Q1 2020
April 1, 2020
I’ve emailed you over the past few weeks to provide our thinking on the markets and this situation we now find ourselves. Let me give you an update on what we’ve been through and our thoughts on how we will proceed.
Fixed Income
The fixed income portfolios we manage for many of our clients are constructed around scheduled cash needs. We buy bonds so the interest income and cash received at maturity, fund scheduled withdrawals. We build fixed income portfolios this way so bonds do not have to be sold to meet scheduled withdrawals; we can hold the bonds owned to maturity.
For clients with no scheduled cash needs, we have built bond portfolios with short average maturities. We did want to lock in low interest rates buying longer term bonds.
For all our fixed income portfolios, we use only investment grade bonds. We do not attempt to seek higher yields buying the bonds of lower quality issuers.
In March, when the COVID-19 news turned grim, risks to the whole fixed income market rose. I’ll discuss this in more detail below.
Our assessment was that the most significant risk faced in the individual bond portfolios we manage was a prolonged shut-down of the markets. An unlikely occurrence, but this is an unusual circumstance.
We initiated a review of all bond portfolios taking scheduled withdrawals. We made sure each had at least 3-months of cash available to fund those withdrawals. Aside from that, we concluded the fixed income portfolios we are managing are in good shape.
Stocks. The collapse of the stock market in mid-March was sharp and severe. Everyone was caught off-guard by the rapid spread of COVID-19 and something of a panic ensued. You’ve all been watching the news, so there’s not a lot more I need to add.
A recovery in stock prices started when it became clear that the Federal Government was going to pump cash into the economy. As important, they put in place financial backstops for companies facing the worst from the crisis. The initial bounce in stock prices reflected relief that a wide-spread financial crisis was not at–hand.
During the market’s fall, we did sell some stocks and raised cash. We sold the stocks of companies whose businesses we believe will continue to be adversely affected after the crisis ends. We have not chased this rebound in stocks, so we have cash available to buy stocks. I’ll talk more about that in a moment.
General Commentary
I wrote you a couple weeks ago that: the price of a stock reflects the discounted value of the earnings it’s expected to generate over the years. The loss of a quarter or two in earnings will hurt the stock’s price, but so long as its long-term earning power is intact, the stock will recover.
This is my first pandemic and I am not a doctor, so I cannot draw from experience to assess how this plays out. I do know that the pathology of the virus will continue to be critical to how the markets behave. Should we go back to “normal” too soon and cases again spike, the market will start assessing this as an ongoing crisis and the economic impact prolonged. That would not be a good scenario.
We’ve been watching how the hospitalization numbers have been trending in places like New York. If social distancing is to prove effective, we’ll see it in New York’s numbers first. Currently the numbers show that although the number of people hospitalized grows, the rate of increase is slowing. A good sign but there’s just not enough data to draw any conclusions.
How does the virus impact the economy over the intermediate term? That’s the important question to consider now. In my opinion, the impact of this social distancing, stay-at-home, and self-quarantine mentality will persist well beyond the day the government proclaims: “all’s clear”.
I believe that unless a proven vaccine is introduced, consumers will be slow in returning to crowded venues. For that reason, we have exited the stocks of companies whose earnings are derived from consumers gathering at their places of business. That doesn’t mean we believe all consumers will stop frequenting restaurants, bars, and such, it’s just that on the margin people will remain cautious. We believe it’s better to wait and see how that plays out.
In a similar vein, we are assessing which companies and industries may see business trends improve after the crisis has passed. There will be some and that’s where we want to deploy the cash raised from the stock sales made to date.
The temptation in all this is to try and call bottoms in the market. Maybe it’s already too late. Our assessment is that it’s better to proceed cautiously until we have a better sense of the duration of this crisis.
Next, I’d like to go over in more detail the disruption to the fixed income market in March. During the worst days of the stock market’s decline, investors were truly starting to panic. Selling pressure from retail investors hit both stocks and bonds. Most retail investors own stocks and bonds through “pooled” investments like mutual funds and exchange traded funds.
When a mutual fund is sold, the manager of the fund must go into the market and sell investments to raise cash for the redemption. In the fixed income market, for a couple days, the prices of bond mutual funds were collapsing as managers were forced to keep selling to cover a spike in redemptions.
To stem the collapse, the Federal Reserve announced that they would start buying bonds across the spectrum of the bond market. That policy response provided a deep pocketed buyer and was enough to stabilize the fixed income markets.
This highlights why we only use individual bonds in building fixed income portfolios. Although the prices of the all bonds are impacted by a panic sell-off, we can hold the bonds to maturity and avoid the effect of turbulent markets.
Next, I want to talk about the stimulus package. As you know, the Federal Government has passed legislation which looks to inject around $2 Trillion into the economy. The injection is coming in several forms: some people are getting checks; other allocations are set to shore up businesses impacted by the crisis. The idea is to partially offset the decline in private sector spending with government spending on those they feel need the money.
As I noted above, passing this stimulus package coupled with the Federal Reserve’s efforts, stopped the panic in the markets.
I only wish our policymakers would conceive better tools for addressing crises. Instead, they have grown comfortable expressing the magnitude of their concern, by the amount thrown at the problem. President Bush’s 2008 response to the Great Recession was a stimulus package of around $156 Billion; President Obama’s 2009 economic package was around $780 Billion; now we are moving up to $2 Trillion.
How do the amounts spent weigh against the cost of the debt raised to fund them?
On the one hand, I believe money for the airlines, for Boeing, and other large companies will be repaid. The availability of the governments backing simply calms markets and acts as a bridge over a tough period. This seems a wise policy so long as the money is repaid.
My concern is how the country’s small businesses are treated. Making credit available to them does not address their problem. We can extend a loan to a restaurant owner, but it’s still debt and will need to be repaid. The sales lost by a restaurant or barber shop are not recouped once this is over. In simplistic terms, the policy response has small businesses incurring more debt in a period of reduced revenue. That’s just increasing financial risk.
Therein lies the greatest risk to our economy. If the crisis goes on for too long, a lot of small businesses are going to be financially damaged. I don’t think current policy response(s) addresses this.
We do not need to expand relief programs to cover more people (and businesses). Instead, I believe there are alternate approaches to these crises that need to be considered.
Some new ideas are being discussed now that the stimulus has passed. One proposal is forbearance on loan accruals; payments would not be required while the nation is on lock-down. It’s an interesting proposition. To be effective, it would have to be broadly applied to all debt and other accruing payments and it would have to be a waiver of the cost of money during the crisis.
If we limit cash needs during a crisis to items consumed, it will go a long way towards reducing everyone’s short-term cash flow needs. Long-term damage to the economy could be minimized, especially if we exit the crisis with less debt on everyone’s balance sheet.
I’m not proposing this is the answer, I just believe these cash stimulus programs have become too easy a policy response from Washington. We need to start thinking of alternatives as ever increasing debt is not a solution and periodic crises seem a fact of life.
Nicollet is Moving
Nicollet is moving its offices in the May/June time period. We were planning on moving on the first of May, but that might be pushed back.
I decided to start looking for new office space over a year ago. Although we have enjoyed being in Butler Square, we have had too many issues with parking. I need you to feel parking will be available when you come to meet with us.
Our new office is in the TractorWorks building.
The address is:
800 North Washington Avenue
Minneapolis, MN 55401
Suite #150
The advantage to this building is it has a dedicated parking ramp connected to the building. Parking will no longer be an issue.
We will send out another announcement once our move-in date is known.
And finally, during this crisis, Nicollet has stayed open for business. Our employees have the option to work from home if they want or need to.
My Very Best,
Mark Hoonsbeen, CFA
Principal