Lengthened and Strengthened

The Monthly Five Author Avator

Katie Nixon, CFA, CPWA®, CIMA®

Chief Investment Officer, Northern Trust Wealth Management

July 31, 2020

Your Questions Answered

With continued COVID-19 flare-ups throughout the country and new economic data raising questions about the shape of the recovery, all eyes are on Washington to deliver a meaningful stimulus bill. In this Weekly Five, we answer the week’s most pressing client questions – including why we believe the fiscal bridge must be “lengthened and strengthened,” whether we think widespread dividend cuts are likely, and our outlook for one of the most-inquired on asset classes in recent weeks, gold.


Economic news seems to be deteriorating lately. How should I interpret the recent GDP report and rising jobless claims?

The second quarter GDP report in the U.S. reflected an anticipated and significant drop in economic activity as the country spent much of the quarter in various stages of lockdown. While interesting, this is certainly a backward looking report. The weekly jobless claims data, however, is more real-time and suggests that the improvements we had seen recently on the employment front may have plateaued as the U.S. experiences a resurgence of the virus across large states. The stalling of the jobs improvement puts the 3Q economic recovery story at risk, particularly as many households face a “fiscal cliff” at the end of July. Congress passed the $2.2T CARES Act in March as the country faced lock down, and the design of the relief package was intentional: Provide an “income” bridge for households and businesses to sustain them through the expected economic fallout. The base case was that, post lock down, the U.S. economy would recover – quickly at first, then stabilize at a slow but steady pace. The risk case was centered on fears of a second wave in the fourth quarter.

The unanticipated infection spikes within this first COVID-19 wave have called into question that base case and at the very least have postponed the durable recovery. The rise in jobless claims is a clear indication that unemployment remains a significant problem. We also see other “high frequency” data indicate a significant slowdown in economic activity. With the enhanced weekly unemployment benefit of $600 set to end today for 30 million Americans, and with an apparent stalemate in Washington, the financial pressure across many households in the U.S. will be tremendous. It is imperative that a substantial relief package is successfully negotiated and passed. In addition to the support to households, we hope the package will include support to state and local governments, which is critical to fill deep budget holes resulting from the significant fall off in state and local revenues. The fiscal bridge must be lengthened and strengthened.


With the economy remaining weak, are you worried that companies might cut their dividends?

As the U.S. economy effectively shut down with broad stay at home orders bringing activity to a virtual halt, we were concerned about dividend policies. As the crisis unfolded, we began to see companies (and individuals, for that matter) focusing on building resilience into their balance sheets. Many companies issued debt; others drew down on existing lines of credit. With uncertainty high, caution was warranted. A natural additional step would be to cut the dividend as earnings and cash flow became stressed. We know from history that dividend cuts do happen, although they are frequently considered to be a last resort for companies. During the Global Financial Crisis of 2008, dividends fell 76%, leading investors to worry about experiencing a repeat.

It is important to note there are key differences between these time periods. Our analysis of the Global Financial Crisis showed that, with financials representing 32% of dividends, the 76% drop suggests that they were more than the entire decline for the S&P. Other sectors saw cuts during that time, but some were actually increasing dividends. In March 2020, Wall Street analysts were extremely concerned about cuts and started to model a cut in dividends of 25-30%. At one point, the futures market for S&P dividends was pricing in a 37% drop in dividends! We were never that pessimistic, although we did consider the possibility for 10-15% aggregate cuts. The reality is that dividends have been cut; however, the magnitude has been far less. According to our analysis of all 500 S&P constituents, we found the current indicated dividends are 6.7% below mid-Feb. The current futures markets, which likely assume a few additional cuts, support the data. We believe the futures market is right, and we will end up with an aggregate 10% cut or less, unless the economic cycle turns out worse than current expectations.


Is Europe faring better in fighting the virus?

While the data on COVID-19 infections and hospitalizations support the premise that Europe was successful in flattening the curve, we have seen recent signs of flare-ups, most notably in Spain and now in the U.K. The economic cost of containment has been great, with Eurozone GDP falling 12.1% second quarter over first quarter – and deeper declines in Spain and France. European leaders appear to agree that the path forward will be slow and uneven, and that strategic support will be needed. Of note, the reaction on the fiscal front here in the U.S. has been very tactical, with established deadlines and expiration dates. The E.U. Recovery Fund represents a significant and tangible sign of unity, with 750B euro grants and loans provided to countries most adversely impacted by COVID-19 and funded with commonly issued debt. To use the bridge analogy, the fiscal bridge has been strengthened and the monetary policy bridge is also strong, which should not only provide support during the downturn but potentially provide stimulus during the recovery period. Of course, we will be watching closely the path of the virus and weighing the potential impact of some of the needed measures taken to crush the recent outbreaks.

Our base case calls for an economic recovery into 2021. From an earnings perspective, we expect that positive growth can resume in the latter half of 2021, but conditions over the near term will remain challenging. It is important for investors to understand some of the key differences between the commonly used Europe/Australasia/Far East (EAFE) benchmark and the S&P 500. As we have commented on in the past, the S&P is heavily dominated by large cap technology and communications companies. The top five holdings [Microsoft, Apple, Amazon, Facebook, and Alphabet (Google)] represent over 20% of the index, and technology and communications services represent nearly 38% of the overall index. In contrast, the top five holdings in the EAFE index represent only 8% of the index, and the technology and communication services weighting represents only 15%. The largest sectors in EAFE are Financial Services (16%), Healthcare (14.9%) and Industrials (14.26%) which should benefit from resurgence in growth.


Yields on Treasury bonds have fallen significantly, and the 10 year bond hit .55% this week. Is the bond market telling us something that is falling on deaf equity market ears?

The dichotomy of low and falling bond yields with ebullient risk asset markets is confusing, and investors are becoming increasingly nervous as yields grind lower. There are really two potential drivers at play here: Is it fear that the economy is “rolling over,” or is it faith in the Federal Reserve to stick to the “whatever it takes” playbook? We believe that it may be a little bit of both. From an economic standpoint, we do not see a meaningful and sustainable acceleration in GDP growth in the U.S. and are looking at a full recovery to 2019 levels not occurring until 4Q 2021 or even beyond. There is lasting damage to the demand side of the economy that will take time to heal. We do not, however, anticipate a “rolling over,” or a double dip recession. On the flip side, we also see high confidence in the Fed driving yields lower. Not only has the Fed pledged to “not even think about thinking about” raising interest rates, but has also committed to asset purchases and is very much a price agnostic buyer. This faith is manifested in lower yields across the yield curve, and it is our belief that yields will remain suppressed well into the foreseeable future. Equity markets are also reflecting faith in the Fed, with elevated valuations supported by extremely low interest rates and with persistent negative real rates pushing investors into risk assets.


What is your outlook for gold?

This seems to be an increasingly popular question, no doubt driven by the nearly 30% increase in the most popular gold exchange traded fund (GLD) year to date. It certainly is an interesting asset class, and one that is difficult (impossible?) to value given there is no associated cash flow stream. We recently did a deeper dive into gold as an investment, and we drew a few important conclusions that confirmed our initial premise: Outside of extreme market circumstances, we don’t recommend an allocation to gold. Our research suggests the following in response to several commonly asked questions on gold.

  • Does gold offer an attractive risk-adjusted return? The risk/return profile of gold over long periods of time is unattractive, and gold actually profiles as one of the riskiest assets with no dependable return. We continue to believe risk and return should be related, so cannot recommend a strategic allocation to an asset with the lowest risk adjusted return across the asset class spectrum.

  • “Assets Serve a Purpose.” So what is the purpose for gold? Investors seem to have a variety of reasons to hold gold, the most common being to hedge inflation. Aside from the fact that our base case calls for inflation to remain muted, which somewhat mitigates the need for a tactical inflation hedge, we tested gold against other popular inflation hedges to determine whether this was the best hedge available. Based on our research, gold is an inferior hedge than Treasury Inflation Protected securities (TIPS) and natural resources equities, both of which provide superior performance in an inflationary environment.

  • Is gold a good hedge against dollar debasement? While there is evidence that gold is negatively correlated with the U.S. dollar, we found this to be the most volatile of all the correlation tests we ran. We also believe that the news of the death of the U.S. dollar as a global reserve currency has been greatly exaggerated. And while the recent weakness in the dollar is understood in the context of the convergence of U.S. real interest rates with the negative real rates of Japan and Europe, we do not anticipate dramatic weakness from here.

  • How about using gold to hedge known unknowns? Many investors buy gold as a hedge against uncertainty, and with uncertainty so high today believe that the environment supports owning gold. We looked back in history, and the premise is valid. Gold has been a diversifying asset during distinct periods of market stress; however, what we found was that the portfolio benefits were relatively marginal given a 5-10% position.

    For greater detail on this view, read Chief Investment Strategist Jim McDonald’s recently published Investment Strategy Commentary: The Role of Gold.


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