On the Radar

City National Rochdale, | Jun. 11, 2020

FAQs on the Markets and Economy

How could estimates for May’s labor report be so wrong?

The Bloomberg consensus estimate for the May unemployment rate was to increase 4.3 percentage points, from 14.7% to 19.0%. Instead, the unemployment rate fell to 13.3%. The nonfarm payroll number was forecasted to fall 7.5 million; instead, it increased by 2.5 million. In both cases, they were massive misses.

Most of Wall Street firms that forecast the unemployment rate use the weekly claims for unemployment insurance as their guiding light. In normal times, that works well. But we are not in normal times.

In the past 11 weeks, there have been 42.6 million initial claims for unemployment insurance. Keep in mind that the labor force was around 160 million before the coronavirus pandemic. Does it make sense that one-fourth of the labor force needed to file? Probably not.

Many people filed more than once since they never heard back on their first request; many states have systems that are antiquated and overloaded. Furthermore, states have reported substantial fraud, including widespread identity theft. Scammers are taking money after filing several times on behalf of strangers. The CARES Act made it easier to collect unemployment insurance by removing some filing requirements. This made it easier to scam the system.

The good news is that the worst of the labor market appears to be behind us, which is excellent news. The bad news is that the unemployment rate is still at one of the highest levels in history.

The recovery in U.S. stock prices from March lows has been impressive, but the durability of the current rally will likely depend on the path to recovery from the COVID-triggered economic shutdown.

The good news is that many of the timelier indicators we monitor are signaling the worst of the damage is behind us, including a range of business and consumer surveys, jobs data and other high-frequency measures.

Still, the overall message is that the wider economic recovery is likely to be slow going. While activity in some sectors appears to be picking up fairly rapidly as lockdowns are lifted, more COVID-impacted industries such as restaurants, lodging, airlines/travel and entertainment remain deeply depressed.

Overall, we expect sizeable gains in GDP over the next two quarters, but a return to full normalization and prior GDP levels will take some time as social distance measures linger and consumer confidence gradually rebuilds.

There will also be more long-lasting implications (i.e., bankruptcies, permanent job losses and reduced business investment) from the virus outbreak and economic shutdown, which will limit the economy’s return to potential.

Investors have justifiably looked past the near-term economic damage and focused on recovery. However, the danger is that the stock prices now are not accurately reflecting these second-order and longer-term impacts, which could leave the market primed for some disappointment in the months ahead should fundamentals and corporate earnings not catch up to expectations as fast as anticipated.

Against this conflicting backdrop, we are maintaining our preference for quality companies, but are increasingly comfortable taking a bit more equity exposure opportunistically where we still see pockets of value.

The Fed is one of many central banks giving thought of implementing a policy called Yield Curve Control (YCC). With this strategy, the Fed will announce a target interest rate for various maturities along the yield curve. The Fed will buy enough securities in the open market to peg the interest rate at that level. In doing so, it will bring down the cost of borrowing for consumers, businesses and the government.

Back during World War II, the Fed had a program very close to this when they capped the yield of Treasury bills and 30-year bonds.

Other central banks have already begun such strategies. The Bank of Japan began implementing YCC in 2016. Back in March, the Reserve Bank of Australia began targeting the yield of the three-year bond at 0.25%.

For two decades, Europe’s aggregate economic growth has been slower than that of the U.S. (see chart). Making economic decisions has been difficult with the various governments, European Central Bank (ECB) and other central banks.

With the global economic slowdown brought on by the coronavirus, there has been growing concern that the ongoing economic contraction in Europe will be more severe than the one in the U.S. The eurozone’s 2020 GDP is expected to fall 8.7%, while the U.S.’s is expected to decline 5.6%.

That said, the European Central Bank has stepped up in a big way to ease the pressure of the eurozone’s embattled governments. (The eurozone makes up 19 of the European Union’s 27 countries.) The ECB is setting up a bond purchase program in the amount of $1.5 trillion. This money will be used to buy the estimated $1 trillion in additional government debt that countries will issue to help fight the economic downturn from the pandemic.

The ECB will be buying both government and corporate debt. The overall goals of the program are to ease the strains in the European financial markets, support bank lending and economic growth and push inflation toward their target of just under 2.0%.

As we look back at the first quarter of 2020, we see a true black swan negative shock to the economic system. The economic pain was different than prior economic downturns in that it came out of nowhere and inflicted quick and painful damage, especially in the month of March. It was also unique in that it had outsized effects on industries that have often been safe havens in past downturns. In past recessions, dividend stocks had defensive characteristics, but that was not true in the first quarter. Suddenly, the prediction became that stocks in the S&P 500 could cut their dividends by as much as 25% and dividend stocks were not havens.

As the dust continues to settle, the CNR dividend research team is focused on owning stocks that can maintain their dividends through the downturn. This would include being in steady cash flow businesses that have much of their revenue tied to “essential services.” In addition, strong balance sheets with reasonable payout levels are important. While maintaining the dividend in our holdings has always been one of our mantras, in this environment it is of highest importance. We needed to shift some of our holdings, much of this turnover having happened in the first quarter. In the end, we feel having a solid portfolio yield that is as steady as possible will be the factor that can generate positive returns over time.

With interest rates so low (both short and long) and likely to remain that way for a prolonged amount of time, we do feel investors will be attracted to solid dividend names – provided the dividend remains. So what does the opportunity look like? In the graph, we see spreads to Treasuries of three main equity income assets: consumer staples, utilities and REITs. As shown, all three sectors are trading at the highest spread to Treasury level in the past 10 years. The income opportunity is there. The key is researching names that can maintain that advantage and to focus on those names. Finally, we look to pick up opportunities as they may present themselves. Later in the recovery, we would look to increase dividend growth opportunities.

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Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

There are inherent risks with equity investing. These include, but are not limited to, stock market, manager, or investment style risks. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices.

Investing in international markets carries risks such as currency fluctuation, regulatory risks, and economic and political instability.

Emerging markets involve heightened risks related to the same factors as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks, and less developed legal and accounting systems, than developed markets.

There are inherent risks with fixed income investing. These may include, but are not limited to, interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond risks. When interest rates rise, bond prices fall. This risk is heightened with investments in longer-duration fixed income securities and during periods when prevailing interest rates are low or negative.

Investments in below-investment-grade debt securities, which are usually called “high-yield” or “junk” bonds, are typically in weaker financial health, and such securities can be harder to value and sell and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.

The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the federal Alternative Minimum Tax (AMT), and taxable gains are also possible.

Investments in the municipal securities of a particular state or territory may be subject to the risk that changes in the economic conditions of that state or territory will negatively impact performance. These events may include severe financial difficulties and continued budget deficits, economic or political policy changes, tax base erosion, state constitutional limits on tax increases, and changes in the credit ratings.

Investments in emerging markets bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more developed foreign markets.

Returns include the reinvestment of interest and dividends.

Investing involves risk, including the loss of principal.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.

Past performance is no guarantee of future performance.

Index Definitions

The Standard & Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.

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