— 2020 Q2 UPDATE —
The Federal Reserve continues to support the United States with emergency measures. The Federal Reserve drastically increased the size of their balance sheet in record time and deployed new faculties in order to support the economy and financial markets.
Summary:
- Market uncertainty can disrupt rational decision making in investors. We attempt to shine a light on what is happening in the economy and markets so investors may be able to reduce uncertainty and make a more calculated choice.
- Learn about what the true unemployment rates are vs. the shocking unemployment claims reported.
- Monetary policy has been the major reason the S&P 500 Index returned 19.47% during the second quarter despite nationwide lock-downs.
- There are a wide variety of Federal loan types available during COVID-19 the overall goal of stabilizing the financial markets and economy.
This continues to be a strenuous year for many people on a level that goes beyond the scope of investing. Here at K2 Financial Partners, we attempt to give insight into the economy and financial markets during these unprecedented times. We wish all of our clients and global community at large good health and peace of mind.
Equity Markets:
Statistics:
Philosophy of Risk, Rewards & Uncertainty:
With a better understanding of what is driving the financial markets and economy, it is easier to make informed decisions. The differences and inextricable links between risk, rewards & uncertainty play a key role in an individual’s decision making process. And uncertainty is often a disruption in rational decision making.
This excerpt is designed to illuminate that thought process.
Imagine you are in a pitch-black room with only a flash light. Luckily, you have a special flashlight that exponentially increases in strength the longer it stays on. When you first get in that dark room you are in a situation with extreme uncertainty. There could be something dangerous in front of you, or there could something wonderful in front of you. The point is, you have no idea; the uncertainty of the situation is 100%. You have been robbed of the ability to make calculated decisions.
When the light first turns on you gain the ability to reduce the uncertainty within the room. Over time, as you are able to see the entire room, the level of uncertainty will diminish down to 0%. Once you have a clear picture of the room, you have identifiable risks and the potential rewards from taking those risks.
Being in the dark with growing illumination is a clear metaphor of our ability to gain clarity as we learn more. The further we push the bounds of our knowledge, the more we are able to transform the darkness of uncertainty into light which allows for identification of risks. Ultimately, there is a reason it is called taking a risk and that is because it is a conscious choice. Humans choose to take risks in order to obtain a reward. For example, a risk a person might be willing to take is the act of getting in a car and driving. The average driver knows a lot of the risks of driving a vehicle, and the more experience the driver obtains, the more nuanced her understanding of the risks associated with driving become.
Uncertainty is the antithesis to conscious decision making because it dives into the infinite list of things you do not that you do not know (such as not knowing anything about a pitch black room you are in for the first time). This is similar to how large market corrections or recessions, which seemingly come out of nowhere to the majority of market participants, can cause investors to sell their investments because there is too much uncertainty for them. They would rather exit the activity completely in order to eliminate the anxiety ridden uncertainty during those times which causes investors to sell at a low. With more knowledge of what is happening in the economy and markets, investors may be able to reduce uncertainty and make a more calculated choice The reduction of uncertainty allows us to identify risks and rewards which gives us the ability to make conscious decisions on which risks we want to take for different potential rewards.
Through this discovery process, we grant ourselves the ability to make educated financial decisions which allow us to stick to our financial plan with confidence. Ultimately, our research at K2 Financial Partners is done with our clients’ in mind throughout the whole process. We firmly believe that by attempting to understand the intricacies of the financial markets we arm ourselves with the tools to withstand the rough times and thrive during the good times.
This quarterly update is an attempt to reduce the uncertainty embedded within the complexities of the financial markets in order for us to have the ability to make rational investment decisions.
The Macroeconomy:
The worldwide lockdowns that espoused from the pandemic caused unprecedented economic change in the second quarter of 2020. Normally, any individual country going through the kind of vast economic change we saw in Q2 would be enough to fill up an entire book and we saw rapid change in just about every region of the world. Therefore, for the sake of brevity, we are going to solely focus on the biggest events and market drivers of United States economy.
Towards the end of the first quarter, the coronavirus outbreak caused the majority of United States to go into quarantine in order to flatten the curve of the outbreak. The result of this lockdown was an unprecedented spike in initial unemployment claims, which at their weekly high on the week of March 28th (last week of Q1) was 6,867,000. However, even though that was the peak of the indicator, that was just the beginning. According to FRED, between the week of April 4th until June 27th, 38,491,000 people filed for unemployment in the United States. To put that in perspective, according to Statista, as of 2018 there were only 155,760,000 working adults in the United States. Based on the chart below, this is obviously an unprecedented spike in the unemployment numbers and it happened in a rapid period of time. To put this figure in perspective, the worst week for the Initial Unemployment Claims during the Great Recession of 2008 was ironically exactly 11 years earlier on the week of March 28th, 2009 at 665,000. That would make this indicator over 10x as high as the work week for unemployment during the Great Recession.
Source: Fred
Based on that number alone, it would be easy to assume that the situation is much worse than it actually is. There are two vital factors that make these unemployment claims much less severe than they seem. The first is that they are not representative of the unemployment rate across time the way they were being purported because they do not count for the opposite effect of initial hires. Second, they came from an exogenous shock induced by government action, which is not as structurally severe as having an endogenous issue causing layoffs within the market.
Saying that initial unemployment claims are not representative of the unemployment rate across time means that if someone files for unemployment one week, and then gets hired the next week, it does not subtract from the indicator. Therefore, if we simply add up all the initial unemployment claims across a period of time, there is a higher number of unemployed people counted than the true figure. For example, if we simply divide the initial unemployment claims from April 4th-June 27th by the estimated working population we would get an unemployment rate of approximately 24.7% for that period. However, the true unemployment rate at this time (11.1% for June) is much lower than 24.7% because the initial unemployment claims does not take into account new hires.
Source: Fred
As you can see from the chart above, during the time that unemployment claims were being filed, it was being partially mitigated by new hires which is the other side of the unemployment rate figure.
Source: Fred
Another reason this initial unemployment claims spike was not treated as badly by the market as one would anticipate is that it was caused by an exogenous shock to the market which artificially separated the supply from the demand for labor. This artificial separation reduced the markets’ reaction because investors perceived it as a temporary measure until the virus subsided where the labor supply would then be allowed to meet labor demand again. The major risk to this exogenous shock was that it had a time decay aspect to it, which means the longer that the market was held in a state of suspension, the more the unemployment numbers would reflect the true underlying market because of reduced profit margins and bankruptcies. The point where the demand for labor meets the supply of labor in the state of suspension is when there is an inflection point because in that scenario once the lockdown is lifted there would not be enough open businesses to employ people.
Another potential issue with the lockdowns and increased unemployment is the non-linear ripple effects this has throughout the economy. When there is high unemployment that means that there will be a drop in consumer spending because of lack of disposable income. This can lead to even more layoffs ultimately causing a deflationary spiral even with stimulus money included in the equation. Investors’ have been worried, the same way they did after the stimulus of the 2008 financial crises, that there would be an inflationary spike. However, that is ignoring the velocity of money that is required to spike inflation. If there is a lack of consumer demand, there will naturally be deflationary pressures on businesses and we saw that in the CPI indicator where year over year inflation went from 2.48% in January to 0.24% in May even with the influx of stimulus from the government.
Source: Fred
Ultimately, this government induced lockdown required a government solution in order to bridge the separation of supply and demand until the lockdowns would be lifted. There have been unprecedented fiscal and monetary responses in the context of quickness of the response and scale. The fiscal response was highlighted by the CARES Act, which was a $2.2 trillion relief package that provided stimulus to businesses and consumers in order to keep the economy functioning. The CARES Act has been covered in detail because it was an explicit bill that showed exactly what was happening. On the other hand, monetary policy moves in the background, pulling even larger levers than the fiscal response and in much more esoteric ways. Monetary policy has been the major reason the S&P 500 Index returned 19.47% during Q2 despite nationwide lockdowns. Understanding the scope and magnitude of the actions taken by the Federal Reserve (Fed) during q2 will help us understand the logic behind the market’s return vector.
The Federal Reserve during Covid-19:
“Don’t fight the Fed” – Marty Zweig
This is a quote that means you want to be long the equity market when the Fed is dovish and short the equity market when the Fed is hawkish. This is because the Fed has major influence over the shape of the yield curve through open market operations (where they mainly manipulate the short tenor of the curve) and through quantitative easing/tightening (where they affect longer tenors of the curve). The shape of the yield curve affects lending by financial institutions and it affects the demands for loans by businesses. Essentially, the shape of the yield curve affects all aspects of the economy and financial markets to one degree or another.
During Q2, the Federal Reserve drastically increased the size of their balance sheet in record time and deployed new faculties in order to support the economy and financial markets. Here we take a look at what these programs were designed to accomplish and the magnitude of how they have been implemented through time.
Yield Curve:
Source: Treasury.gov
As you can see, the yield curve is currently upward sloping and it did not change much during Q2. The reason it did not change much was because the short term interest rates were already established at the end of Q1, with the Fed aiming between 0-0.25% for the target interest rate. This rate that the Fed targeted is called the federal funds rate and according to the Brookings Institute, “it is a benchmark for other short-term rates, and also affects longer-term rates. The move is aimed at lowering the cost of borrowing on mortgages, auto loans, home equity loans, and other loans.” Therefore, the federal fund rate has ripple effects throughout the entire economy.
Through the Fed establishing this interest rate they were able to put a positive slope back into the yield curve which encourages lending by financial institutions because they can make the spread on the difference. This is an expansionary move by the Fed that was highly expected because it is done through their open market operations which is their most common tool.
Securities Held Outright:
Source: FRED
Purchasing securities from institutions was a major tool used during the 2008 financial crises in order to establish stability in the financial system. This tool is commonly referred to as quantitative easing and it expands the open market operations that the Fed normally conducts because they are not targeting the federal funds rate anymore, instead they are buying securities with longer maturity dates. According to the Federal Reserve’s balance sheet, securities held outright grew from $3.9 trillion in mid-March to $6.1 trillion in late June. According to the Brooking’s Institute, the reasoning for the Fed taking such drastic steps is because “treasury and mortgage-backed securities markets have become dysfunctional since the outbreak of COVID-19, and the Fed’s actions aim to restore smooth market functioning so that cred can continue to flow.” Essentially, it means that the Fed was providing liquidity to the credit markets when the markets were drying up. This is similar to a doctor putting a stent in a heart to keep blood flowing, they were attempting to keep the heart of the financial system pumping.
Loans:
Source: Federal Reserve
There are many different types of loans that the Fed has taken advantage of during the COVID-19 outbreak. Each one is intended to provide a specific function with the overall goal of stabilizing the financial markets and economy.
Below is a brief description of most of the loans, according to the Brooking’s Institute and the Federal Reserve:
- Primary Dealer Credit Facility (PDCF): “The Fed will offer low interest rate loans up to 90 days to 24 large financial institutions know as primary dealers. The dealers will provide the Fed with equities and investment grade debt securities, including commercial paper and municipal bonds, as collateral.” The main goal of this facility is to keep credit markets functioning properly at a time when individuals have a tendency to be overly fearful with how they lend.
- Money Market Mutual Fund Liquidity Facility (MMLF): This facility “lends to banks against collateral they purchase from prime money market funds, the ones that invest in corporate short-term IOUs known as commercial paper, as well as in Treasury securities.” This facility is to help support money market mutual funds with redemptions from investors. The Fed said this facility “will assist money market funds in meeting demands for redemptions by households and other investors, enhancing overall market functioning and credit provision to the broader economy.”
- Paycheck Protection Program Liquidity Facility: This program “will facilitate loans made under the PPP. Bank lending to small businesses can borrow form the facility using PPP loans as collateral.”
Source: Federal Reserve
- Commercial Paper Funding Facility (CPFF): Through this program, the Fed buys commercial paper which is essentially the same as lending directly to corporations for up to three months. This improves the liquidity of the commercial credit market and it also serves as a confidence booster that corporations will be able to have adequate cash flow to meet short term needs during the lockdowns.
- Term Asset-Backed Securities Loan Facility (TALF II): Through this facility, “the Fed supports lending to households, consumers, and small businesses by lending to holders of asset-backed securities collateralized by new loans.” According to the Federal Reserve press release, “The TALF special purpose vehicle initially will make up to $100 billion of loans available. The loans will have a term of three years; will be nonrecourse to the borrower; and will be fully secured by eligible ABS.” This means that if a corporation has loans (auto loans, leases, student loans, credit card receivables etc.) that they want to get off their balance sheet by securitizing them, the Fed will provide that securitization by purchasing the ABS.
- Municipal Liquidity Facility: According the Federal Reserve website, “The Federal Reserve established the Municipal Liquidity Facility to help state and local governments better manage cash flow pressure sin order to continue to serve households and businesses in their communities. The facility will purchase up to $500 billion of short term notes directly from U.S. states.” This is an attempt to keep the flow of money towards states as they currently have a lot of budgetary pressures with the lockdowns.
- Main Street Lending Program: “This program aims to support businesses too large for the Small Business Administrations Paycheck Protection Program and too small for the Fed’s two corporate credit facilities. Businesses with up to 15,000 employees or up to $5 billion in annual revenue can participate. Borrowers are subject to restrictions on stock buybacks, dividends, and executive compensation.”
- Corporate Credit Facilities: This program includes the “Primary Market Corporate Credit Facility (PMCCF) and the “Secondary market Corporate Credit Facility (SMCCF)”. The PMCCF allows the Fed to lend directly to corporations by buying new bond issuances and providing loans. The SMCCF allows the Fed to purchase existing corporate bonds as well as exchange-traded funds that are investing in investment-grade corporate bonds.
Overall, currently the Federal Reserve has become the ultimate backstop to the financial markets. It has replaced the direction of liquidity in the markets. Where normal liquidity comes from private market transactions, the Fed has stepped in to fill the role of buyer when there is no buyer and seller when there is no seller. This has ramifications on the financial markets that are beyond the scope of this discussion but in the short term they have been a savior to the financial markets and economy at large.
Here at K2 Financial Partners, our number one focus is making sure our clients are in the right position to reach their financial goals. This is why it is important during times like this that you stay in contact with your financial advisor to make sure you are properly allocated to potentially capitalize on the positive times in the market and feel confident during the more difficult times.
SOURCES:
https://www.federalreserve.gov/newsevents/pressreleases/files/monetary20200323b3.pdf
https://www.brookings.edu/research/fed-response-to-covid19/
https://www.federalreserve.gov/monetarypolicy/muni.htm
https://www.federalreserve.gov/monetarypolicy/bst_fedsbalancesheet.htm
The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Lincoln Investment. The material presented is provided for informational purposes only. S&P 500 Index is an index of 500 of the largest exchange-traded stocks in the US from a broad range of industries whose collective performance mirrors the overall stock market. Investors cannot invest directly in an index. The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the central banking system of the United States. The Federal Reserve System is composed of 12 regional Reserve banks which supervise state member banks. The Federal Reserve System controls the Federal Funds Rate (aka Fed Rate), an important benchmark in financial markets used to influence the supply of money in the U.S. economy. Inflation is the rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market. Moderate inflation is a common result of economic growth. Deflation is the decline in the prices of goods and services. Generally, the economic effects of deflation are the opposite of those produced by inflation, with two notable exceptions: (1) prices that increase with inflation do not necessarily decrease with deflation; (2) while inflation may or may not stimulate output and employment, marked deflation has always affected both negatively. Consumer Price Index (CPI) measures prices of a fixed basket of goods bought by a typical consumer, widely used as a cost-of-living benchmark, and uses January 1982 as the base year.