'Not Much More' Fed Can Do. Now, We're on Our Own

Federal Reserve Chair Jerome Powell gave testimony this week before Congress, pursuant to a requirement in the CARES Act -- the $2 trillion Coronavirus Aid, Relief, and Economic Security package. Powell used this time in part to continue to implore Congress to pass some sort of fiscal stimulus. Unfortunately, it seems very unlikely any such stimulus is forthcoming. There haven't been meaningful negotiations between the Democratic and Republican parties in some time, and the tragic passing of Supreme Court Justice Ruth Bader Ginsburg is only going to increase partisan rancor. Meanwhile, in that same testimony, Powell said pretty plainly that there was not much more we can do, should the economy weaken from here. This leaves both the real economy and markets in quite a bind. Here's how I'm thinking about where we are and how to position portfolios. We're on Our Own Now In many ways, the economy has rebounded more quickly than I expected. Employment is improving for now, home sales are booming, retail spending has completely recovered, and even small business sentiment is back to about where it was in December. This impressive rebound could continue. Indeed, it could continue, even if there's another increase in Covid-19 cases. Remember that cases last peaked in July, and the economy added over 1.7 million jobs that month. But in this column I want to explore the downside risks if the economy stalls here. The first thing to say is that we're probably on our own. The extraordinary stimulus that came in the early days of the Covid crisis won't be repeated. This isn't just about political partisanship, but also that the support for fiscal stimulus was partially based on a need for literal lockdowns. Since the lockdowns aren't likely to be repeated, even if cases shoot up again, that will greatly hamper support for new payments to consumers. In addition, the Fed has already cut rates to zero and doesn't seem inclined to do anything else to stimulate the economy directly. As markets plunged in March, for some companies, a falling discount rate was enough to offset falling earnings. If earnings decline from here, there won't be any offset from lower interest rates. Economy's Biggest Test Aside from a slower rise in cases from what we saw earlier in the summer, we're not out of danger economically. We are probably entering a period where normal recessionary forces are going to become more important than the public health factor. It would take a lot for us to get back into lockdowns again, but even with improving caseloads, companies are still likely to downsize their workforce given weaker aggregate demand. This is what I mean by a normal recessionary force. In the early going, layoffs were all about literal lockdowns. Firms were making decisions primarily based on Covid. Now they are considering normal business issues. While this round of layoffs won't be as severe, it might make a bigger dent. Those fired during the lockdown knew they could be hired back as soon as the lockdowns ended. Those laid off now are looking at a much longer time without a job. Here's What the Credit Markets Say Credit markets are saying what we all know to be true: Not all beat up companies are the same. The chart below shows the change in spread between January and now for various high-yield bond sectors. Remember that the spread just means the yield difference between a given bond and a Treasury with the same maturity. Hence, a higher yield spread means the market is pricing in more credit risk, so not surprisingly almost everything is elevated. (Source: Bloomberg Barclays Indices) The sectors that have performed the worst (far left) include some obvious ones: Retail real estate investment trusts, oil field services and airlines. But look through the list, and you see several where weakness is less about Covid per se, and more about poor economic conditions: railroads, capital goods, chemicals, consumer cyclical and construction. The Value vs. the Value Trap For my team as credit investors, we actually prefer companies more directly Covid-impacted vs. those that are just cyclical. That isn't to say that all Covid stories are winners or all cyclicals losers. There's a lot more to it. But in general, the Covid story is probably improving, and thus companies where the primary problem is the pandemic are most likely on the upswing. We are very likely getting closer to cheaper and quicker testing, and ultimately to a vaccine. If you can find companies with a strong enough balance sheet to handle variation in the timing, and if the company is well run enough to rebound quickly, those are interesting buys. Then there are companies where the primary problem is the cycle. Generally speaking, I think these companies have more downside than upside. Too many of these cyclicals are priced as though the cycle is already on the upswing. It isn't clear to me that it is at all. In other words, I think there's still value in Covid-impacted sectors, like travel, restaurants, gaming, and media. I think pure cyclicals are value traps. Growth vs. Value Two parting thoughts on stocks. I know, I know, I should stay in my lane. But if you agree with my points above, they also have substantial implications for stocks. In September, there has been a decent pull-back in stocks led by the same tech stocks that had driven markets higher since March. This sell-off has basically been ignored by the credit markets. Corporate bonds traders don't really care about fluctuations in P/Es, we only really care about actual free cash flow. If the Nasdaq continues to blow off steam, there aren't really any deeper implications for the general economy. But over the last year we've continuously heard about an impending rotation from growth to value. I'd argue that this is way simplistic. Looking back at my high-yield chart above, most of these sectors would fall into value. But the triggers for a rebound in the various industries are quite different. We've got some where progress on Covid could solve all their woes, such as leisure. We've got others were covid has touched off a new trend that might last long after the pandemic is over, like office REITs. Then, we have some that are probably suffering from a structural decline and Covid is only playing a supportive role, including energy and traditional retail. Just calling all this value and expecting a rotation that looks like past rotations is paining with too broad of a brush.

'Not Much More' Fed Can Do. Now, We're on Our Own

With Fed's toolbox emptied and a big stimulus package unlikely, here's what I see for the economy, credit markets, and ... yes, stocks.

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