'Corona Crisis' update: Enter the stock picker
With the S&P 500 up 26% in less than a month, Federated Hermes’ PRISM® Committee on Monday modestly trimmed its equity overweight (from 4% to 3%). Although we continue to expect the market to be broadly higher by late 2021, our view is it has limited upside for the next several months as we work through a sloppy global economy restart. Downside also seems limited, given the massive fiscal and monetary response ongoing in the U.S. and elsewhere. Hence, only a modest taking of profits, which we put into corporate bonds, where yields are very attractive in our view.
The committee chose to take the overweight out of large-cap value stocks, given their huge bounce since March 23 and the choppiness that we anticipate in the weeks ahead. We similarly took a point out of large-cap international, itself a value-tilted asset class, and moved that to international small cap, where stock-picking opportunities are very high and where many international emerging growth and “new economy” stocks are to be found. We already are overweight in emerging markets by a point for the same reasons.
Let’s quickly run through our “Corona Crisis” framework to summarize where we are:
Most data within the U.S., and globally, suggest the virus curve is flattening, and with each day better news arrives. Italy, Spain and now New York have all seen a decline in new infection and death rates. Most U.S. states seem to be in far better shape than New York, with the exception of New Jersey, where infection rates are still rising. Daily, positive news reports have been flowing in on improved personal protective equipment (PPE) availability, ramped up respirator manufacturing and early positive trials of possible drug treatments. Moderna’s vaccine development program seems to be going well, and last week pharmaceutical giant Johnson & Johnson confidently said it expects its vaccine program will reach full production by January. Testing and antibody testing, though still not perfect, is improving daily. And President Trump’s coronavirus task force unveiled federal guidelines for a state-by-state economic re-opening that envisions a phased approach in which key health-care milestones must be met before moving to the next opening phase. Collectively, this news has helped investors start to share our vision that the economy, though largely shut down, will gradually start becoming less so by the end of April, and even less so as May progresses, and so on through June.
Importantly, the policy response seems to be helping thaw financial markets and, through its bridge financing characteristics, keep many small and medium-sized businesses afloat. The corporate and municipal bond markets are beginning to normalize and open up, while the initial $350 billion tranche of SBA funding for small business—thought by cynics to be too cumbersome to get out quickly—already has been disbursed, with a replenishment by Congress underway. Unemployment checks are rolling out, helping hard-pressed gig-economy workers who are temporarily out of work. Nothing here really good, but certainly less bad than anticipated. More federal spending programs on such things as infrastructure are probably on the way later this quarter.
The economic numbers for sure have been terrible. Unemployment claims are at record levels, though importantly, leveling off. Economists have hustled to pull down their GDP estimates for Q2, with consensus now at -22% (annualized) and some outliers at -50% (annualized). This implies an actual contraction in GDP this quarter of about 7%, a big number for sure. But consensus also expects a positive rebound in Q3, as much of the economic shutdown was caused not by bankruptcies but rather government fiat, and many businesses stand ready to restart later this quarter as the phased-in economic reboot gets underway. For sure, not all businesses will make it back and some sectors—think energy, tourism and travel—are being particularly hard hit. But so far, all of this is consistent with our view that following a terrible Q2, we are likely to see a slow, choppy and uneven “U-shaped” recovery for the next several quarters.
Enter the stock pickers
As we enter this important new phase of the stock market’s rapid evolution through what we continue to see as a short-term “cyclical bear market,” we expect many industries, particularly ones in the “value” indexes, to see an acceleration of already existing trends toward a separation of economic winners and losers. Beneath all the turmoil, this sorting-out process already has been loosely at play, with the key criteria so far for identifying “winners” being balance-sheet strength (i.e., the ability to weather the economic storm long enough to make it to the other side of the valley), and market positioning (where especially companies involved in technology, communication and pharmaceuticals/biotech development have been identified as the big winners.)
Now, the selection process, we think, will grow trickier. Especially in the value sectors of the market, where the economic backdrop is most challenging, the broader help of a rising tide no longer will be enough to raise all the boats. Companies are going to have to do it on their own. At Federated Hermes, we are blessed to have embedded in our portfolio teams experienced research analysts who are talented at picking stocks in the investment styles and disciplines in which they delve (be it growth, value, international or income).
At times in this secular bull, as ETF and passive investing were all the rage, these skills were not always appreciated by markets, as market momentum and incoming cash flows into passive portfolios encouraged across-the-board “blind” buying of all names in any given space, regardless of their quality or market position. The game has now changed in a dramatic fashion, and the coronavirus crisis is accelerating and upping the stakes.
In the energy space, for instance, companies with weakened balance sheets due to overly aggressive investment and M&A now find themselves without the flexibility to take advantage of historically low oil prices. In retail, the premium for a successful online offering just went up, and retailers that rely heavily on especially secondary malls are finding themselves suddenly out of cards. In restaurants, national chains with lower-cost offerings and diversified end markets are winning the game, as are those with increased at-home delivery options. In real estate, the suburbs are in and the inner cities are out; office properties are under pressure as are nursing home providers. In travel, domestic is in, international is gone. In tech and health care, companies that can keep the R&D pipelines robust as product cycles continue to shorten at a rapid pace have a decided advantage. And everywhere, how and from where you source your product is now, more than ever, paramount to success. On and on I could go. You get it.
This is now the era of the stock picker. Nice to have a few of those on my side.
March 30 2020