Insights & Thoughts

When the Government Runs it All

Sep 20, 2020 | Quarterly Commentary

The third quarter was relatively calm compared to the first half of the year. The second quarter’s rebound from the March lows has largely held firm or in many cases continued to advance. In fact, large cap stock indices are now positive for the year thanks to the tech sector. More specifically, the S&P 500’s gains can be largely attributed to just five companies – Apple, Google, Facebook, Amazon and Microsoft. These companies have been trading at all-time highs and now make up roughly a quarter of the value of the S&P 500. They have become the main driver of every large cap index performance.

The S&P 500 is a cap-weighted index, as are most indices. This means that a company’s size determines how large a percentage their stock represents in the index. COVID’s impact has driven a tremendous amount of commerce, work and social time to the internet and any business in that space has benefited greatly. The downside is that this market is now very reliant on a handful of firms. It has also led to a significant gap in the performance between large, mid and small cap stocks. Where large cap indices are up around 10% for the year, mid-caps are still down by about 3% and small caps down roughly 8%.

The question remains whether or not these tech valuations are justified in light of the state of the economy. While it is true internet related businesses are doing well relative to everyone else, there is a real concern on whether this enthusiasm is fundamentally deserved. And while the tech sector seems to have benefited from this crisis, the stock market in general has held up pretty well. When you cut through all the noise, what you’ll find is that government policies are really responsible for most of the economic and market activity today, good or bad. The government’s role is coming from three directions.

First, there are the various state mandated shutdown policies due to COVID. These have impacted unemployment, accelerated the shift to online commerce, small business failures, office space rentals, and so much more. Because these rules vary from state to state, there has been a wide ranging impact across the country. This impact has also varied based on the state’s financial health headed into the shutdown. The loss of tax revenue has been a real problem for the Northeast and Midwest in particular as many of those states were cash strapped to begin with.

The second notable policy response has been the various direct payment programs by the Federal government. These stimulus programs have been in the trillion dollar range and provided significant support to the economy during the shutdown. Without them, the market rebound would surely look different. As those programs have expired, it has become more and more difficult to reinstate or replace them as the politics keep getting in the way. This has been especially true the closer we get to the election.

The final and probably most significant government policy response has been by the Federal Reserve. Before the pandemic even started, the Fed was still wrestling with unwinding its quantitative easing program leftover from the financial crisis. When the economy started spiraling out of control in March, the Fed announced it would support the corporate bond market by reinstating quantitative easing. The concern was that tightening financial conditions would leave companies with nowhere to turn if they needed to issue debt to survive. The mere announcement of this program drove money into corporate bonds as investors hoped to front run the Fed’s purchases.

Bond yields have collapsed as a result and rates are likely going to be stuck at these levels for some time. The only solution to such a scenario for income investors is to assume more risk in a portfolio by diversifying the sources of cash flow. We’ve always managed our client holdings this way. Portfolios generate income from many different sources, such corporate and high yield bonds, bank loans, mortgage securities, preferred stocks, etc.

Admittedly, the scenario we currently face is more difficult than any in recent memory. We will continue to navigate through this by being even more selective in our securities and the type of risks they present. As a result, expect us to continue to favor areas that still produce reasonable income such as preferred stocks and strategic income.


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