I have avoided writing on the topic of Covid for a while just because after the initial surge, I think I had early Covid fatigue. I have been compelled to touch on the topic considering we find ourselves in such an odd place right now.
First and foremost, we are in the midst of a post Thanksgiving and winter surge that may now see its peak until after Christmas, if it even peaks then, or just keeps on increasing. At the same time, the US was in the midst of an economic recovery from the initial shock of the lockdowns which happened in March. Throughout the summer, although some restrictions remained in place, most places were able to start to climb back economically and lower levels of transmission to a point where some facets of life started to exhibit some normality. With this second surge though, many places have resumed their local patchwork of lockdowns while other states have left well enough alone. This will have uneven effects for the economy as well as the transmission of Covid and is likely to be the big question mark for the economy for the next 3 months.
The main action that could counter the lockdowns, would be the passing of a new stimulus bill by Congress. Unfortunately, even if things go the Democrats way in Georgia, which I think they won’t, I don’t have faith that any new stimulus will be passed. One side is proposing another $2 trillion and the other $500 billion. The compromise, and weirdly precise $908 billion proposal has just been rejected. Whether you agree with them or not, we have to take it as a given that some state and local officials will resort to the blunt and unwieldy instrument of lockdowns as well as curfews. Once a supporter of these policies with the initial onset of the pandemic, I am now against them.
One reason is that there is no end game with lockdowns. We have lost sight of the fact that the whole lockdown idea emanated from China, a repressive dictatorship with a president for life, and it didn’t work there (it got out anyway and spread around the world). Despite all the heavy handed measures of March, during this recent surge, states that previously locked down are doing just about in terms of infection levels as the states that didn’t lock down. New York has an infection rate similar to that of California, but also as to that of Texas and Florida.
The focus rather, should probably be more on compliance with social distancing protocols, not shutting down business for the reckless actions of its customers. Despite a recent resurgence in Covid, Japan has had much lower rates and deaths from the virus. Unfortunately, compliance with social and government pressure is much more ingrained into Japanese culture than in the West. This can hobble the country sometimes when it comes to innovation, but has served it well in the pandemic. In addition, the stimulus in Japan has been less chaotic and more focused. The push to get PPP loans out the door is pointing towards an elevated level of fraud in the US. The blanket nature and the need for getting the money to people quickly, trumped concerns on protecting against widespread fraud. In Japan the stimulus has focused on particular industries that have taken the brunt of the hit. Subsidies are offered for hotels and tourist businesses and incentives offered for domestic travel to replace the international travelers who won’t be showing up this year.
Given that the entire West Coast of the United States, arguably the engine of much of the US economy, is shut down for small business, it’s reasonable to assume that it may tip GDP growth into negative territory in the 4th quarter and may deep into the 1st quarter of 2021. This is the scenario that S&P’s economist is forecasting.
This could further contribute to the argument that this recession is going to be a K-shaped one and that certain workers may need a more focused fiscal stimulus this time around.
Bounce and Stagnation at the Same Time
What is a K-shaped recession anyway? The narrative at the beginning of the recession talked about a short severe recession followed by a swift bounce back, this was the V-shape. Then there was talk of the U-shape: a more prolonged down period followed by an uptick. Then, as is common with the bombastic financial press, came the L-shape: a drop and then growth never returning. Some are now speaking of a K-shaped recovery, meaning a V-shaped bounce back for the top of the income spectrum and a drop followed by stagnation for those on the lower income side of the spectrum.
Again, this is a bit alarmist because employment, income and wealth does tend to bounce back after a recession but recent recessions have seen different income levels bounce back at different speeds. Below you will find comparisons of how different wealth quartiles bounced back after the last 3 recessions.
Clearly, something has changed since the recession of the early 90’s. To put this in perspective, the bottom 50% in terms of net worth in 2017 included those worth about $104,000 or less. This would seemingly include many middle and even upper class people as well as poor people since net worth and income are somewhat independent of each other. Making more money increases the chance that you can have a high net worth but doesn’t guarantee it.
Who mostly falls into the bottom 50% are students, the poor, lower middle class, some of the middle class and some near affluent. Barring the near affluent, who may be highly skilled people starting their career with little net worth, this is this segment of the population that most benefitted from the stimulus through the top up in unemployment benefits as well as the stimulus check. The wealthy may really have the spending and saving of this segment from the stimulus to partially thank for such a strong bounce back, first in the stock market, then in unemployment. Prolonged stagnation and unemployment isn’t in the interest of any portion of the population, including the rich.
The wealthy also have the Fed to thank. Backstopping corporate bonds, mortgages, junk bonds and even opening municipal facilities maintained a buyer of last resort for strained assets and provided a demand floor which restored confidence in the viability of these assets.
At the very least, if governments are going to lock down, the federal government should step in to extend the same type of “earnings floor” to people through extended unemployment benefits that the Fed provides to financial assets. There has been some research done which points to the idea that much of the workers who had previously worked in manufacturing in the past shifted to the services industry. This includes a large segment who moved to leisure and hospitality. This area has been hit particularly hard during this pandemic and as well was hit hard during the last recession. At the very least, both researchers and government need a better understanding of where to point these workers in terms of skill sets to acquire better paying and less cyclical positions.
How to Invest
Given the current situation and the knowledge that in the short term there are more risks to the downside than existed just a few months ago, how should those with something to invest or already invested position themselves?
Worth noting is that valuations are completely out of whack with the fundamentals. We now find ourselves again in a frothy market. There is an argument that valuations are justified based on near zero rates and QE but even by those standards, long term valuations look worrying on an historical basis.
The cyclically adjusted P/E ratio currently sits around 34, which would imply a projected future return of 2% to 4% annually.
We are in uncharted territory at this point. No one has seen a global pandemic in 100 years, the stock market seems to have disconnected from reality and we we are staring down lockdowns which will surely strangle what small businesses are left. Given all the developments this year, it doesn’t pay to bet against the market.
The bubble in the late 90’s spent a year or two at stratospheric valuations before it started its crash. For those already long though, you have the benefit of the upside already in your portfolio, it wouldn’t hurt to protect yourself on the downside with some put positions on the major index’s like the S&P 500 as well as the Nasdaq.
If options are not your thing, diversifying out of tech and out of the US may pay in the coming years. Valuations are half of what they are in the US in many markets and China has shown that the US won’t have a monopoly on tech forever.
Bonds may offer some safety in the short term if we do experience the double dip but in the medium term bonds don’t have much to offer: no interest, the price risk of inflation higher inflation and the opportunity cost of better returns in shares.
It’s been a great and unexpected run in shares and a vaccine is on the way. There are things to be thankful for and look forward to at the end of 2020 but be on the look out for one last guy punch from the pandemic.
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