Market Outlook – 2Q20
Cambiar President Brian Barish provides his latest market insights where he discusses current market performance and the variables that could dictate market direction in the latter half of 2020.
Good day, this is Brian Barish, President and Manager of Cambiar Investors, Large Cap domestic investment strategies. I’m here today to offer some perspectives on how we see investment opportunities in the investment landscape developing over the balance of 2020.
We get a lot of questions from clients with the general theme of why is the stock market not down more than it is? That the virus and the impact on the economy seems utterly devastating. Shouldn’t we see the stock market down further? So in response, to those questions, we have three answers and we’re going to give them in least to most important order.
First, when you look at the companies that are most profoundly impacted by the virus, things like restaurants, gyms, forms of collective entertainment like movie theaters. These are infinitesimal businesses in relation to the overall value of the stock market. They do employ a lot of people and it is very sad for those business owners to see their businesses damaged or bankrupted by what society is needing to do to combat the virus. But they’re just not that important to the overall stock market.
The second reason is that we were at the end of a long and fairly prosperous business cycle when the virus broke out, and a great number of businesses that are considered cyclical, whether it’s autos, banks and other credit-driven financials, basic materials, other kinds of industrial manufacturing businesses, none of them were really trading at very full evaluations on price-to-earnings or a price-to-cashflow type of multiples. They tended to be trading at discounted valuations as they were anticipating an eventual end to the economic expansion.
They had really been tailing off from a multiples point of view for most of the last three or four years. Now, obviously the COVID-19-driven recession is far worse and far more severe than anybody might have imagined the late-cycle or end of the cycle recession would be. But these stocks have declined, but not by as much as you might otherwise think they would. A second and very important point is that even though we’re having a very severe recession, it is also a very fast recession. And by the month of May, we were already back to adding jobs rather than shedding jobs in the overall economy.
So it could be argued and I think reasonably successfully that we’re in a new economic cycle now, which actually favors at the margin, some investment in notionally-pro cyclical type of businesses. And I think those are both pretty good reasons why the market isn’t down as much as you might think it would be, but there is one very powerful reason that trumps them all and that is not Trump. It’s actually the number two most powerful person in the world, the chairman of the Fed, Jay Powell.
The Fed has been unbelievably active and they have unleashed money supply growth the likes of which we have simply never seen in the history of the United States. And this shows the sheer magnitude of this M2 growth is a good proxy for overall money supply growth and it is simply a gusher. At our last reading, M2 growth was up 25% year over year. It should be up to over 30% if the Fed is true to its word by the end of the summer and could be as high as 40% by the end of 2020.
I put this in some perspective during the worst moments of the great financial crisis of 2008, early 2009, money supply growth was about 10 to 11% and during the initial QE phase in 2010, when the Fed needed add reserves to offset the impact of much higher capital requirements on the banking system, M2 growth was also about at 10%. So we’re at somewhere between two and a half and four times the peak of the financial crisis.
And there is a very old economic theory, it’s authored by an economist named Alfred Marshall. Mr. Marshall was in his prime in the very late 19th century, the early 20th century called the Marshallian K and the Marshallian K is a simple theory basically says that when money supply growth exceeds nominal GDP growth, that excess tends to get into financial assets and tends to drive stock market valuations higher, all other things held equal.
Conversely, when money supply growth is below nominal GDP growth, which was in late 2018 as a for instance, then that money needs to come from somewhere. And it tends to get out of financial assets, driving stock market underperformance. I’ve been doing this for a long time and I can tell you that the money supply growth stuff, it works. It’s a fairly potent predictor of stock market performance. So that leads to our comments about what to expect for the balance of the year.
If you did not have money supply growth, that was as prodigious as what we are seeing. And if you do not have that money supply growth offsetting what is it likely to be a noisy political season, I would be at the margin fairly cautious going into the second half of the year. And it’s probably, you’re going to see some rotations into this sector and out of that sector because markets just kind of do this. But with the amount of money supply growth that we have, I don’t think I’d be too cautious here. It’s just simply going to overwhelm other factors.
Now that’s all said, I don’t want you to think we’re drinking the Kool-Aid here. It is an uneasy feeling and it’s uneasy for two reasons. On the one hand, it’s not hard to see ample speculative forces in very newfangled businesses and people extrapolating very short-term business success, way, way, way out into the future. I’ve seen this movie before and it usually doesn’t end very well and it’s a little bit disconcerting. But by the same token, there are a lot of fairly straightforward businesses to analyze that traded undemanding valuations.
Indeed, the spread between growth and value has literally never been higher on simple P.E., and on price-to-book based evaluation measures, the stock market was roughly in the 99 to 100th percentile in historical terms of growth stock valuation versus value stock valuation. So there’s a lot of opportunity to be had that just by leaning a little bit towards the cheap and the unloved, which is not surprising. Most of those companies live in the physical economy that has been damaged as badly as it has by the COVID-19 virus and the impact on the overall economy.
Let’s talk about the outlook. I think it’s going to be commonplace in reviews of this sort for people to extol just how many uncertainties there are. What I want to try to convince you of is that yes, there are uncertainties because there always uncertainties, but that many of the ones that we are focused on right now are actually not nearly as uncertain as you may suspect.
First, let’s talk about the shape of the economic recovery that we are having and the impact of a possible vaccine on how that evolves. So we know that we’re having an absolutely brutal global recession, or we had one in any way. The worst of it was clearly in April, when we were under a hard lockdown, and those impacts are evident in the second quarter GDP numbers that are just trickling out now. The US was down about 33%, various countries in Europe were down in the 25 to 40% range. Other countries are doing similarly in the developed world. In the developing world the lockdowns have been less extreme.
From mid-May onwards, we’ve gone from a hard lockdown in the US to more of a soft lockdown. So we continue to not be able to go to movie theaters and sporting events, but other places of business are operating reasonably. So we’re getting more economic activity. That is causing various diffusion indices to basically look positive, if you’re looking for rates of change in industrial production. We know that the actual number of COVID cases continues to rise and somewhat scarily in various states, but if you actually look at the death statistics, and admittedly, this is a morbid topic, they’re fairly stable. It’s clear that we’re learning how to manage the disease better in the healthcare community. And I would argue that we’re probably not going back to a hard lockdown, unless deaths were to suddenly spike up in a big way. Currently, there are about 400 or so per day in the US.
So two uncertainties that people will point to are elections in November, and secondly, the timing and effectiveness of a vaccine for COVID. We’re not going to even try to get our hands around the November election. You can read all about that on your own. Suffice to say the market has known for many years that there was going to be an election in November. And the outcome of it will be whatever it will be. Generally in the US it’s difficult to enact radical changes from a legislative point of view. Our system is designed to make that difficult to occur, and we suspect something similar will be the case.
On the virus front, or the vaccine front more specifically, there are several promising candidates for vaccines. I’m not a virologist, but like many of us have become a closet virologist in the last several months. There are two companies, Moderna and Pfizer partnered with a German company called BioNT, that are working on modified RNA vaccines. There are several other candidates, most notably an AstraZeneca/Oxford University partnership, another partnership between Sanofi and Glaxo, and another one with J&J that use more conventional de-tuned virus or safe animal virus methods of creating immunity.
Our sense at the moment is that if the modified RNA vaccines by either Moderna or Pfizer work, they could be on the market as soon as the latter part of the fourth quarter. These are new methods of creating immunity, and they will be studied and scrutinized very carefully, especially as it relates to safety since these are new. With any vaccine you are, by nature, giving the vaccine to a massive population of healthy people to keep them healthy. And that’s why safety is a paramount issue. If the modified RNA vaccines have safety concerns, we suspect that the timing of an eventual vaccine will slip into the first quarter, but not too much later than that with all of the AstraZeneca, Sanofi, and J&J candidates looking what we would say as interesting and promising and very likely to be safe.
So at the end of the day, although there’s a lot of quote-unquote uncertainty, it’s really a window of about three to five months in length as to when we’re going to get a vaccine. Will the vaccine be in short supply? No, I don’t think so. The cost to the economy per day of not having a vaccine is tens, if not hundreds of billions of dollars. So the government will find a way to fund this. And it sounds like most of the companies producing the vaccines are not looking to make extraordinary profits out of the situation.
Assuming that governments keep patching the donut hole in various kinds of businesses that simply can’t operate and that the vaccine does arrive in the window that we’re anticipating, we should see a fierce economic recovery over the course of 2021 in particular, as the vaccine and its safety effects are layered in over the overall economy. So rather than thinking of the economy is looking like a V or a U or a square root sign, it’s more like a trampoline. We had a big bounce off of the hard lockdown. We’re going to have a little bit of jagging around, around a soft lockdown, and then an eventual next big bounce around the actual vaccine.
Over the course of the last several years, and perhaps this has been accelerated by the impacts of the COVID-19 crisis, we’ve seen a change in the prevailing economic orthodoxy. To put it in simple terms, it’s an end of the neoliberal economic consensus. Now what does that mean? So the neoliberal economic consensus, which is something that emerged in the 1980s under Reagan and Thatcher, implies that we have free markets, that we have a free movement of capital and labor from region to region and from country to country, and that we have a reduced role of the state in terms of the state not trying to get involved in deciding winners and losers, let the markets figure things out and don’t tax people too much, it just tends to get in the way. The neoliberal consensus is giving way to some version of tribalism and nationalism. It’s not just a US affair under Trump. It’s happening in a lot of other places. This includes China. This includes various countries in Europe. Russia has very obviously turned to a more nationalistic posture. It is a global phenomenon.
So a couple of things the neoliberal consensus failed to consider. One was that governments would be needed for various things, with the current global lockdown and virus crisis being at or near the top of the list. We are fighting a war and the private sector is just not very well equipped to fight a war. A second feature, and this invariably involves discussing China and China policy, is that you cannot have a massively populated, totalitarian regime, that can control capital and prices by fiat with full access to global markets. China gained access to The World Trade Organization in 2002. And that event is probably a bigger one than 9/11, which happened just a few months earlier, in terms of the impact on the global economy and economic disruption.
A third factor that the neoliberal consensus did not really consider would be the role of currencies and sovereignty. What should that role be? How should currency markets work? And I want to be clear about something. I’m not saying that neoliberal consensus is a bad one. There’s clearly a lot of features of it that if you’re in the stock market at all at a professional capacity, you probably embrace philosophically at a pretty deep level. It’s just run into some limitations. We are currently struggling, not just as a country, but as a world, to figure out how things should be governed with these limitations that the neoliberal consensus exposed. That does create a lot of uncertainty. And that to me is the biggest one in the future.
I want to focus on one other variable, which is currency. So if you look at global financial performance and stock market performance in the last several years, it’s been utterly dominated by the US. A big chunk of that is the incredible performance of US technology and internet titans like Apple and Google and Amazon and Microsoft. But a big part of that spectacular relative performance has been the dollar. The dollar has been strong against just about everything. The dollar is the dominant world reserve currency and some 15 to 20 years ago after the Euro was incepted and with China rising, there was a lot of talk about the dollar perhaps having a less important role. That has not happened at all. I would say that the dollar’s role as the core reserve currency of the world has been all the more cemented by the various challenges that Europe has had in it’s integration. China is not advancing in a totally free markets way at this point calls into question the yuan as a reserve currency. The dollar is practically unchallenged. And that unchallenged position has been a challenge in emerging markets and outside of the US in particular.
If foreign stock markets and financial systems are going to generate better returns, it tends to start at the currency level. If you look at the periods of time over the years when you’ve seen the US markets underperform, it’s tended to be associated with dollar weakness. I don’t like the term dollar strength and dollar weakness to describe currency markets because it evokes the wrong imagery. It sounds like the US dollar’s been lifting weights and eating a lot of protein if it’s strong and it sounds like it’s been sitting on the couch watching television, if it’s weak. That’s not the way that financial markets work. Financial markets work on the basis of supply and demand.
So there are many variables that go into how a currency is priced. These include money supply growth, the size of a current account, the size of a capital account, interest rates and interest rate differentials, and as well the financial and industrial capacity of a country to put its currency to productive use. All of these are variables that you need to consider. Three big ones, the current account, interest rate differentials, and relative economic growth have all favored the US over the last several years. And those have led to fewer dollars being exported outside of the US, more uses for the dollar in the US, and in general a very tight global market for dollars. A tight global market for dollars doesn’t really affect us too much in the United States, but it affects people a lot outside the United States. All manner of industrial and commodity products are costed and priced in dollars from wheat, to aircraft, to rubber, to oil, to even many advanced technology services. The dollar is utterly dominant on the global stage in that regard. And when the dollar is priced expensively, it acts as a big break on global growth outside the United States.
That picture may be changing, maybe changing decisively, as a result of the COVID crisis. To put the matter in some perspective, our budget deficit in the US for 2020 is likely to be 100% of tax revenue. Hard to make a strong prediction on 2021. It won’t be as big as a 100%, but it’s still going to be very large, and even if you had a change in tax policy as a result of the upcoming November elections, it’s still very likely that the US will be running a massive budget deficit. Our capacity to close that gap in the medium term appears unlikely. That means the Fed is going to continue to be active. The Fed will probably be monetizing a lot of that deficit and exporting those dollars essentially wherever they may go.
The market has sniffed this out. You’ve seen the dollar weaken against other reserve currencies. It’s weakened against gold. It has weakened somewhat against more industrial type of commodities, like copper, lead, zinc, et cetera. If this continues, it does auger for a change in the US dominance on the capital market spectrum. It’s been such a long and drawn-out period of relatively weaker non-US returns that I dare not make any predictions beyond that, but it seems like a distinct possibility to me.
One last point, we are living through an interesting moment in history and it would probably be inappropriate to extrapolate too much out of our current variable unconventional day-to-day lives into the long-term. But there is a feeling that’s hard to completely dismiss that we’re perhaps leaving one era and entering a new one in terms of how we go about certain things.
I don’t think the world of physical retail is going to be the same. I don’t think the world of transportation is going to be completely the same. I certainly don’t think that my business trips are going to be the same because we’ll be able to telecommute in so many cases.
Anyway, I’m not sure what that means, but it does give me both a sense of nervousness about how those changes will feed through to the overall economy and optimism that there is ultimately a brighter future out there.
Thank you for listening and good day.
Certain information contained in this communication constitutes “forward-looking statements”, which are based on Cambiar’s beliefs, as well as certain assumptions concerning future events, using information currently available to Cambiar. Due to market risk and uncertainties, actual events, results or performance may differ materially from that reflected or contemplated in such forward-looking statements. The information provided is not intended to be, and should not be construed as, investment, legal or tax advice. Nothing contained herein should be construed as a recommendation or endorsement to buy or sell any security, investment or portfolio allocation.
Any characteristics included are for illustrative purposes and accordingly, no assumptions or comparisons should be made based upon these ratios. Statistics/charts and other information presented may be based upon third-party sources that are deemed reliable; however, Cambiar does not guarantee its accuracy or completeness. As with any investments, there are risks to be considered. Past performance is no indication of future results. All material is provided for informational purposes only and there is no guarantee that any opinions expressed herein will be valid beyond the date of this communication.
M2 is a measure of the money supply that includes cash, checking deposits, and easily convertible near money.
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