First Quarter 2020 - Well that was Fast
As we began 2020, there were signs that domestic economy was strong. Unemployment was historically low, real wages were rising, some housing markets were strong and broad measures of consumer sentiment were promising. The consumer was thought to be healthy, GDP was growing and the stock market hit record highs. In January, the U.S./China trade negotiations appeared to be moving in a positive direction with a “Phase 1” trade deal signed. The Fed was telling the market they believed policy was in such a good place that further action wouldn’t be needed for quite some time. The market had a “risk on” mindset and whispers of Coronavirus were something that was going to be mostly China’s problem.
In last quarter’s Insights piece, we offered a somewhat different view of the cracks in the domestic economy. We also speculated that the near future would determine whether the economy could stand on its own, or if we would become wards of the state (and that the Fed would have to support the economy – resulting in us having the same fate as Europe and Japan). The future would be dependent on the consumer. In full disclosure we anticipated that the consumer would carry the economy for 5/6th of the year. Specifically, we pointed the first decline in capital expenditures expectations by U.S. manufacturers in 11 years, the most credit rating downgrades for US corporate debt since 2009, the highest auto loan delinquency rate since 2011, nearly $2 Trillion of debt assumed by U.S. households over the past decade, and the largest drop in long-term inflation expectations to the lowest reading on record as signs of significant cracks in the economy. We also referenced a study by UBS that said 44% of consumers were not meeting their monthly expenses. People talk about “zombie companies” that are only in existence due to cheap funding but as we began 2020, we certainly had a sad number of “zombie consumers.”
All that information was in place before the consequences of a global pandemic was a twinkle in the eye of reality as we know it today. To gain a sense of the speed and magnitude of this cessation of the domestic economy, in mid-March and for the year prior, the average number of weekly jobless claims was a bit over 200,000. At the end of March, that number spiked to 6,600,000 people. In early 2009, at the peak of the Great Recession, the largest weekly job loss number was just under 700,000 people. In our lifetime we haven’t had to shut down the economy this quickly to fight an unexpected war (against an enemy that is one micron in size and that thrives in an open and mobile society). It feels like after the fact, this episode in our history will either show us to be resilient, resourceful, and civic-minded or it may expose us as being fragile, kept, selfish, and divided.
"It feels like after the fact, this episode in our history will either show us to be resilient, resourceful, and civic-minded or it may expose us as being fragile, kept, selfish, and divided."
Both the Federal Government and the Federal Reserve’s response has been nearly as rapid as the economic malaise. The Federal Reserve unfroze capital markets through two surprise rate cuts on March 3rd and again on March 15th (taking the lower bound of the Fed Funds rate to 0%) along with opening several lending facilities to prop up a multitude of cash-starved entities. The Federal Government did what it is supposed to do (move briskly in a broad crisis) and provided forgivable loans to a wide array of entities and increased unemployment benefits as a lifeline to many individuals. There will likely need to be additional rounds of relief and there will certainly be opportunity for waste and abuse in the fiscal policy solutions, but it seems like the executive and legislative branches of government got more “right” in this solution than they got “wrong.” The Federal Reserve has said they “will not run out of ammunition” as it relates to keeping the capital markets functioning through their lending powers. Both the Federal Government and the Federal Reserve have trillions of dollars allocated to their initial solution. At this point it is logical to think that if an additional hundred billion here or there is needed, what’s the difference (in for a penny, in for a pound)? It feels like there is a collective understanding that the necessary pause of the economy is a shared sacrifice and that the cost will need to be shared, or at least put on the credit card for some future generation to pay. Certainly, there will be tragic stories of death, failed businesses, and challenges for some people that fall through the cracks. On a large scale, we anticipate that for many Americans this pandemic will be the “months they worked from home” or “the spring when they didn’t go to school” or “the weird time when you couldn’t get toilet paper” (incidentally, the toilet paper thing is real and likely to persist while we are stuck at home due to the distinctly different institutional and consumer/residential producers and the massive increase in home usage).
Observations and Outlook – The End of the World as We Know it is Not the End of the World
The Plague (1347 AD -1400 AD) killed between 25 million to 50 million people. A smallpox outbreak in the 19th century is estimated to have killed 300 million to 500 million people. The 1918 (Spanish) Flu is believed to have caused between 20 million to 50 million fatalities. A 1930’s outbreak of Whooping Cough saw 200,000 cases per year and was especially deadly for infants and young children. The Polio epidemic of the late 1940’s and early 1950’s paralyzed 16,000 people a year and killed roughly 2,000 per year (it also was met with an inadequate supply of “iron lungs”). The 1968 (Hong Kong) Flu, is said to have killed between 1 million to 4 million. As of the time of the writing of this piece, we have had roughly 1.5 million cases of COVID-19 and just over 100,000 fatalities, with a bit over 20,000 in the U.S. The current moment feels both scary and bad, but it seems to be a case where people’s view of health risks, especially communicable diseases, is skewed by a lack of understanding of our history. We may also be overconfident in the “safety” that modern sanitation methods, hygiene practices, and access to medical care afford us. Perhaps all those advancements reduce the frequency of this particular risk, but the hypermobility and general openness of our world likely amplifies the speed and spread of pandemics. Also, through a risk management lens, had the world community been given better information about the risks and characteristics of this virus, the U.S. could have better-managed travel restrictions, reducing the 750,000 to 900,000 people who flew from China to the U.S. since COVID-19 was identified. It has been estimated that this move could have reduced the number of domestic cases by 60% to 90%.
The point is that although it feels different this time, we have seen healthcare crises on this scale, but we have not had the ability to have large numbers of people working in their homes while distancing. There are still large segments of the population who can’t work from home and they are either essential to keeping social order (and are still working) or they are now unemployed (along with 22 million of their fellow Americans). To maintain our quality of life after this event, it seems to be in our collective interest to socialize their risk and recent hardship. Beyond all of the central bank and political solutions designed to shoulder much of the pain of this challenge, people have a “hard wired” desire to return to normalcy. As an example of this drive, a friend is a senior person at the Bureau of Criminal Apprehension. He has had the duty of putting the handcuffs on some of the worst criminals (he calls them “clients”) and he says that the almost dutiful desire to maintain a routine is how the “clients” are caught most of the time. We are creatures of habit. The other side of this event is no different. The end of the world as we know it is not the end of the world. Life will resume to be mostly like the world as we knew it – although there will be fewer handshakes and more sanitization.
"We are creatures of habit. The other side of this event is no different. The end of the world as we know it is not the end of the world."
This desire to resume our routine is why we expect much of the broader economy to mirror the stock market behavior. It can best be described as a fall, a stall, and then a surge. The stock market is generally made up of the most well-capitalized, best-managed, and competitive companies and the valuations are magnified by the risk appetite emotions of the moment. The nail salon on the corner is in a different league and is easily substituted by a bottle of nail polish. It will take more time for consumers to feel good about elective expenditures, but it will happen. We anticipate that “main street” will see a delayed and muted version of what “Wall Street” has seen. The “surge” may be of the variety demonstrated by a college student bouncing back from a hangover. We too will eventually rally.
Entrepreneurs will adapt, government solutions will use the credit card to manage the pain, heroes in the medical profession will save lives now and work tirelessly to address delayed procedures for many months and the scientists and researchers will get us out of this mess. So, where does this leave us? This should look more like a sharp recession, followed by a multi-year Great Regression (to lackluster levels of growth) rather than being an economic depression. We think there is a scenario where the inefficiencies in the numerous programs (some would call it waste or bailout candy) could offer a short-term “bounce” to the economy, especially if it coincided with a sooner-than-expected scientific breakthrough that led people to believe we were heading back to “normal.” Stock values could see small losses on a year-to-date basis and Treasury yields would climb. We continue to think that euphoria will be short lived as global growth will continue to pull us down and segments of the economy will struggle under the weight of shifts in preferences and buying habits. We forecast that the second quarter of the year will be sobering and sad, the third quarter will be optimistic, and the fourth quarter will be realistic. In the end, we expect Treasury yields will end the year at current levels or modestly higher (but significantly lower than where we started 2020). Plan on significant levels of volatility in the interim.
Special Section - The Fed Gone Wild
Although it is nearly impossible to keep up with the almost daily announcement of a new program rolled out by the Fed to prop up the economy, it is worth discussing the Fed’s unconventional approach to expanding its reach. Historically, the Fed has only been allowed to purchase, or lend against, securities that have a government guarantee. Recently Fed Chairman Powell has verbally normalized the idea that the Fed is only using its lending power to assist solvent entities. So how has the Fed become a dominant buyer in the corporate, municipal and junk bond sectors? The Fed set up and finances a special purpose vehicle (SPV) for each of their programs where the US Treasury makes an equity investment in the SPV and assumes a “first loss” position. The US Treasury is effectively buying the related securities and the Fed is just providing the financing to leverage the US Treasury investment (and Blackrock has been hired by the Fed to purchase the related securities and run the SPVs for the true owner, the US Treasury). A genuine concern is that this degree of coordination blurs the lines between and independent central bank and the Treasury. To date, the Fed has roughly nine different lending programs designed to support orderly functioning in commercial paper and corporate bond markets, asset-backed securities, municipal bonds, and small and medium businesses. With plans to buy $625 billion in securities a week, it wouldn’t take long before the Fed (or the Fed/Treasury joint ventures) would be the financers of the nation.
Municipal Bond Market – A Liquidity Crisis, Cheap Bonds and Dangerous Legal Development
Leading into this “situation” the median balance of state rainy day funds was the strongest level of reserves ever. States seemed well-positioned to weather a modest recession. Investors continued pouring money into municipal bond funds (the culmination more than a consecutive year of inflows), which drove high-quality 10-year municipal bond yields as low as low as 0.81% on March 9th. One measure of municipal bond yields, The Bond Buyer’s 20-Year index, saw the lowest yields since the 1950s. As pandemic fears caused a clamoring for liquidity in almost all asset classes, massive selling pressure hit the muni market. March saw four consecutive weeks of outflows, totaling roughly $40 billion, driving yields on 10-year high-grade munis up to 2.88% on March 20th. As legislative and Fed solutions (including expanded Fed purchase powers) gave the markets hope, the muni bond fund redemptions moderated and 10-year muni yields closed the quarter at 1.44%. In a week’s time, we had the worst drop in muni bond prices since 1981, followed by the largest price increase since 1993. Yields were moving 50 basis points in a single day. The “sleep well at night” municipal asset class experienced losses of roughly 10% one week and generally recovered in the following weeks of the quarter.
Municipal bond yields are attractive as compared to similar maturity Treasury securities. In fact, that ratio currently sits at nearly 200% of the recent historical relationship. Some of that relationship is deserved as there will be pain in segments of the municipal bond market. Specific areas to watch include; hospitals, private colleges, transportation authorities, airports (especially where the true exposure is to a particular airline), nursing homes, senior living facilities, bonds supported by hospitality revenues, arenas, convention centers, multi-family housing, and any odd-ball or really specific revenue bonds (think golf course revenue bonds or tax increment financing bonds focused on retail development projects). Credit analysis is a nuanced expertise and if you hold exposures to these areas, you are not necessarily heading for trouble. Those areas of the muni market will likely garner significant headline space in the coming months. With “headline risk” looming, there is a distinct possibility that municipal fund redemptions will resume, driving muni bond prices lower. If, as is often the case, investors throw the baby out with the bathwater, there will be opportunity to buy “cheap” bonds of essential purpose issuers. We do not expect the opportunity will be anything close to what was experienced in March.
Beyond the issuers who will face a cashflow crisis related to this issue, there may be some credits that see a longer-term downward trajectory. San Francisco has estimated that revenues over the next two years will be 10% lower than originally expected. Presumably, municipalities with less diverse streams of revenue, or in areas of the country with focused economic activity (energy) will face greater challenges. Ridership for transportation systems, which has fallen by nearly 90% in some areas, will likely be depressed for quite some time (and some riders/toll payers may decide to work from home one or two days a week). Depending on the length of time that we have the COVID-19 risk over our heads, and the efficacy of treatments/vaccines, it is very possible tastes will change and other areas will see a secular drop in both demand and revenue.
"Depending on the length of time that we have the COVID-19 risk over our heads, and the efficacy of treatments/vaccines, it is very possible tastes will change and other areas will see a secular drop in both demand and revenue."
Some poorly run municipalities will likely see a cashflow bailout but unless they can finagle a full taxpayer bailout, they are still headed for failure. If it weren’t for the recent stock market recovery, the aggregate public pension funding ratio went from 52% to potentially as low as 37%. On that basis, the ratio for Illinois could have dipped to as low as 20%, resulting in assets that would support roughly four years of pension benefit payments. Prior to the COVID-19 crisis, Illinois had $7 billion in unpaid bills, roughly $140 billion in unfunded pension liabilities and $1.2 million (yes, million) in reserves. We are not sure that this episode will precipitate the final solution for Illinois, but it seems logical that the long-term outcome will be collapsing the Illinois pension systems into Social Security (a mutually miserable solution for all parties involved).
We have said for years to watch the Puerto Rico default saga for a glimpse into the major municipal bankruptcies of the future. Two recent developments set a dangerous precedent for bondholders in the riskier corners of the municipal bond market. First, a new restructuring deal was proposed by Puerto Rico’s financial oversight board. The proposal would hand general obligation bondholders losses of between 30% to 40% and investors would be given new replacement bonds mature in 20 years. Perhaps not as shocking but of greater impact is the U.S. Supreme Court’s refusal to consider a lower court’s ruling on the treatment of revenue bonds in a bankruptcy. The lower appeals court ruling said that payment of special revenues pledged to highway bondholders are voluntary and cannot be judicially imposed during bankruptcy. The case reverses the prior expectation that bondholders with a pledge of special revenues would continue to be paid in a bankruptcy. Special revenues include revenues from transportation projects, utility systems, special excise taxes, tax-increment financings and taxes levied to finance specific projects. It seems, as has been the case in other areas, the value of a pledge has eroded over time and people who extend credit to borrowers should be more vigilant about the creditworthiness of their counterparties.
Strategy and Summary
Last quarter we suggested muni investors “buy on the dips.” There was a great opportunity to buy high-quality bonds at yields approaching 3%. The headline risk that may face the muni market, along with recovery-based economic optimism may offer another opportunity to buy bonds at what we expect will be viewed as attractive yields over the next year or two, during the Great Regression. As we are facing uncertain times and an unavoidable near-term recession, focus on buying high-quality exposures to essential purpose projects and issuers. A likelihood exists that recovery expectations could drive the 10-year Treasury yield somewhere between 1.0% and 1.50% mid-year. Municipal bond yields, relative to Treasuries, are once again quite appealing and we would be a buyer as “AA” rated bond yields reach a level that is 200% of the comparable Treasury, or if you can buy 10-year munis at yields of 2.0% or better.
"As we are facing uncertain times and an unavoidable near-term recession, focus on buying high-quality exposures to essential purpose projects and issuers."
Nobody knows what will happen to the markets. This situation has so many variables. How long will this last, what areas will benefit from political favor, how permanent will the solutions be in eradicating this scourge? What we can observe is that humans tend to be creatures of habit. The desire to return to normal, financed by future generations, will likely cause the U.S. to start this economic engine as fast as is both possible and sustainable. As is often the case, we tend to extrapolate the current trajectory of our experience. That will likely result in an overconfidence in the ability to achieve meaningful economic growth. Yields will rise and long-term buying opportunities should result. Be patient, volatility breeds opportunity.
Finally, a heart-felt “thank you” to all first responders, medical professionals and essential workers that are keeping the country functioning. If anyone knows where we can source some Charmin Ultra Soft, please let me know. Be safe out there.
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