Dark clouds to clearer skies
A torrent of events in 2020’s first quarter rattled the global economy and markets. What’s the outlook for investors for the rest of the year? Join Phil Orlando, R.J. Gallo and Linda Duessel as they share insights.
Published May 1 2020
Hello and welcome again to the Hear & Now podcast. Today we're joined by Linda Duessel, Phil Orlando and RJ Gallo.
Linda Duessel: I'm Linda Duessel, senior vice president and senior equity strategist at Federated Hermes, and I will be the moderator of today's presentation. I'm happy to be here to join Phil Orlando, our chief equity strategist, and RJ Gallo, head of our duration committee, as we provide our analysis and insights on the economy, policy and implications for the financial markets. Phil, I'd like to start with you. Phil, how should we measure success in the United States with the virus, and how do we see the economy opening up again?
Phil Orlando: So this virus is the biggest deal that we've ever dealt with in terms of a market crisis, there's no question about that. And none of us are epidemiologists, but we're going to do our best. And I think the way to study this is to look at the trajectory of the disease in four key countries, China, South Korea, Italy, and the United States. The Chinese got the ball rolling, the WHO let us know about what was going on in China somewhere around the third week or so of January.
Phil: And based upon the actions that they took, they seem to be achieving a peak and then a plateau somewhere at the end of February. So we are running at about a six to seven-week lag to what's going on with China. We're running at about a two to three-week lag to what's going on with Italy. So as we studied the trajectory of this disease across the globe, recognizing that everyone had different starting points, and we're going to take different policy approaches to dealing with the disease, our best guess when we studied this back in February was that we would see potentially a peak and the start of a plateau here in the United States somewhere in the middle of April.
Phil: Optimistically, I circled 'Holy Week' on my calendar. And the idea was that if we peak there, and then could generate a plateau in the beginning of a roll down over the balance of April, we could potentially talk about reopening the economy sometime in May. And I think probably more due to good luck than anything else, that's fairly close to the timeline that we're dealing with right now. And I think what the experts are turning their attention to right now is, 'Okay, how do we determine when to reopen the economy, and what's the process?'
Phil: So if we can get the economy 10%, 20% reopened during May, maybe something in the 50% neighborhood during the third quarter, maybe we could be 90% opened a past Labor Day, and maybe we could be fully reopened and functioning again by the end of the year. I think that might be aggressive, it might be optimistic, but I think it's realistic in terms of suggesting this is a process, not the flipping of the switch.
Linda: Thank you Phil. RJ, have you any thoughts to add?
RJ Gallo: I'll just echo Phil in pointing out how extraordinary this challenge really is. We've been through a lot at Federated Hermes, both as a company, going back almost 60 years I believe, but also the people who were on the line, Phil, Linda, myself, our fellow PMs, analysts, we were here for the financial crisis, which were very dark days and very challenging days. We were around other more typical recessions back in the 90s for example.
RJ: And this really takes the cake in so many ways. A public health challenge of this scale, there really is no modern precedent. You have to go back to 1918, the Spanish flu. The world's changed a lot since 1918 in a lot of good ways, but perhaps most notably, globally interconnected ways. The markets have begun to behave better. That doesn't alleviate the fact that we're going to have an extraordinary economic downturn.
RJ: We're going to get into that a lot in this call, and it calls for, excuse me, extraordinary policy responses, which we will also get to as this call proceeds. But in short, it really is all about the virus and the economic impact of the measures to contain the virus. And that's really what we'll be talking about for much of the rest of this call once we establish how extraordinary the market moves have been throughout March and early April.
Linda: All right, then let's move on and look at some of the implications of what's happened here as a result of this virus. Looking here now, Phil, at jobless claims which have surged in an unprecedented way beginning in late March, how bad do you think it will get, and how will those laid off likely fair?
Phil: So I'll start by borrowing a word from RJ, extraordinary. You look at the history of the US labor market and the single worst week we've ever seen in terms of initial weekly jobless claims, which is an important forward looking economic indicator, was 695,000 claims back in 1982. The other part of your question is, how are folks going to fare? And I think the answer is pretty good, if the trajectory of the Corona virus stays relatively short lived, which is to say that we're peaking here in April and not August or September.
Phil: And I would focus on one element of the CARES Act, Phase 3, where individuals had their unemployment extended from 26 weeks to 39 weeks, and they were a added a bonus of 600 dollars a week for the first four months. So those individuals are going to be collecting 1,000 dollars a week, which is an annualized run rate of 52,000 dollars a year. If you're a minimum wage employee working a full time gig, you're making about 15,000 dollars a year.
Phil: So for a period of time, again, if we can get this economy rolling again in the second half of the year, individuals will be made whole for that period of time. And then we expect that they'll get hired back by their companies once the companies reopen again in the second half of the year. So there's a blueprint at this could work out, obviously we'll have to see if it plays out the way it's planned.
Linda: That result for the minimum wage workers that you described is really in bright contrast with these long lines we're seeing of food lines on television, RJ, any thoughts here?
RJ: I think it's particularly interesting, claims, the markets were geared up for claims. Claims are a weekly indicator, high-frequency indicator, oftentimes they're a ho-hum release. They've been anything but, because they've been the first manifestations of the profound economic challenges we currently face. And I think it's also notable that now that we're starting to roll the calendar forward with each day, and we're starting to see those monthly releases, most economic data comes out with a monthly tenor, we already had the employment report for the month of March and the unemployment rate rose to 4.4%, it was 3.5% in the prior month.
RJ: So as each day goes by, we'll start getting industrial production, we'll start getting retail sales, durable goods, these broad based indicators of both the consumer and the business economy, and we'll really be able to see the depth that we're facing. Maybe the news is that everybody expects it to be challenging. In markets, if you can lower the bar and clear the lowered bar, you might be able to have more optimistic reactions. The very few people that I've talked to in any way, or have read about in terms of market research, expect this to be easy. We're going to have a profound economic downturn and the data will start to build it out as each state clicks forward.
Linda: From your side of things, RJ, how have investors responded to the record breaking volatility in markets?
RJ: Sure. It's been very dramatic. It's almost hard to exaggerate. Just for context, in the beginning of the month of March, the yield on the 10 year Treasury fell 60 basis points in six trading days to close at its record low of 54 basis points on March 9th. During March, the daily change in the US 10 year Treasury yield exceeded 10 basis points in 12 of 22 days. For context, the average absolute change in the 10 year Treasury yield over five years is three and a half basis points per day. We had some days where it changed 34 basis points and 25 basis points.
RJ: So obviously extraordinary things were happening, not just in stocks, but in Treasury yields and in corporate spread. Oddly at times during March, even Treasury yields went up. On some days when stocks were falling, and corporates charts were widening, Treasury yields were also widening. Because the traditional flight to quality took on a new cast, it became a flight to cash as highly volatile markets and recession fears drove an emotional rush to pretty much sell everything. Now that rush to cash was most evident on this chart with the weekly change in the assets of US government money market funds surging upwards at the same time that you see bond and equity funds bleeding money out.
RJ: Now the volume of selling in bonds, combined with this rush to cash, including money pouring out of prime money market funds and into government money market funds, because investors, even at the very short end of the curve, didn't want corporate credit risk amid the rising recession risk. All this movement of money in huge volumes stressed the financial system in many ways, causing markets to become nearly dysfunctional in some sectors, fully preventing the issuance of high yield bonds, preventing the issuance of some types of commercial paper.
RJ: Muni Bond issuance completely disappeared. Bid offer spreads widened out sharply and the yields on short term corporate muni instruments that were already outstanding in the market spiked to levels that were many hundreds of basis points above Treasury yields. Meanwhile, T bill yields temporarily turned negative. It was an extraordinary series of events fueled by a massive movement and rush to cash. I would suggest to you, one of the factors that we're dealing with here is that over the decades, the investment community, to include mutual funds and institutional investors have become much larger than the securities dealers to whom we go when we want to buy and sell securities.
RJ: And as a result, when so much money was moving so rapidly, the securities dealers were in many ways overwhelmed. Amid high volatility, they were unable to manage risk and many of them were forced to take a turtle approach and put their head in their shell. And that helped to fuel outrageous bond price volatility as a result. Now, once the Fed stepped in, aggressively lowering rates, buying huge volumes of treasuries and mortgages, and introducing a wide array of market support programs, market functioning started to return to normal, or least to normalize, is probably a better word. As the month of March turned into April in particular, we have seen markets starting to behave much better.
Linda: Phil, if you would start us off for how we should look at the possibilities for how the economy comes out of this, and I'd invite RJ to chime in here as well if you wish.
Phil: This is a question we get asked a lot by clients, and it's basically to describe the indescribable. What might the shape of this economic recovery look like? And there were three probabilities in our mind. The probability, the left tail, if you will, is that the corona virus infection rates continue to spike into the late summer, early fall period. The fiscal and monetary policy response that the government has as thrown at this problem, which we would all agree has been extraordinary, just isn't enough.
Phil: The economy plunges into a deep recession that probably runs through next year. This 35% decline that we've already seen in the stock market, that's not the bottom, stocks continue to go lower, and then eventually we just go sideways. So the economy and the markets, absolutely nothing positive there for the next couple of years. We would put about a 10% probability on that outcome.
Phil: Our base case is what we refer to as the U shape recovery, where the economy and the markets have obviously taken a hit. There's no defending that point. But we've already seen the potential peaking and plateauing here during April, and maybe as we get to the end of the month, we'll feel better about where we are. The government, both the fiscal and monetary policy response has been effective. It serves as a bridge loan to allow people to continue to successfully shelter in place and then allow us to begin to turn the economy on slowly later in the year.
Phil: So the economic data collapse that we saw in March and in April begins to flatten out over the course of the second quarter and then begins to turn up in third quarter. So yes, things have plunged, they've rallied, maybe there's a retest, but then the market picks up and we get a sustainable improvement such that if you've got the ability to be patient and look out over the next two years, we get back to where we want to be, back to record highs. We put about an 80% probability on that outcome.
Phil: The right tail is the V-shaped recovery. That yes, we've had the sharp move down, but we're going to have a very sharp move back up. Everything we've done from a social distancing perspective, and the medical advances that you articulated so beautifully, Linda, work, the monetary and fiscal policy programs that the government threw at this problem work, the stock market as a forward looking discounting mechanism recognizes all of that, the market bottoms on March 23rd, and we have an equally sharp recovery such that we're back at record highs by the end of this year. It's a nice optimistic narrative. We would probably put a 10% probability on the right tail. So we think the slower, more methodical rebuilding of the markets and the economy with the U-shaped recovery is our best guess.
Linda: Well, I see a lot of optimistic signs out there from you both, Phil and RJ. I've run out of superlatives to describe the unprecedented stimulus that's come from our administration and the Federal Reserve to this crisis. Is this modern monetary theory in action? What about the debt? What about moral hazard? What do you think, Phil?
Phil: I think the government did exactly what it needed to do from the perspective of what the Fed's done and what the administration and Congress have done. I remember Ben Bernanke, RJ's favorite professor from Princeton, often tells the story about how he studied The Great Depression as part of his doctoral work at MIT. And his conclusion was that we created The Great Depression as a result of poor fiscal and monetary policy response. He conducted himself very differently during The Great Recession, and I think Powell and the administration and Congress conducted themselves very differently here.
Phil: So they, they've done the right thing, but there's a bill to be paid at the end of the day. And yes, we may have stronger economic growth starting in the second half of the year, but that's not going to be enough to pay the bill. So maybe Mnuchin's talking about the issuing of this 20 year bond at 1% give or take is the way to finance it near term, but ultimately we've still got to eventually pay that bill, either through stronger economic growth, higher taxes, restructuring the amount of payments we're making, entitlements, let's say, so there is a bill that needs to be paid, and eventually that day of reckoning will come. Today's not that day however.
Thank you Linda, Phil and RJ. And thank you to our listeners. We look forward to you joining us again on the Federated Hermes Hear & Now podcast.
Disclosure: Views are as of April 15th and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector. CARES Act stands for 'Coronavirus Aid, Relief, and Economic Security Act.' No method of investing can assure a profit or protect against a loss in a declining markets. Bond prices are sensitive to changes in interest rates, and a rise in interest rates can cause a decline in their prices. High-yield, lower-rated securities generally entail greater market, credit/default and liquidity risks and may be more volatile than investment-grade securities. Past performance is no guarantee of future results. Federated Advisory Services Company 20-40213 (4/20).