Quarterly Updates

July 30, 2020 By BFT Financial

Financial Updates | July 2020

As things stand today, there are many encouraging signs of a rapid economic rebound around the world, but uncertainties also abound. Federal Reserve Chairman Jerome Powell describes the prospect of U.S. economic recovery as “extraordinarily uncertain.”

This probably best characterizes the broad economic environment facing most investors. To be clear, we are still bullish on risk assets, but also think that a short-term set back in markets is very well possible.

Will The Bulls Continue?

Although the U.S. stock market has so far shrugged off the renewed viral spikes in Florida, Arizona and Texas, the increasing number of COVID-19 infections will remain a key risk to equities. At present, the market seems to be assuming that the viral spikes will likely be contained within these states, while the broad economic reopening in the U.S. will stay on track.

Over the past quarter we saw a combination of large-scale monetary and fiscal easing stabilize financial markets. The optimism of relaxing lockdown measures continued to spur the stock market recovery through April, May and June. The question on most investors’ minds is whether this new bull market will continue.

The next few months could be a precarious time as we see renewed virus outbreaks. Depending on how governments choose to steer through the next wave there is a high chance that stock markets will be volatile over summer and we may see again a short-term correction. However, we remain positive on equities versus bonds on a 12-month period.

Global equities have rallied strongly from their March 23rd lows. However, the fixed income environment in the past quarter paints a different picture. Bond yields have barely recovered from March. The US 10-year Treasury note is currently yielding 0.58%, down from 1.92% at the beginning of January and the 30-year bond yield offers only 1.24%. On the commodity side, we have seen oil and industrial metal prices mirror the bond yield picture whereas gold rallied with equities. The divergence in the markets have left investors perplexed.

Despite the second quarter rally, the world equity market is still down since the start of the year. More importantly is to realize that the market rebound has been driven mostly by large technology stocks. A number of large banks, industrial and energy stocks are still down 35% or more from their February levels.

We navigate the choppy waters by considering the main trends at play. In general, bond and industrial commodity markets tend to reflect the outlook of the real economy whereas stocks reflect the outlook for corporate earnings.

A Second Wave is Gaining Momentum

Countries all around the globe are on the path of relaxing lockdown measures. Governments are gradually permitting larger group gatherings and the opening of restaurants, bars and non-essential shops. This opening of the economy takes place against the backdrop of limited success in virus containment.

Although some countries have accomplished lower case and death rates, others still face increasing infection rates. These countries, however, continue down the path of relaxing measures, fearing the prospect of being left behind in the economic recovery.

Predicting the effect of a second wave on markets is difficult plagued by unknown factors. The public appetite for lockdown measures is clearly fading with a growing number of people choosing to flout or protest remaining lockdown measures in place. It is also unlikely that governments will impose the same lockdown measures as seen in the first wave, choosing instead to prioritize the economy by following the “Swedish model” which markets will favor.

Also, developments in technology have given governments the ability to create tracing systems which are better equipped to contain small breakout clusters. Furthermore, treatment options have improved since the onset of the first wave with medical professionals learning more about the virus.
Concerning equity markets, if a more deadly second wave occurs, we would expect to see some severe short-term weakness in the equity market as many sectors would reel from a second punch.

Geopolitical Risk

Another risk factor is the increasing animosity between China and the rest of the world. The implementation of a new National Security Law in Hong Kong triggered a reaction from countries like the U.S. and the U.K., while clashes at the China-India border created tensions with India, which prompted India to basically block many popular Chinese Apps.

Hong Kong is at risk of losing several legal and trade agreements with western countries. However, we feel Hong Kong as a financial center is not at risk in the short-term, as its capital market is too important to both China and the western world. Hong Kong also has more than enough monetary reserves to maintain the HKD-peg to the US dollar.

The positive news is that the increased tensions have spurred China to provide large economic stimulus packages to its domestic economy and start new infrastructure spending programs. This will be positive for Asian economies and indirectly for the world.

Equity Markets

Although equity markets will face an uncertain period, there are plenty of positive drivers which will likely keep the bull market pushing on higher. As economic data continues to improve equity markets should pull higher.
Although we may see a slowdown in growth during the second peak it is likely governments will not halt economic activity altogether in the same way. Typically recoveries from external market shocks tend to be more rapid than those created by internal problems. The pandemic would qualify as an exogenous (external) shock and, therefore, equity markets should see a more rapid recovery than for example after the 2008 global financial crisis.

The amount of government spending to protect people’s incomes is extraordinary. Although the CARES Act will expire by the end of July, and the 18 million Americans who are unemployed could lose the $600USD/week in extra unemployment benefits.

Both Congress and the White House agree that more fiscal support is needed, but they differ on how the next package will be structured. The Trump administration, worried about unemployment benefits being too generous, favors a “back to work” bonus. The House democrats want to simply extend the extra $600USD/week to January 2021, send another round of $1,200 cheques to each family and increase infrastructure spending.

Will ideological differences between the Republicans and Democrats lead to a blockage of the second stimulus bill? Not likely, as both parties understand that the stakes are too high. Especially now with the flare up of the virus in the southern states. Therefore, we can expect to see additional economic stimulus on top of the huge amount of fiscal spending we have already seen. This explains why the economy remains in reasonable shape despite the pandemic.

The same is happening in Europe, where it is likely that Angela Merkel will manage to get a new EU backed economic stimulus fund of 750 billion Euro approved in the short-term. Which comes on top of an earlier package of 540 billion Euro plus all the individual government spending programs.
The upcoming US elections have the potential to cause a stir in markets. If Biden ousts Trump and the democrats take control of the Senate, corporations will shudder at the prospect of Trump’s corporate tax cuts being rolled back. However, given that the current forecast is now expecting a democratic win, this risk is likely already priced into the market.

Furthermore, a Biden win would likely lead to improved relations with China which would be welcomed by global markets. Anyway, four months is still a long time in Presidential politics, and anything can still happen.

Source: Predictit via BCA Research

Bond Markets

Bond yields will remain depressed until inflation picks up, which we do not expect to happen any time soon. The unemployment rates have jumped so rapidly it will take likely 1-2 years to return to the levels before the pandemic and even then, it will still be another year or more before a tight labour market would lead to higher inflation.

Central banks would likely let inflation levels run up before stepping in to increase rates. Furthermore, highly indebted governments will prefer a higher inflation environment so that the real value of debt is eroded.
Bond yields could see some recovery alongside global economic growth. We will likely begin to see long term yields rising more than short-term rates. However, yields will remain low in absolute terms.

The Fed has been actively buying fixed income Exchange Traded Funds (ETFs) in the past two months to provide liquidity to the (high yield) credit market. This means the credit market does not offer particularly attractive opportunities at the moment. Given our outlook for the world we would prefer to add credit risk in emerging market debt or, for clients who can accept low liquidity, opportunities in private credit.

Investment Strategy

During the past quarter we made slight changes to our investment allocations. After the initial rebound we de-risked the portfolio slightly which we intend to hold until we see opportunities in the market which would warrant an increased appetite for risk. Specifically, we are looking forward to the presidential election in November.

There are several themes we are incorporating into our models. First, we feel that higher quality companies with stronger balance sheets and sound financial statements are better suited for a prolonged slow down should that prove to be the case. Second, we view health care innovation and biotechnology as a potential expanding segment as the pandemic crisis should lead to even more investment in healthcare and especially in health technology. And third, we believe big tech, which provided a significant boost to the market rebound, can continue to lead as the reliance on technology becomes evermore critical for business operations in a shutdown COVID environment.

With those ideas in mind, our model allocations were adjusted to reduce or eliminate small cap equity exposure, introduce large cap healthcare and technology positions and slightly underweight developed foreign large value equity. Our fixed income weightings remain unchanged overall for all allocation models and our sentiment for quality mirrors that of equities.

DISCLAIMER: The views expressed in this economic update are those of the author and do not necessarily reflect those of BFT. This update contains “forward-looking statements” that relate to future events, including future economic performance and plans. These forward-looking statements can be identified by the use of such words as “believe,” “think,” “intend,” “may,” “will,” “should,” ”expect,” ”anticipate,” “estimate,” or “could,” or variations of these terms or the use of other comparable terms. There are certain risks and uncertainties that could cause actual results to differ from those predicted in the forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this update.

Mutual Funds and Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.

Emerging Markets Disclosure: Investments in emerging markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.

April 13, 2020 By BFT Financial

Quarterly Review Q1 2020

In the first quarter of 2020 the Dow Jones Industrial Index2 declined 23%, which makes it the worst quarter in its 135-year history1. However, the Dow declined 38.4% from February 19th till March 23rd before a rebound in the last week of March. Markets have never dropped this far this fast before.

A month ago, there was still hope that the Coronavirus outbreak could be brought under control before it would paralyze the global economy. Since then, the number of new, recorded COVID-19 cases has mounted every day and outright fear prevails.

At the moment, a painful global recession is underway. Consumers are not spending; firms are facing a cash crunch and potential bankruptcy. And globally employment will be slashed. The next few quarters could result in some of the worst Gross Domestic Product (GDP) growth numbers since the Great Depression.

Risk assets have very quickly discounted this dire scenario. The global stock-to-bond ratio has collapsed by 47% since its peak in January. 10-year US bond yields temporarily fell below 0.4%¹.

The dollar has rallied against every currency and even gold traded below $1500 an ounce. Brent crude trades below $30/bbl¹.

In this context, investors must assess if risk asset prices have declined enough to compensate for the economic hazards created by the COVID-19 pandemic. If the massive amount of monetary and fiscal stimulus announced can turn around the economy in the second half of the year, then stocks and risk assets are attractive. Otherwise, they are still not cheap enough.

It is important to remember, this is a medical crisis and the situation is not comparable to the Global Financial Crisis (GFC) of 2008 or even the 1930s depression. While the shock is of unknown depth and duration, what we do know is that the containment measures and social distancing almost automatically bring economic activity to a halt. The impact on economic activity will likely be sharp and deep. We see the shock as akin to a large-scale natural disaster that severely disrupts activity for one or two quarters, but eventually results in a sharp economic recovery.

The OECD released its estimate of the economic impact of COVID-19 lockdown policies around the world. The sobering conclusion of the OECD’s work is that the initial direct impact of the shutdowns could be a decline in the level of output between one-fifth to one-quarter in many economies. Put differently, the OECD’s estimates imply a decline in annual GDP growth of up to 2 percentage points for each month that strict containment measures continue. If the shutdown continued for three months, with no offsetting factors, the OECD’s research suggests that annual GDP growth in OECD economies could be between 4-6 percentage points lower than it otherwise might have been.

Fortunately, monetary and fiscal authorities are responding forcefully to the crisis, but the length of the lockdowns remains a major source of downside risk to the economy. We see encouraging signs from major central banks and governments that monetary and fiscal response is starting to take shape. The pledged policy response has been swift, and we expect total fiscal stimulus to be similar in size to that of the global financial crisis but compressed into a shorter timeframe. At this moment, global governments have pledged an amount of economic stimulus equal to 5% of global GDP. In the US, the Coronavirus Aid, Relief, and Economic Security (CARES) Act provides for fiscal spending on the order of 10% of GDP, the majority of which is likely to be spent this year.

Macroeconomic Outlook

The global economy is now in recession and this has occurred because policymakers saw it as the lesser of two evils. They judged, with good reason, that a temporary shutdown of most non-essential economic activities was a price worth paying to contain the virus.

Outside of China, the level of real GDP is likely to be down 1%-to-3% in Q1 of 2020 relative to Q4 of 2019, and down another 5%-to-10% in Q2 relative to Q1. On an annualized basis, this implies that GDP growth could register a negative print of 40% in some countries in the second quarter, a stunning number that has few parallels in history. Growth in China should stage a modest rebound in the second quarter, reflecting the success the country has had in containing the virus.

Nevertheless, the level of Chinese economic activity will remain well below its pre-crisis trend, with exports increasingly weighed down by the collapse in overseas spending.

A One-Two Punch

The “sudden stop” nature of the downturn stems from the fact that the global economy was simultaneously hit by both a massive demand and supply shock. When households are confined to their homes, they cannot spend as much as they normally would. This is particularly the case in an environment of heightened risk aversion, which usually leads to increased precautionary savings. At times like these, businesses also slash spending in a desperate effort to preserve cash.

All this reduces aggregate demand.

On the supply side, production has been impaired because of workers’ inability to get to their jobs. According to the Bureau of Labor Statistics, less than 30% of US employees can work from home. Since modern economies rely on an intricate division of labor, disturbances in one part of the economy quickly ripple through to other parts. The global supply chain ceases to function normally.

The fact that both shocks have been concentrated in the service sector, which represents at least two-thirds of GDP in most economies, has made the situation even worse. During most recessions, the service sector is the ballast that helps stabilize the economy in the face of sharp declines in the more cyclical sectors such as manufacturing and housing. This time is different.

The Night Is Always Darkest Just Before Dawn

“The night is darkest just before dawn. But keep your eyes open; if you avert your eyes from the dark, you’ll be blind to the rays of a new day…So keep your eyes open, no matter how dark the night ahead may be.” – Hideaki Sorachi

Right now, we are fighting an invisible enemy that is ravaging the world. However, victory might be in sight. The number of new infections has peaked in China and South Korea. We should watch Italy closely. If the number of new infections peaks there, that would send an encouraging signal to financial markets that other western democracies will be able to get the virus under control. While it is too early to be certain, this may be happening: Both the number of new cases and deaths in Italy have stabilized over the past week. Of course, there is still the risk that the number of new infections will rise again if containment measures are relaxed prematurely. Nevertheless, it is likely that global growth will begin to rebound in the third quarter of this year.

President Trump signed into law the Coronavirus Aid, Relief, and Economic Security (CARES) Act. The bill provides fiscal stimulus of $2.2 trillion (or 10% of GDP), with at least 46% of the spending taking the form of direct funds for households and small businesses including $290 billion in direct cash handouts to middle-class households.

For investors, the passage of the law shifts the question about stimulus from “how big?” to “how effective?”. It is difficult to answer that question with high confidence because it depends in large part on the duration of the physical distancing measures in place. But at least two factors argue in favor of its effectiveness: the total size of the plan is large relative to other countries and relative to the fiscal stimulus that occurred in 2008/2009, and the plan will disproportionately benefit lower-income Americans who will likely need assistance the most. And U.S. politicians have already hinted that a second stimulus package might be a possibility if necessary.

The Fed has also dusted off the whole alphabet of programs created during the financial crisis to improve proper market functioning, and has even added a few more to the list, including a program to support investment-grade corporate bonds and another to support small businesses.

The good news is that there is no limit to how many dollars the Federal Reserve can create. The Fed has already expanded the supply of bank reserves by initiating the purchase of $500 billion in treasuries and another $200 billion in agency mortgage-backed securities (MBS) since relaunching its QE program on March 15th. Further MBS purchases will be especially useful given that mortgage rates have not come down as quickly as Treasury yields.

The Shape of The Recovery: L, U, or V?

Provided that the number of new infections around the world stabilizes during the next two months, growth should begin to recover in the third quarter.

What will the recovery look like? From the perspective of sequential quarterly growth rates, a V-shaped recovery is inevitable simply because a string of quarters of negative 20%-to-40% growth
would quickly leave the world with no GDP at all. However, thinking in terms of growth rates is not the best approach. It is better to think of the level of real GDP.

The following chart shows three scenarios:

A rapid V-shaped recovery where output quickly moves back to its pre-crisis trend.
A sluggish U-shaped recovery where output slowly rebounds starting in the second half of the year.
An L-shaped profile for real GDP where the level of output falls and then remains permanently depressed relative to its long-term trend.

In the end it will depend on how long it takes before the world will be able to go back to work. But when it does, the amount of fiscal stimulus will likely help the global economy to rebound in a way that is in between a V and U shape. In other words, we are more positive on the economic rebound then the majority of the current media reports.

Government Bonds: Deflation Today, Inflation Tomorrow?

As noted at the outset of this report, the current economic downturn involves both an adverse supply and demand shock. Outside of a few categories of consumer staples and medical products, we expect demand to fall more than supply, resulting in downward pressure on prices. This deflationary shock will be enlarged by rising unemployment in the short-term.

Looking beyond the next 12-to-18 months, the outlook for inflation is less clear. On the one hand, it is possible that the psychological trauma from the pandemic will produce a permanent, or at least semi-permanent, increase in precautionary savings. If budget deficits are reined in too quickly, many countries could find themselves facing a shortage of aggregate demand. This would be
deflationary.

On the other hand, one can easily envision a scenario where monetary policy remains highly accommodative and many of the fiscal measures put in place to support households are maintained long after the virus is eradicated. In such an environment, unemployment could fall back to its lows, eventually leading to an overheated economy, which would lead to higher than expected inflation.

We think that the more inflationary scenario over the next 2-to-3 years is more likely. Interestingly, that is not the market’s opinion. For example, the 5-year US TIPS breakeven inflation rate is currently only 0.69% and the 10-year rate is 1.07%. This means that a buy-and-hold investor will make money owning TIPS versus fixed coupon Treasuries if inflation averages more than 0.69% per year for the next five years, or 1.07% per year for the next decade. That is a bet we would be willing to take.

Equity Markets

In order for equity markets to find a bottom and start a more sustainable recovery, markets need to have more visibility on the potential economic outcome. Right now, the market does not see the light at the end of the tunnel but that could change quickly if we see the growth rate of the number of new infections starts to decline, especially in the U.S.

If and when that happens investors can start to estimate the length of the showdown and equity markets will quickly start to discount any recovery.

As mentioned before, we think the outlook is not as dire as the market now thinks. The extraordinary amount of fiscal and monetary stimulus will limit a lot of the current damage. And the market is discounting a lot of damage at this moment. We don’t know if of the market already has reached its bottom or that there will be further downside in the coming months, but we do think that
equity markets will start to offer value and are likely to be higher on a 12-month basis. Some of the sectors that had the largest selloffs like energy and financials could become outperformers in such a rebound.

Investment Strategy

The recent market volatility has been extreme, and it was made worse by the fact that liquidity in the market was severely disrupted, which led for example to a large selloff in investment grade fixed income ETFs and funds3. Only when the Fed stepped in and announced effectively unlimited liquidity operations, markets started to normalize.

As long-term investors, event driven market corrections generally do not move us to make changes in our asset allocations. Given the large movements in the stock versus bond ratio resulting from the market sell-off, a rebalancing of portfolios back to their strategic allocation will likely be appropriate once the market volatility calms down.

¹Performance data by Bloomberg.

²The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 actively traded “blue chip” stocks, primarily industrials, but includes financials and other service-oriented companies. The components, which change from time to time, represent between 15% and 20% of the market value of NYSE stocks.

³ Mutual Funds and Exchange Traded Funds (ETF’s) are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from the Fund Company or your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.

Disclosures

Securities and investment advisory services offered through BFT Financial Group LLC, a registered investment advisor. Member FINRA, SIPC, MSRB.

This material represents an assessment of the market and economic environment at a specific point in time an is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.

This document may contain forward-looking statements based on BFT Financial Group’s expectations and projections about the methods by which it expects to invest. Those statements are sometimes indicated by words as “expects”, “believes”, “will” and similar expressions. In addition, any statements that refer to expectations, projections or characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Such statements are not a guarantee of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore actual returns could differ materially and adversely from those expressed or implied in any forward-looking statements as a result of various factors.

Neither Asset Allocation nor Diversification guarantee a profit or protect against a loss in a declining market. They are methods used to help manage investment risk.

Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.

Investments in emerging markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.

The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value.

The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets.

You cannot invest directly into an index.