May 21, 2020
Fiduciary Trust Chief Investment Officer Hans F. Olsen, CFA discusses the current state of the economy and markets, the likelihood of another material near-term stock market drop, and our views on the pace of economic recovery. He also highlights investment opportunities that are presenting themselves in the current environment.
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Transcript
Todd Eckler: Thank you for joining this edition of the Fiduciary Insights podcast series. We hope you’re staying safe and healthy in this challenging time. I’m Todd Eckler, Chief Marketing Officer at Fiduciary Trust Company. And today we’re providing a mid-quarter update to our outlook for the economy and markets. I’m joined by Hans Olsen, Chief Investment Officer at Fiduciary Trust. In our discussion, we’ll focus on the current state of the economy and the markets, the likelihood of another material near-term stock market drop, our views on the pace of economic recovery, and we’ll also discuss investment opportunities that are presenting themselves in the current environment. So, let’s get started. Hans, as everyone is painfully aware, the global economy has taken a major hit in the wake of the COVID-19 pandemic and to varying degrees, the financial markets have followed. With the economies opening up again, and consumers dialing up spending, what type of recovery should we expect? Is it going to be quick and strong or slow and weak?
Hans Olsen: Thanks, Todd. There’s been a lot of conversation about what the recovery will look like. To imagine the recovery, one has to consider from where we are recovering. With more than 36 million jobs lost and an economic contraction, that might be on the order of 43%. Driven by a 34% fall on personal consumption and a roughly 62% drop in private investment, the rapid shutdown of our commercial lives is really without precedence. Looking to history as people tend to do during times like these, is not likely to be very helpful, as this has never happened before. There’s been a lot of talk about the shape of the recovery, something we call the eye chart of economic recovery. Ideas such as the road back to economic health will be a V-shape or U-shape or an L, all have been posited. Given the length of the shutdown and the fact that no vaccine exists, the way forward will likely be uneven and messy.
A W-shaped recovery is the one that comes to mind. It assumes that any recovery will be regional and bedeviled by the occasional viral flares that necessitates localized shutdowns. Of course, the possibility of a fall/winter second wave of infection remains a very real possibility. Consequently, I’m not sure we will achieve the pre-pandemic levels of employment anytime soon. Indeed investors, I think, should be thinking about recovery in terms of years and not months.
Todd Eckler: Well, Hans, what needs to happen before the economy can return to normal operations? And when do you see that happening?
Hans Olsen: Well, because the economic disruptions are driven by the efforts to combat the pandemic, the way out really centers on arresting the spread of COVID-19. I think three things need to occur before a familiar pattern of our economic lives can resume. First, we need broad-based testing to identify who has had, as well as who has, the virus. This helps to refine the tracing and quarantining of individuals. The second thing we need is a discovery of a vaccine, which is really the only way to arrest the spread of the virus. And third, mass scale manufacturing and distribution of the vaccine, which creates the herd immunity that is required. Now these logistical demands are going to be considerable and will take time to pull off.
Todd Eckler: Well, clearly there are a lot of important steps that need to happen for the economy to get back to normal. I wanted to switch gears and talk about the markets for a moment. Clearly there was a huge pullback in the markets earlier in the year, and then it’s bounced back considerably. Given the current high-equity market valuations, given projected earnings going forward, at the same time opposing economic indicators that don’t look so strong, at least in the near term, is the stock market at risk for another fall?
Hans Olsen: Yeah, that’s a good question, Todd. The stock market is always at risk of a fall when something unexpected happens as we’ve seen. The rapid recovery of the US market is nothing short of remarkable. It’s roughly 86% of its pre-crisis high. This suggests investors expect a V-shaped recovery. That strikes us as wishful thinking. The implied discount rate—which is essentially the rate investors discount the unknown, right?—so a higher discount rate would say there’s more uncertainty, lower discount rate, less uncertainty. The implied discount rate right now applied to the market is a relatively modest 3% or so. This is a level that we haven’t seen in decades. So in other words, markets are not pricing much uncertainty and it’s at odds with the state of play, given that many leaders of companies right now have given up on any earnings guidance, as it’s anyone’s best guess as to where corporate profits will land. Of course, trillions of dollars of spending by the federal reserve will help considerably in putting steel in the nerves of investors.
Todd Eckler: There is clearly a lot of uncertainty there in the markets, and it’s going to play out over a number of months, as we see how the earnings and the economic recovery goes. The pandemic is clearly having a major impact on the short-term economy and markets, as we were just discussing, and there’re also concerns about the ballooning deficit and will that have longer term repercussions for us and the economy and the markets. Do these factors change your long-term outlook for the US economy and markets?
Hans Olsen: They do and really what they do is they inject more questions on the way forward and what the future will look like. Without a doubt, the economy that emerges from this pandemic will be very different from the one that entered it. These types of exogenous shocks to the system, such as pandemics, tend to be accelerators of trends that are already in place. The carnage rolling through the retail sector’s a good case in point. The companies that do make it through bankruptcy will emerge as smaller operations. Meaning a lot of those jobs that are lost are gone for good. They’re simply not coming back. Something else will have to emerge to absorb those displaced workers. The other thing that’s happening is the new, what do they call it? The WFH, the work from home arrangements, that we’re all experimenting with right now, is going to change the way the office place looks.
Indeed, this process was already entrain before the pandemic. WeWork perhaps best represented this new paradigm and work. But now even that paradigm looks terribly outdated in the age of Zoom conference calls and Google Meets. The other trend that will likely accelerate is going to be centered on the idea of peak globalization. Now, you and I have talked about this in the past, but the reordering of the global trade order of the last several years is likely to accelerate as a result of this. We’re calling it re-regionalization. We’re still going to be a global economy, but there’s going to be a new emphasis on the local. And this emphasis on just-in-case supply chains will replace the generations-old, just-in-time structure. That will accelerate domestic economic durability and sustainability going forward. So, that basically pulls the reassuring back to the United States.
Now, there’s also a huge unknown in the policy actions that policymakers have taken in order to support the economy through this period. The rate at which the government is spending money to alleviate the hardships is unprecedented in modern times. Todd, the deficit could be on the order of 17 to 20% this year. I think that’s something on the order of about $3.7 trillion and they’re talking about another $3 trillion plus follow on stimulus. So that number could be considerably higher relative to GDP, but the ability to fund these deficits this large, it’s going to be a test of what the ultimate cost will be. It’s too early to tell but, in time, this has to lead to higher taxes and result in the dead hand of debt, crowding out productive investment. To be sure trillions and money printing inevitably leads to concerns about inflation. I think that, however is a concern for another day, because we’re probably going to suffer the effects of deflation because people can’t consume in the near term. But inflation, that’s a concern for another day.
Todd Eckler: Yeah, certainly we’re not sowing the seeds for some of the things that would create a more sound long-term foundation. I wanted to pick up on a couple of the points you were making earlier about globalization and “just in time” versus “just in case.” It kind of brings up the question of other markets outside the US and to think about what’s going on in Europe or China and emerging markets. How do you expect the recovery to play out there?
Hans Olsen: Well, we’ve come back to the notion that these shocks cause an acceleration of events or trends already in process. I think this concept applies pretty strongly to Europe, China, and other emerging markets. So in Europe, they’ve been struggling now for more than a decade at some sort of fiscal union, right? The notion of a Euro bond and various parts of the economic block have pushed back against it. They’re just not ready for that type of integration. And in fact, even recently, there was a German court ruling that said the ECB has overstepped its mandate. So, there’s going to be a challenge there, and this is really at the very core of the project. I think that the pandemic will accelerate the discord and the problems, and that’ll put Italy really right at the center of it, a country that is way too big to fail and still have the European project survive.
So that’s going to put a significant headwind on Europe, leading anything anywhere. They’re going to be very inwardly focused. China was slowing before this and the slow down with re-regionalization is going to clip China and both its forward growth and it’ll probably force it to accelerate its internal consumption. And if anything, it might have geopolitical consequences for its program of projecting power around the globe, when people are beginning to sort of question their motives and their role and their responsibilities. This might be a point where the Chinese start to behave a bit differently and perhaps in a more confrontational way, we’ll have to see. In emerging markets more broadly, the story has been global integration, the low-cost producers. Those trends all accrued to the emerging markets. Well, if those things start to reverse themselves, the whole emerging market story starts to change a bit. The demographics are still there. Perhaps the hope is still there. The reality might be something different indeed.
Todd Eckler: Well, certainly something to pay close attention to in thinking about allocating assets across different markets. And we talked about some of the uncertainties in the marketplace and challenges that have been in place over the course of the year. On the other side, are there investment opportunities that are being created by what’s unfolded in the markets, in the economy? And if so, what are they?
Hans Olsen: Well, indeed there are, and there have been a number of opportunities to take advantage of. So for example, a couple of weeks ago, the very easy trade to make was to sell European and emerging market equities and buy US large cap. It’s hard, as I’ve said, it’s hard to see how the global recovery occurs without the US leading the way. The other thing is that, while considerable money has been flowing into very large US companies, so you’d think of those as the mega caps. Which makes it a bit of a crowded investment. Big companies however, at the end of the day with strong managements, tend to do particularly well during times like these, as they’re in a position to consolidate their power, take advantage of opportunities that unfold, and they come through stronger, bigger, and more competitive companies on the other side. I think the final thing that’s capturing our attention, if we’re right about higher taxes being required to pay back all the debt that’s being floated in order to support the economy, then that those higher taxes should start to make the municipal market look increasingly attractive for investors.
Todd Eckler: Hans, thanks for sharing your perspectives today. I hope our listeners found it useful. So, that wraps up this edition of Fiduciary Insights.
If our listeners have questions about the topics discussed today, please reach out to your fiduciary trust investment officer or contact Rick Tyson at (617) 292-6799 or tyson@fiduciary-trust.com. Thanks for joining today. We hope you stay safe and healthy.
