Capital Market Outlook (March 16, 2020)

In This Issue

  • Macro Strategy—The deflationary shock from the COVID-19 epidemic has been compounded by the collapse in oil prices. Federal Reserve (Fed) officials see that inflation expectations have come unanchored, causing U.S. interest rates to join those in Japan and Europe around the lowest levels in history, and are acting aggressively to provide short-term support and ultimately to prevent a disastrous longer-term deflationary outcome. A coordinated monetary and fiscal response that will support nominal magnitudes is beginning. A "fiscal bazooka" is in the early stages to complete the coming "unprecedented policy coordination."
  • Global Market View—The duration of the COVID-19 pandemic-induced bear market remains anyone's guess but will have a lasting imprint on the investment landscape and global economy. While near-term, uncertainty and volatility will remain the norm, investors should not lose sight of buying opportunities on the other side—whether healthcare, automation/robotics/artificial intelligence, and e-commerce.
  • Thought of the Week—As yields have fallen in response to a murky economic outlook, the housing market has been a beneficiary of historically low interest rates with home sales, average prices, building permits, and refinance activity picking up. In fact, refinances recently touched levels last seen in April 2009. While the forces driving interest rates lower are of critical importance, even during challenging times, housing activity can be one of the earlier reflexive indicators of financial conditions and economic strength.
  • Portfolio Considerations—We prefer equities over fixed income as valuations in bonds are extreme levels. With Treasury yields at historically low levels, oil prices correcting aggressively, and investor sentiment in equities at levels close to crisis levels, we would let the capital markets stabilize in the near term. Long-term investors should consider rebalancing portfolios in the coming weeks as more data is released regarding this virus and the economy.

Market Volatility Update

After the quickest equity drop from a bull market to a bear market in the history of the capital markets, volatility continued last Friday with a 7% higher move in the S&P 500 in the last hour of trading after the Administration enacted the Stafford Act which kicksoff a public private partnership to develop virus containment policies and procedures. Moreover, the additional emergency cut of 100 basis points (bps) to zero, the inclusion of forward guidance, and a new asset purchase program of $700 billion by the Fed this past Sunday evening pressured equity futures to the downside overnight. Investors decided to pull back and assess the Fed's latest sharp actions before shifting to risk-neutral let alone risk-on. This is a sentiment driven market that is on fragile ground until there are clear signs that the containment policies put in place are beginning to work. This is likely to take many weeks. We believe investors should consider rebalancing portfolios at least back toward strategic targets through this period.

We believe we are in a two stage bottoming process in the equity markets. One that includes the height of fear regarding the financial markets due to liquidity concerns, which is the current environment. And then a second bottom based on economic concerns once more data is available regarding the length and magnitude of the containment procedures. Coming out of this, we expect a U-shaped type of economic recovery (negative growth in Q2 followed by small increments of growth in the subsequent quarters) with the equity markets exhibiting a square root-shaped path with a W-based—sawtooth—bottom. Given the fact that this is a "known unknown" with fluid data, we expect further economic and profit growth forecast adjustments. This bottoming process will attempt to price in the worst case scenarios, based on the latest data, in the coming weeks, in our view.

Time to Get Serious About Inflation

The U.S. monetary-policy framework, based on the Phillip's curve and potential-gross domestic product (GDP)-growth framework, has not been working, in our view. In particular, it is not working to guide policy toward achieving its long-term goal of keeping inflation symmetrically around a 2% objective. This failure of the prevailing economics paradigm helps account for the fact that Japanese and European interest rates, inflation, and nominal GDP growth reflect a much lower inflation environment than 2%. In short, the Fed is now in the same boat as the negative-rate countries, as the collapse in U.S. sovereign rates makes clear.

Over the past decade, the Fed's chosen inflation measure has averaged about 1.5%. A recent study finds the actual rate has been closer to 1.1% and "the mismeasurement has widened notably over the past decade" because of deflation in prices paid for consumer digital-access services. The 1.1% estimate uses an alternate, better measure of digital access-service prices that the authors of the study developed. This lower measure is more consistent with the behavior of financial markets.

In November 2018, the Fed announced a "broad review of the strategy, tools and communication practices it uses to pursue the monetary policy goals established by the Congress…" Policymakers plan to report their findings to the public during the first half of 2020. The COVID-19 emergency has accelerated the timetable for the Fed to more proactively address low inflation.

Elements of a new approach are implicit in speeches and discussions by officials during the past year as well as thought leaders in academia. One key factor will involve how policy can function around the effective lower bound of zero interest rates. Avoiding negative rates is another important consideration. One consequence of near-zero interest rates is the diminished power and scope of interest-rate changes and the increased need to integrate fiscal policy with monetary policy. The increased public discussion of modern monetary theory (MMT) reflects this new economic reality.

In a paper published by the BlackRock Investment Institute in August 2019, "Dealing With the Next Downturn: From Unconventional Monetary Policy to Unprecedented Policy Coordination", the authors including monetary policy veterans, Stanley Fischer and Philipp Hildebrand, synthesize what we regard as the best thinking to date on how central banks can restore their credibility for achieving a 2% inflation target. If adopted, we believe this approach would also eventually restore interest rates to the higher levels that would typically be associated with persistent average inflation around 2%, such as we saw during the 1950s in the U.S., for example.

The Fischer paper makes the inflation target the centerpiece of the new policy approach. In a section on post-crisis progress, it cites the successes from the response to the Great Financial Crisis of 2007-2009, but concludes with the observation: "Yet bringing inflation back to target in a sustainable way is still proving challenging." The recent collapse of inflation and U.S. rates makes that an understatement.

Exhibit 1: Can the U.S. Escape the Liquidity Trap?

Average Nominal GDP Growth 2010–2019 (%)







Source: Haver Analytics. Data as of March 10, 2020.

Inflation and real GDP growth have been higher in the U.S. than in Japan and Europe, where nominal growth has run much lower, helping to explain their continued zero-rate quagmire (Exhibit 1). The recent collapse of the U.S. interest-rate structure toward European and Japanese levels is a worrisome leading indicator suggesting the U.S. is falling into this liquidity trap scenario. Since financial assets such as equities are priced based on expectations of revenue and profit growth that are directly linked to the trend in nominal GDP, a prolonged U.S. collapse into a European and Japanese-like growth environment would be devastating for asset values.

This increases the urgency for the Fed to adopt a realistic framework to keep inflation around 2%. We believe the latest bout of financial-market volatility reflects this urgency for monetary policy to avoid the persistently weak nominal-growth outcome. Initially, this will mean overshooting the 2% target for a sustained period in order to convince markets that the central bank is serious and capable of achieving this objective. A rampant skepticism is currently permeating expectations, however, causing the near-zero levels we are currently seeing in long-term interest rates to proliferate for the first time in U.S. history.

More formally, the new inflation-targeting framework outlined in the Fischer paper is designed as follows:

  • A standing emergency fiscal facility (SEFF) would operate with the explicit objective of bringing the price level back to target.
  • The Central Bank would activate the SEFF "when interest rates cannot be lowered and a significant inflation miss is expected over the policy horizon."
  • The size of the SEFF would be based on what is needed to achieve the inflation target.

By directly linking the conduct of monetary policy to "printing money" until an inflation target is hit, the SEFF incorporates the fundamental mechanism that creates inflation: "too much money chasing too few goods." Historically, central banking has focused on interest-rate control rather than money-supply control. Interest rates are more directly related to economic transactions that bankers understand, whereas the money-supply process is more abstract and poorly understood. Over the years, most major mistakes in monetary policy have been the result of ignoring the role that the money supply plays

in creating inflation. This was a major theme in Milton Friedman and Anna Schwartz' A Monetary History of the United States 1867-1960.

In a liquidity trap, when interest rates are at the zero bound and the central bank is pushing on a string, it is necessary to combine fiscal demand stimulus with monetary policy to have an impact. This virus outbreak creates a pressing need to fill the economic void from the "social distancing" shock to growth.

Three stages of fiscal policy are currently being designed. The first is focused on helping the most immediately impacted with relief measures, like extended unemployment insurance benefits for lower income workers who lose their jobs. The second, and most important, will provide a general stimulus across the economy. A year-long payroll-tax holiday could deliver about a trillion dollars of stimulus and has the advantage of being easily implemented, is timely and widespread helping the lowest-income workers the most as it is a 15% regressive tax on the earnings of lower income workers. Half is paid by employees and half by employers, so it would deliver major stimulus quickly helping both workers to keep their jobs and small businesses to keep operating.

Finally, targeted programs for disproportionately affected industries like airlines will be necessary to prevent a systemic cascading of debt defaults. All these programs provide the fodder for an SEFF that could monetize (extinguish the debt from) a trillion dollar response to cushion the impact of the global pandemic and help preempt a selfreinforcing debt-deflation down spiral.

The Other Side: Buying Opportunities in the Post-COVID-19 World

Every crisis leaves its mark, and the global COVID-19 pandemic will be no different. More spending on global healthcare; new automation-led supply chain configurations, notably among big pharmaceutical firms; and the acceleration of digital retail—these are some of the key dynamics that investors can expect on the other side of the crisis.

In a nutshell: the duration of the virus-induced bear market remains anyone's guess, although for long-term investors rebalancing portfolios, think large cap leaders in healthcare, automation and robotics, and e-commerce.

In brief, we outline each trend below.

The boost to global healthcare spending. The COVID-19 has not only pushed healthcare to the top of the agenda of every government in the world. It's also brutally exposed cracks in the healthcare systems of rich and poor nations alike, portending more global spending on healthcare in the decade ahead.

Per the numbers, global healthcare expenditures have climbed steadily over the past two decades, reaching nearly $8 trillion in 2017. However, spending on global healthcare as a percentage of world GDP has barely budged, flat-lining at around 9% over the past two decades (Exhibit 2). This, at a time when the world is rapidly aging (putting even more stress on healthcare systems); when non-communicable diseases are exploding around the world; and when global obesity levels are at all-time highs. So even before this virus hit, the world's healthcare infrastructure was straining at the seams, notably in Asia.

Exhibit 2: Global Healthcare Spending.

Sources: International Monetary Fund, World Health Organization. Data as of 2020.

The region is home to 52% of the world's population but accounts for just 21% of global healthcare spending, an unhealthy mismatch between demand (billions of people living longer and expecting better healthcare) and supply (an underfunded and overwhelmed healthcare system). Total health care spending in Asia—home to over 3 billion people— was just $1.6 trillion in 2017, less than half the total healthcare spend in the U.S. and just 6% of regional GDP. Whereas healthcare expenditures on a per capita basis in 2017 totaled $10, 246 in the United States, $4,169 in Japan and $5,332 in Australia, the comparable figure in China was $441. In India and Indonesia, home to over 1.5 billion people, the figures were even worse, $69 and $115, respectively.

Suffice it to say, that in the post-COVID-19 world global healthcare expenditures are set to accelerate, a bullish prospect for world leaders in pharmaceuticals, diagnostic equipment, medical software/hardware, tele-medicine and related medical goods and services.

Rethinking global supply chains, notably drug supply chains. Also set to accelerate: the shift in global supply chains, and more generally, the migration out of China. This dynamic was already in train thanks to ongoing U.S.-Sino trade frictions. But this virus has only underscored and exposed the true nature of China's importance to global manufacturing, with the mainland today accounting for roughly 20% of global trade in manufacturing intermediate products versus 4% in 2002, according to figures from the United Nations.

China has become a critical supplier to every industry in the world, including pharmaceutical products. Exhibit 3 highlights America's dependence on China for drugs—whether finished products or active pharmaceutical ingredients. According to the U.S. Commerce Department, 95% of ibuprofen, 91% of hydrocortisone, 70% of acetaminophen, 45% of penicillin, and 40% of heparin imported to the U.S. in 2018 came from China. In other words, "Made in China" is at the heart of the U.S. pharmaceutical industry.

Exhibit 3: China's Choke Hold On the Supply of U.S. Drugs.

Unbeknownst to many, since the 1990s, China and India have emerged as key sources of drug supplies for the United States thanks to lower costs and fewer regulations. However, given the supply disruptions in China and the fact that India recently put a curb on various drug exports, U.S. drug makers, like many other U.S. industries, are actively rethinking their global supply chains.

This rethink, in time, will lead to reconfigured global supply chains, with the biggest winners not necessarily low-cost locales like Vietnam and Cambodia, the ongoing consensus. But rather automation, robotics, and artificial intelligence. The factory of the future, notably in high-end activities like critical drugs and active ingredients, will be driven by machines, not humans, and be based closer to home (US) as opposed to half-way around the world.

We remain long term bulls on technology, artificial intelligence, 3-D printing, robotics and related goods and services.

A boost to everything "E". We are also long term bulls on most things "E" or "electronic". While COVID-19 has brought the physical world (humans/goods, etc.) to a near stand-still, the virtual world has avoided the virus-related lockdown and is set to thrive over the short and long-term.

E-health, e-sports, e-groceries, e-learning, e-finance, e-entertainment—pick your activity and there is a good chance it is moving to an online platform and becoming electronized. What's more, and rarely appreciated among investors, e-retailing (buying online) remains a rather underdeveloped undertaking in the United States.

As Exhibit 4 highlights, online retailing in the U.S.—despite the Amazonification of one sector after another—represents less than 16% of total U.S. retail spending. In other words, Americans love their bricks and mortar, although COVID-19 and the attendant fear and paranoid about crowds/malls/travel portends less malling and more upside e-retailing among consumers and businesses. In the end, the COVID-19 pandemic will accelerate the global push to live/shop/work/school/entertain online or virtually.

Exhibit 4: U.S. e-Commerce Sales: It's Not Over For Brick and Mortar.

Source: Bank of America Corporation internal data. Data as of 2019.

Investment summary

The COVID-19 pandemic of 2020 will have a lasting imprint on the investment landscape and global economy. Near-term, uncertainty and volatility will remain the norm. However, amid the noise and negative headlines of today, investors should not lose sight of tomorrow. The crisis has reshaped the world, which requires investors to recalibrate and rebalance their portfolios. As a starting point, think healthcare, automation/robotics/ artificial intelligence, and e-commerce.

Lower rates helping to raise the roof for housing

As yields have fallen in response to a murky economic outlook, the housing market has been a beneficiary of historically low rates with home sales, average prices, building permits, and refinance activity picking up. In fact, refi's recently touched levels last seen in April 2009. While the forces driving rates lower are of critical importance, even during challenging times housing activity can be one of the earlier reflexive indicators of financial conditions and economic strength.

The Fed has dramatically accelerated the pace, scale, and scope of accommodative monetary policy that began last year and continues now in response to COVID-19. This transmission mechanism can operate on a lag across many pockets of the real economy, but housing often represents a more immediate outlet as lower mortgage rates help stimulate demand especially under conditions of a tight labor market. In addition to policy easing, the recent "risk off" market backdrop has helped to funnel capital into treasury holdings, putting downward pressure on yields including the 10 Year Treasury, of which mortgage rates tend to track. As a result, mortgage rates have rapidly fallen towards historic lows with the 30-Year Fixed Rate Mortgage now averaging 3.29% in March, down from nearly 4.9% in October of 2018.

The resulting effects in housing activity are substantial. Refinance activity has surged close to a seven year high, representing 66% of all mortgage applications in February and helping to put more cash in the pockets of consumers. In January, pending home sales rose 6.7% year-over-year (YoY) and new home sales rose 19% YoY while low inventory helped to drive values higher. This helps broaden the "wealth effect" which can bolster consumer confidence and strength, which is the critical backbone of the U.S. economy. Lower mortgage rates may not just save consumers in monthly payments or make a new home more affordable but the broader effects of a strong housing market can indicate and contribute towards a solid economy.

Exhibit 5: Refi Activity is Surging as Rates Drop.

Source: Chief Investment Office, Mortgage Bankers Association, Bankrate. Data as of March 11, 2020.