Synopsis: “A Brighter Future”, Episode 21
In this episode I discuss with RICHARD CALHOUN, CEO of Laidlaw Wealth Management LLC, the strong start to 2Q 2020 earnings season, the chances for further COVID relief support by Congress and the Fed and other developments.
The topics discussed in this episode are: While 2Q 2020 results looking good, what are bonds telling investors?, What is the “Fed Put” and should it exist?, Time to look at bank stocks?, Was it QE that brought about depressed capacity utilization?, and chances for a “Blue Wave” in November, does the market yet care?
Please tune in for more timely insights.
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David, I hope you had a great weekend and you were able to stay properly hydrated as the “Heat Dome” descended upon us.
Rick, I managed to defeat the heat this last weekend by going offshore to Martha’s Vineyard where the temperatures were a good 20 degrees Fahrenheit less than the mainland. With my toes in the sand and a drink my hand I was on top of the world, thank you for asking. With limited internet connectivity, it was a good chance to sit back to consider the issues we are discussing now.
David, last week we saw stocks finish higher for the third consecutive week on coronavirus-vaccine optimism and positive economic data. U.S. retail sales jumped +7.5% in June, and industrial production increased the most since 1959, both surprising to the upside. Following a two-month rebound, retail sales are almost back to their pre-virus levels, largely helped by the direct support and fiscal transfers from the government to consumers. As the expanded unemployment benefits are due to expire at the end of the month, expectations are that Congress will manage to reach a deal on a new aid package, which is much needed to support the economic recovery. Oh and we started Earning Season – WOW there was a lot going last week!! So, let me make this a two part question: 1) What were your thoughts after the first week of earnings, and 2) There is no rest for the weary, as this week we have 337 companies scheduled to report, 20% of them representing the S&P 500. As well as important economic data being released including existing home sales on Wednesday, leading economic indicators on Thursday, and July’s preliminary Purchasing Managers’ Index on Friday?
Another WOW week!!
Rick, Last week did kick off 2Q 2020 earnings season and so far 9% of the companies in the S&P 500 index have turned in results that surprisingly have been quite good with 78% of companies reporting better-than-expected revenues by an average of +3.5% more than forecast and 73% reporting better-than-expected EPS by an average of +6.3% more than forecast.
In terms of profit margins, the sector that continues to have the highest is IT forecast at 19.2% for 2Q 2020 (five-year average 20.2%). The next closest sector is Utilities at 12.5% (five-year average 11.9%). While investors may take issue with the Tech sector’s valuation, it is clearly one where there are relatively resilient fundamentals offering support as for all other sectors the outlook with the Covid-19 Coronavirus (“COVID”) still uncontained is contingent on robust fiscal and monetary stimulus continuing. Tech earnings will start coming out this week with IBM (Mon 7/20), Snap (Tues 7/21), Texas Instruments (Tues 7/21), Microsoft (Wed 7/22), Tesla (Wed 7/22), Intel (Thurs 7/23) and Twitter (Thurs 7/23).
Away from the stock market, last week was encouraging as it saw high-yield (“HY”) bond spreads tighten relative to Treasuries from +615 basis points (“bp”) over the curve to +576bp at the end of the week. Note that when HY spreads stopped tightening back in early June 2020 that coincided with the end of the “reopening” equity trade with the S&P 500 index topping out at 3232.39 on 6/8/20. With the S&P 500 Friday 7/17/20 close of 3224.73, it appears HY spreads tightening off the back of decent economic reports and a good start to 2Q 2020 earnings season may position the market to move higher.
A note of caution, however, is that investors should know inflation-adjusted Treasury yields have been heading lower for the past 6 weeks. Ten-year real yields, considered a better read on growth since they strip out inflation, are down to -0.85%. The Treasury market is charting its path based on the resurgent coronavirus and expectations that the Federal Reserve will push even harder on the monetary gas pedal, allowing inflation to run above its 2% target in the process. That has real rates, as measured by the yield on 10-year Treasury Inflation-Protected Securities (“TIPS”), on course to possibly slide to as low -2% in the years ahead.
With the next FOMC meeting scheduled for Tuesday 7/28 and Wednesday 7/29, the Fed is going into a black-out period ahead of time so no Fed Governors are scheduled to speak. Meanwhile, look to the Thursday 7/23 auction of $10bn in 10-year TIPS as litmus test of how bullish investor sentiment is on inflation’s upward trajectory, something that may prompt action in the gold market.
Meanwhile, with Congress back in session this week, all eyes will be on whether the Senate will take steps to sustain the economy will the battle to contain COVID rages on in the U.S.. Clearly, with 40 states seeing increased infection levels, the economy’s reopening prospects are becoming more uncertain and there is growing anxiety about how children will be going back to school over the next two months. Time to act now if the GOP wants a shot at winning at the polls in November.
David, in keeping with what has become a bit of a “tradition” with “A Brighter Future” I want to ask you a question about the Fed. If you have been somewhat paying attention to the financial media, you have likely heard the term “Fed Put” used over and over again—not only in recent months but for the bulk of the last 10-year economic expansion that ended earlier this year. But just what does this term mean?
Also, could a “Fed Put” be a headwind for future growth and innovation if the Fed is providing a permanent crutch that does not allow an occasional mild recession?
Rick, it’s often been said that “price leads policy” inasmuch as the financial market’s price action drives the Fed’s monetary policy actions and Congress in its fiscal policy actions. Certainly, this was proven conclusively in March 2020 when both the Fed and Congress responded vigorously to the devastation created by COVID in the financial markets.
The notion, however, of a “Fed Put” has been around since the time when Alan Greenspan was Federal Reserve Chairman and in essence its contention is that the Fed will bail out financial markets by taking steps following a correction to limit the possibility of an economic recession. As a result, investors have become conditioned to “buy the dip” and one might say that over time position risk controls have become more lax and that as a result markets are not accurately reflecting the level of systemic risk because the Fed is seen as being ultimately accommodative and that as such risk is perhaps mispriced.
Let me just stop here for a moment to say that a real central banker like Paul Volcker would never for a second have tolerated such an idea as the “Fed Put” since the effective exercise of monetary policy in controlling financial markets depends on the Fed retaining the ability to take unexpected actions. Markets are not supposed to be able to game the Fed, something which is the case with the “Fed Put.”
That said, with COVID still running rampant across the world, there is clearly a need for the Fed to remain accommodative as to withdraw support now would have catastrophic effect and likely unleash a wave of bankruptcies that would take years to clear and a permanent increase in unemployment levels in its wake.
David, as mentioned at the beginning today, we saw earnings last week from some of the biggest banks in the country and as many of them have been so beaten down, we have gotten a lot of inquiries about whether now is the time to be investing in banks.
If you don’t mind, I’d like to do this as a multi-part question:
First, do you have any specific bank stock’s you like?
Second – of the three (3) primary types of banks in the U.S. (Commercial, Investment and
Universal banks) which do you believe will fare the best coming out of this crisis?
Third and finally, there a lot of metrics used to analyze a potential investment in any company, evaluating things like Price-to-book (P/B) value,
Return on equity (ROE) and Return on assets (ROA). But in looking at Bank stocks there is a unique analysis called the Efficiency ratio. Could you share with listeners why this is so important in evaluating a bank stock investment?
Rick, early in my career I was fortunate to be in the corporate financial management training program at American Express when Jamie Dimon was the assistant to then American Express President Sandy Weill.
Needless to say, I have followed Jamie Dimon’s progress since and so favor JPMorgan in considering bank stocks. That Dimon has taken the management approach of capitalizing JPMorgan with a “bullet-proof” balance sheet strikes me as being a necessary and commendable approach for the current state and expected future for the global economy. The “bullet-proof” balance sheet is necessary as the chances of the feared wave of corporate and consumer defaults grows greater the longer it takes to contain and eradicate COVID. This is not the time in the economic cycle to bet on a bank that has not taken the full amount of reserves needed to address the credit write-offs that will inevitably occur.
In looking across the three types of banks mentioned, I believe that universal banks will likely fare best to the extent that they have a clear understanding of the wants and needs of capital market, institutional, corporate and consumer clienteles and have developed the cost-effective means of delivering the products and services tailored to each clientele.
As you mention, the efficiency ratio is an important measure to consider when investing in bank stocks as it shows whether the bank is earning more than it is spending, the essence of profitable growth. Specifically, the efficiency ratio is calculated by dividing the bank’s noninterest expenses by their net income. Banks strive for lower efficiency ratios as a lower efficiency ratio indicates that the bank is earning more than it is spending. A general rule of thumb is that 50% is the maximum optimal efficiency ratio.
David, let’s talk about Macro-Economics for a moment. Robert Kaplan, President of the Federal Reserve Bank of Dallas and a voter on the FOMC said in an interview with Reuters last week, that he thinks there will be “disinflation for some period of time until we get rid of this excess capacity.”
That statement came after commenting on the decline in producer prices seen in June. His view stands in contrast to a parallel market narrative that talks about the prospect of inflation picking up appreciably on account of the policy largesse provided by fiscal and monetary authorities in the U.S. and around the world. I think we can see why Mr. Kaplan is thinking what he is thinking. Industrial capacity utilization in June was just 68.6%, which is 11.2 percentage points below its long-run (1972-2019) average and the objective truth of the matter is that capacity utilization has been running below its long-run average since the financial crisis.
Coincidentally, the year-over-year change in the PCE Price Index has been running below the Fed’s longer-run inflation goal most months since then as well. Which is noteworthy, because it speaks to the point that the Fed’s initial jaunt down the road of quantitative easing didn’t have the ominous effect on inflation rates that many feared it would when the Fed launched its QE program to help stem the deflationary effects of the financial crisis.
That plan, however, looks like small potatoes compared to what the Fed has undertaken in response to the COVID crisis. So did the QE efforts of the FED, well before the current crisis, have the intended effect or did they exacerbate the “Excess Capacity” problem we have today?
Rick, in considering the issue of capacity utilization it is important to pose it in a global context in which trade flows are factored in.
While it may appear that previous Fed monetary policy through the use of Quantitative Easing (“QE”) might have allowed inefficient producers to remain in operation longer than desired thus resulting in a gradual increase in underutilized capacity, it also important to consider on a sector-by-sector basis how the implementation of globally distributed supply chains has resulted in lower capacity utilization rates domestically and higher capacity utilization rates internationally as the companies managing these supply chains have sought to provide consumers with the highest quality product at the lowest competitive price. While the outcome of this process of globalization may be lower domestic capacity utilization, it does also result in lower price inflation and greater consumer choice.
Theoretically, the growth in international trade stemming from the implementation and expansion of globally distributed supply chains was to be a major driver in raising living standards around the world and in many cases performed appropriately. However, at the same time, we know that countries such as China have sought to exploit the trading system for its own gains in seeking access to other countries economies while barriers in access to its own markets.
As such, declining domestic capacity utilization cannot be laid solely at the Fed’s doorstep, one must consider the motivations of the various actors involved in international trade.
David, as we near the end of today’s episode, I’d like to go back to one of our Laidlaw Five topics – The Election and get your thoughts on why it seems the Market doesn’t care about the Election Yet?
While the election, and more specifically the current state of the presidential polls, is becoming a more popular topic many are wondering if the markets are ignoring the potential consequences of a Biden administration. Or, is it that the market doesn’t believe a “blue wave” where the Democrats take the House, Senate and the White House is a reality?
Rick, the incumbent in The White House appears to be increasingly divorced from the everyday reality that Americans are now living. COVID is far from contained, the economy is on a knife edge dependent on the next fiscal relief program, and families don’t know how safe it will be for their children to return to school in the next two months. As we can easily agree, these are real problems that voters need to have resolved now, not in November. That said, the tide is favoring a change from what we have now.
So, why aren’t financial markets taking more notice, you ask. Based on data from PredictIt.org they should be as the tide has certainly swung in favor of the Democrats in taking the Presidency (62% vs. 50% in mid-April), the Senate (62% vs. 43% in mid-April) and the House of Representatives (86% vs. 72% in mid-April). However, it is clear that due to COVID the 2020 election is going to be unlike any other in living memory as traditional means of campaigning have been for all intents and purposes eliminated. We believe that the Tech sector is going to play a far greater role in the election campaign shapes up in areas such as:
- -Virtual meetings and events
- -Virtual “get out the vote” rallies and live-streamed candidate meet-and-greets
- -Online seminars on how to vote by mail and contacting voters to apply
- -Virtual volunteer training sessions
- Urging people to vote through phone calls, texts, e-mails and physical mail
- -Social media outreach and digital/TV ads
- -Videoconferences for fundraising
To this end, it will be interesting to see what Snap and Twitter managements have to say on the above topic during their earnings conference calls this week.
Relative to the bigger question of why markets don’t appear overly concerned, the most plausible answer lies in plain sight, namely that there are enough questions of equal, if not greater, importance around issues such as whether fiscal and monetary relief efforts will continue to be concerned about the outcome of events in early November 2020, a date in time that by the pace of current events lies well into the future. The time will come to discount the expected election results, but we are not there yet.