Market Commentary: Frozen Thinking

There is at least one place on Earth untouched by the scourge of the pandemic: it is our driest, windiest, and southernmost point, a place that never had an indigenous population, one so cold that if you throw boiling water into the air it will instantly vaporize. With fewer than 5,000 scientists or tourists in peak season, all clumped into one of 70 camps scattered across a desert tundra the size of the United States and Mexico combined, 98% of which is ice, it is the least densely populated of our seven continents, entirely surrounded by water. Antarctica is a scientific preserve governed jointly by 54 countries under a treaty banning military, mining, and nuclear activities. As far as we know, there is no mad rush to seek refuge from pandemic fatigue, Zoom burnout, and anti-lockdown protests there on the Frozen Continent. Most of us have been camping in our homes for two months, creating “quaran-teams”, social bubbles, and virtual cocoons. The cable news, radio, print and social media that so polarized us at the start of the year has largely united us in our need for real-time information, assurance of progress, distraction, and consolation. Some of our thinking, however, is still frozen in time.

Let us take a look at how we view stocks and bonds for a moment. At the start of the new decade, it looked like we were continuing the record-setting 128 month-long economic expansion with rallies ahead in virtually all markets for as far as the eye could see. Unemployment was at 50-year lows. Borrowing rates were at record lows. Inflation was under control. Not everything was rainbows and unicorns for all Americans by any measure. Plus we knew asset prices were inflated. The cycle had to end at some point. But before we heard of SARS-CoV-2, the Fed was our backstop and traders were able to discount nearly all talk of recession, impeachment, war with Iran, or breakdowns in relations with China. Then came the twin traumata of destabilized oil markets and the Wuhan virus cluster that was declared a global pandemic on March 11. Like volcanic eruptions on Antarctica, they changed the landscape. For almost three weeks, the uncertainty was like lava flow and caused markets to move in ways not seen before. Federal, state and local officials then intervened with restrictive policies that had no precedent. Central bankers followed by Congress, moved at the polar opposite of glacial speeds with mountains of money that came out of air as thin as it is on the highest continent in the world.

Citizens complied. Schools quickly learned how to hold online classes. Businesses put up signs: “Sorry Temporarily Closed,” “Take-Out Only,” “Stay Safe, See You Soon.” Markets without trading floors, operating from remote workstations with residential Wi-Fi, took comfort in daily Task Force briefings, reports on the yeomen’s efforts underway to develop tests, treatments and a vaccine, manufacturers nimbly switching from car parts to ventilators, naval hospital ships redeployed, convention centers reconfigured as triage centers. The anguish of separation and loss, particularly among families of those in nursing homes, was in some small part allayed by hopeful signs of slowdowns and recoveries in countries overseas that were earlier afflicted, and reports from hospitals that were not as overwhelmed as feared.

But the lockdowns were extended. Now, barely one third of Americans say they are working and 30% have withdrawn more than $6700 on average from their retirement savings, mainly to buy groceries. More than 4 million Americans are skipping their mortgage payments. Cars are still lining up for hours at food banks. It has become painfully clear how many millions of Americans live paycheck to paycheck, and how many work in jobs not eligible for unemployment. How small businesses are so closely reliant upon daily community patronage that, according to one Washington Post report, more than 100,000 have permanently closed since March. Nevertheless, financial markets turned around. As Fed and federal aid began to flow, the Dow, the Nasdaq, the S&P, the Russell 2000, U.S. Treasuries, municipal bonds, corporate bonds, gold all began upward price swings again. A red, white and blue rally is still underway well before all the damage has been done and counted. Some of this makes sense. We understand that U.S. Treasuries are the world’s most liquid securities and that many of our stocks and bonds have unmatched global value. A 14% run-up in the price of gold since the start of the year is not a surprising increase for this safe haven, given the enormity of the upheaval. We also know how important Amazon and Domino’s Pizza and Dollar Tree have been to all of us during the shutdown. But analysts also point out something that does not sit well: that businesses are declaring bankruptcy and there are likely many more to come, yet the S&P 500 is trading at the highest price-to-earnings ratio since the peak of the dot-com bubble.

Many sectors are still being tarred with a broad brush. In some energy trades, offshore oil drillers have been lumped together with oil storage firms. Well-run airlines are trading alongside those less prepared to endure the groundings of most of their fleet for most of the year. Many well-managed senior living communities have bonds that attract no good bids despite having no cases of the virus and hundreds of staff and residents who are relieved to be safe and well supplied on their carefully tended campuses. Because of the constant clamor from governors and mayors lobbying Congress for aid now that the fat federal wallet has been flashed, some investors are most concerned about state and local bond defaults and possible bankruptcies. Their fears involve municipal authorities with the power to levy taxes and hike user fees rather than companies who never had such powers but have in fact filed for bankruptcy, like Intelsat, Neiman Marcus, J.C. Penny, and Whiting Petroleum.

More than two thirds of states are relaxing restrictions this week and America is slowly returning to work. But the timing of re-opening schools and many types of businesses is still unclear. We know that it will take longer than we would like for our economy to return. The Director of the National Economic Council says things are starting to turn. The White House Economic Adviser thinks we are looking at a very strong third quarter. The Treasury Secretary expects economic conditions to improve in the third and fourth quarters. The Chairman of the Federal Reserve says a full recovery may not happen until the end of 2021. In the meantime, Americans need to repair or shore up some of our personal finances and that means a hunt for current income as well as future returns.

When looking at stocks, the New York Times recently reported that, from 1926 through March 2020, dividends alone accounted for 40.2 percent of the total return of the S&P 500 Index. Several market strategists and asset managers contend that corporate buybacks have in fact been the only net source of money entering the stock market since the 2008 financial crisis. Now, the CARES Act precludes public companies that borrow money from buying back any of its company stock or issuing any dividends for one year after the repayment of the loan or the expiration of the loan guarantee, unless there was a pre-existing contract. There may be political pressure to extend this. Some of the companies that have already announced the reduction or suspension of dividends are Ford, Delta, Boeing, Macy’s, Marriott, and Disney. Unlike bond interest, stock dividends are always only paid at the discretion of corporations. If we assume that the coronavirus-induced recession produces dividend cuts of around 25%, that means investors could collectively lose between $100 billion and $150 billion in annual dividends on top of losses from stock price declines this year. Although the Nasdaq is up more than 2% year-to-date at the time of this writing (primarily due to Netflix, Alphabet, Amazon, and Facebook), the Dow is down 14% and the S&P 500 is down 9%. So, some big portfolio hits are in store.

As public companies announce cuts or suspension of suspend quarterly stock dividends for this year and perhaps longer, we remind ourselves that interest payments on the vast majority of municipal bonds will continue. Munis offer the opportunity to either supplement or replace those missing stock dividends with tax-exempt income. Last week saw an $800 million Baa3 rated financing for the State of Illinois featuring a 25-year maturity with a 5.75% coupon priced at a discount to yield 5.85%. This week, in addition to the $4 billion of new tax-exempt bonds expected to come to market, our municipal bond traders are also seeing $3 billion of taxable municipal bond issues, some of which feature interest exempt from state taxation for in-state residents. These include insured general obligation bonds for the City of Bridgeport, A1 rated revenue bonds of the Great Lakes Water Authority, and an A- minus rated sale for the University of Tampa. In addition, the new issue calendar includes quality municipal bonds being sold in the corporate bond market. Some examples include AA+ rated Northwestern University and AA rated Emory University. Our corporate bond trading desk monitors these sales as well as higher yielding corporate debt trading in the secondary market.

Credit analysis has never been as critical as it is now in the process of evaluating the merits of all these individual offerings. As a result of this pandemic-induced recession, outlooks, ratings, and events affecting performance and durability are changing weekly. Your HJ Sims advisor can help guide you through many of the key considerations. These include reviews of historic default rates for municipal and corporate bonds (at 0.18% and 1.74%, respectively). They include technical factors, such as mutual fund flows, inventories, bids-wanted, redemptions, and visible supply. It is equally important to consider fundamental factors including liquidity, cash flow, utilization, and debt service coverage. But this is a time in which we all need to consider broader contexts: how local and regional economies have been impacted, political leadership, community sentiment, changing demographics, direct federal stimulus whether in the form of low interest loans or block grants, and central bank liquidity facilities made available to support our primary and secondary markets. All play a role in determining the level of risk inherent in an investment and its suitability as a short- or long-term holding in your portfolio. At HJ Sims, we believe in the outcome of income. Thinking together in new ways as we define the “new normal” for our continent, we look forward to finding bond solutions that work for you.

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