact on unemployment, which was Congress's intent. From a higher level, the way activity is snapping back is quite important. We're not back to pre‐COVID‐19 levels, but every week we look at a number of activity trackers – where are people going, how many small businesses are open, what are TSA passenger throughput numbers – they all continue to move higher each and every week. This implies that demand for workers should continue to improve.
Source: Macrobond Financial. Google Maps. The graph compares different activities relative to trend. The U.S. continues to show an increase in activity.
What about furloughed workers and the impact on the unemployment rate?
That’s part of the problem with how the unemployment rate is calculated. There are two different jobs surveys: 1) payroll number, which surveys every company that can be reached and 2) household survey, which determines the unemployment rate by asking households whether individuals have a job, and if not, whether they are looking. Some furloughed employees are answering the survey by saying yes they have a job but were not at work. Others said they weren’t employed and weren’t looking for a job, which doesn’t count the person as unemployed. That's just an issue with how the surveys are structured and creates a little fuzziness.
The CBOE Volatility Index (VIX) is a calculation designed to produce a measure of constant, 30‐day expected volatility of the U.S. stock market, derived from real‐time, mid‐quote prices of S&P 500® Index (SPXSM) call and put options
Bloomberg Corporate Bankruptcy Index is Bloomberg Corporation’s measure of measure of corporate bankruptcies.
Past performance is not a guarantee of future results. This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through June 8, 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This information is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.
Risk factors: Investing involves risk and the potential to lose principal. Fixed‐income securities are subject to interest rate risk and, as such, the value of such securities may fall as interest rates rise. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets.
The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. In addition, the impact of infectious illnesses in emerging market countries may be greater due to generally less established healthcare systems. Public health crises caused by the COVID-19 outbreak may exacerbate other pre-existing political, social and economic risks in certain countries or globally. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.