Last week, I was preparing for a zoom call with some of our client advisors here at JPMorgan Asset Management, by reviewing a list of questions they had kindly supplied in advance, and I came across a particularly awkward one: what has been my biggest investment mistake?
In the end, they forgot to ask me the question live, so I escaped.
But thinking about it afterwards, the answer seems obvious. My biggest mistakes haven’t been the things I couldn’t or didn’t anticipate, but rather the risks that I saw quite clearly but did nothing about. The investment environment is full of risks. However, it is also full of opportunities, many of which can serve as antidotes for the very risks that concern investors the most. The key is to not just worry about the problem, but to focus on the solution.
The week ahead will be one of the busiest of the year with the release of 2nd quarter GDP, further negotiations on a fiscal package, a Federal Reserve FOMC meeting and the biggest week of the earnings season, with 192 S&P500 companies set to report. All of this will occur in the shadow of a continued pandemic which has seen a sharp increase in new cases in recent weeks.
The overarching theme will be one of risk: Risk of an even worse pandemic, risk of an economic relapse and risk that today’s monetary and fiscal stimulus will result in higher taxes, higher inflation and higher interest rates when the pandemic is over. All of this, in turn, seems to increase the danger of significant corrections in financial markets which have, to this point, weathered the coronavirus recession remarkably well. However, beneath the headline risks, there are investment opportunities in areas that many investors have shunned in recent years.
A Slowing Recovery
For economists, Thursday’s GDP report should confirm the deepest recession since World War II. Our models suggest a decline in real GDP of more than 35% annualized in the second quarter, setting up a nearly 20% bounce-back in the third. Some of this is due to an inventory cycle – we expect the swing in real final sales to be slightly less dramatic. However, most of it just reflects the reality of the broad April shutdown and subsequent partial reopening, with consumer spending, in particular, falling by roughly 35% annualized in the second quarter and surging by nearly 30% annualized in the third.
However, this will, unfortunately, leave the economy far short of a full v-shaped recovery. First, of course, it needs to be recognized that in economics, as in portfolios, recovery percentages need to be larger than decline percentages – it would take a 54% annualized bounce in real GDP to recover from a 35% annualized fall. However, more fundamentally, recession psychology will drag on investment spending, budget realities will reduce state and local government spending and the pandemic will slow reopening of businesses across the travel, entertainment, restaurant and retail sectors. Indeed, as cases have grown in recent weeks the recovery in hotel occupancy, airline travel and a wide swath of credit card spending appears to have stalled out, as we show on page 21 of our Guide to the Markets.
A Green Light on Further Stimulus – A Warning Light on Taxes, Inflation and Rates
This slowdown in economic momentum is adding urgency to stimulus talks in Washington and Senate Republicans are expected to unveil their bill this week. This bill, like the House version passed back in May, represents more of an opening bid on further fiscal stimulus rather than a framework for a final deal. The sides are far apart both on the amount of further support and the details. However, it is likely that an agreement will be reached in early August as neither side can afford, in an election year, to be accused of abandoning negotiations in a time of such obvious economic stress.
The final bill will likely contain some continuation of enhanced unemployment benefits, although perhaps at half the current $600 bonus which ends this week. There will probably also be some further relief for state and local governments, although far less than they would need to avoid further layoffs. In addition, the bill will likely contain some reprise of the $1,200 direct payments to taxpayers, albeit phasing out at lower income levels than before.
The final price tag for the bill will likely be closer to the $1 trillion suggested by Senate Republicans than the $3.4 trillion in the House bill. However, even if the bill is “only” between $1 trillion and $1.5 trillion, it will add to an already dramatic deficit for this fiscal year. In addition, our economic forecast suggests another, and hopefully final, coronavirus relief bill will be needed at the end of the year to tide the economy over until the widespread distribution of a vaccine enables a stronger economic recovery in 2021. We believe that this could boost the federal debt from 79% of GDP at the end of the last fiscal year to roughly 118% of GDP by the end on the next fiscal year, in September 2021.
In prior decades, the federal government would have felt entirely unable to borrow a sum of this magnitude. However, the Federal Reserve has made is clear that it is willing to monetize the federal debt to whatever extent is necessary in this crisis. Over the past year, the Fed has increased its holdings of U.S. Treasury bonds by $2.2 trillion and its current $20 billion weekly pace of purchases would add a further $1 trillion to that stockpile over the next year. Even this may be exceeded in the months ahead, if Treasury borrowing is seen as potentially putting upward pressure on long-term interest rates.
The Federal Reserve’s Federal Open Market Committee meets this week to discuss this and other aspects of monetary policy. They are unlikely to make any further dramatic moves except to recommit to doing whatever is necessary to aid the economic recovery. However, the Fed Chair, Jay Powell, may also comment on the idea that the Fed will adopt an “average inflation targeting” policy later this year. This would involve accepting an inflation rate running above their 2% target for some time to make up for all the time inflation has spent below 2% in recent years.
While this policy may have a veneer of intellectual respectability, it is a risky idea in a world where central banks have gradually been removing the implicit guarantees that backstop fiat money. If inflation does begin to accelerate, it is by no means clear that inflation expectations will be slow to follow. If consumers, businesses and workers suddenly begin to expect much higher inflation, they may collectively try to convert cash balances and financial assets into consumer goods, real estate, commodities and foreign assets. This, in turn, could lead to higher interest rates, higher taxes and a lower dollar. This is unlikely to occur this year but could become a more significant threat late next year or in 2022, particularly if Washington does not remove fiscal and monetary stimulus as the economy recovers.
Europe - A Less Imperfect Union
This risk is unsettling, given today’s relatively high valuations in U.S. fixed income and equity markets. However, one broad antidote for this risk could be European equities. As we illustrate on page 51 of the Guide to the Markets, Europe has had significant success in taming the spread of the coronavirus in recent months and this is enabling the continent to continue with a phased reopening of its economy.
In addition, last week, in a watershed agreement, European Union leaders agreed to a €750 billion coronavirus relief fund, financed by E.U. institutions themselves and directing resources to the poorest member states. While this move was clearly triggered by the extraordinary circumstances of the pandemic, it established a crucial principle that the European Union was willing to provide some fiscal aid to nations in an emergency. The lack of this fiscal support was, in large part, responsible for the European debt crisis and this new move towards fiscal coordination, albeit with significant conditions, should reduce the riskiness of the euro and, by extension, euro-denominated assets going forward.
It should also be noted that European equities carry lower P/E ratios than their U.S. counterparts and that Europe will likely have less need to raise taxes in the aftermath of the pandemic than the U.S. Moreover, Europe runs a significant trade surplus, in sharp contrast to the U.S., and a rise in the euro could amplify equity returns for U.S. investors.
It has to be acknowledged that the tech sector is less important in European equities than in the U.S. Indeed, this has been a key reason for European stocks underperforming their U.S. counterparts in recent years. However, for investors who are worried about a slowing in the U.S. recovery, the consequences of excessive monetary and fiscal stimulus and lofty U.S. equity valuations, European equities could provide a logical antidote.