Bob’s Journal for 3/5/2020

Some Notable Events That Grabbed My Attention This Week

On Monday, I was the guest on Jordan Goodman’s podcast, Money Answers, broadcast live on Voice America. We covered a wide range of retirement finance issues.

You can listen to a recording of the interview at your leisure by clicking here. It’s also available on the usual podcast services: iTunes, Stitcher and more.

Markets and the Coronavirus

The markets indicate investors expect the effects of the coronavirus to be extremely negative across the globe.

Stock prices declined. Key commodity prices fell far more. Interest rates on U.S. treasury bonds dropped to their lowest levels ever.

The drop in commodity prices, especially energy, and the tumble in interest rates indicate investors anticipate the decline in economic growth to be significant and lasting.

Markets are priced for a possible deflationary decline of the kind they haven’t worried about since the financial crisis ended. Investors don’t simply expect the growth rates of earnings and the economy to decline. Based on market action, investors expect profits to drop significantly and the economy to shrink by several percentage points.

That looks like a worst-case scenario for the effects of the coronavirus.

However, there are three more likely scenarios.

The most optimistic scenario is that the virus peaks near the end of March and the health threat subsides.

The middle-of-the-road scenario is that, as in previous outbreaks of this kind, the virus spreads for a few more months but peaks before the second quarter ends in June.

Under this scenario, supply chains and trade would be curtailed for several more months, and there would be a meaningful reduction in economic activity. Governments would have to enact significant programs to support the economy until activity begins to increase.

The worst case, among the likely scenarios, is that the virus spreads and disrupts activity into the third quarter and perhaps longer. After that, the economy and markets bounce back. Current market prices, especially treasury interest rates, indicate investors expect something worse than this.

What I don’t see in market pricing is an expectation that, once the virus is contained, economic activity will have a strong rebound.

I expect that, whenever the spread of the virus peaks, global economic activity will recover fairly quickly. The markets don’t. That and the severity of the decline priced into the markets are reasons to believe, as I wrote last week, that more than the coronavirus caused the recent market changes. I believe political volatility is a major factor in the market volatility.

There are good reasons not to expect the worst-case scenario.

Unlike in many past crises, the banking and credit system is in good shape. One reason I like preferred securities now is that a majority of the securities are issued by financial firms, and those firms generally have strong balance sheets.

Governments and central banks are well aware of the dangers. Many are formulating or already implementing plans to support their economies as the consequences of the virus reduce economic activity.

It already appears that the spread of the virus peaked in China, where it originated. Extreme measures were taken in China to control the virus, and those measures sharply curtailed economic activity. But the government also implemented strong economic stimulus measures. Already stock prices in China appear to have hit bottom.

Because the markets already reflect an extremely bad scenario, this isn’t a good time to make defensive adjustments in portfolios. Unless there’s a change in the virus, its spread should peak in the coming months.

I expect the economy to bounce back once the virus seems to be under control. Unlike a financial crisis, the spread of the virus isn’t destroying capital. It is delaying economic activity. Once the virus is contained, a bounce back due to pent-up demand should cause activity to accelerate.

The real danger points are businesses and individuals that carry a lot of debt. They could have problems, because they might not be able to service the debt during the period of economic weakness. Any such investments should be removed from a portfolio.

Otherwise, I stress that you maintain a diversified portfolio and ensure your investments have a margin of safety.

Recovery in China’s Markets

The coronavirus began spreading in China, and China’s economy and stock markets were hit hard. But China’s stocks turned around.

One of China’s stock indexes, the CSI 300, gained 2.5% in the latest trading day. The index now is back where it was before the coronavirus outbreak began. There’s an exchange-traded fund (ETF) in the United States that follows the index (ticker: ASHR) that is back to 2.5% below its 52-week high.

We have to wait to see if this is a sustainable turnaround or a bear market rally.

Warren Buffett’s Latest Letter

Warren Buffett’s annual letter to shareholders didn’t receive much attention because of all the coverage of politics and the coronavirus. As usual, the letter is well-written and contains interesting thoughts.

Early in the letter, Buffett discusses the importance of operating companies retaining some of their earnings and reinvesting them in the business. He begins by mentioning a little-known investment book published in 1924 and then explains how he uses the book’s insights at Berkshire Hathaway.

Buffett also uses this discussion as a springboard to explain how his company’s earnings reports should be evaluated, concluding that the company is doing better than published earnings computed according to general accounting principles indicate.

There also is an interesting discussion about a utility company 91% owned by Berkshire that doesn’t pay any dividends. Buffett explains why he doesn’t want it to pay dividends the way most utilities do.

Of course, Buffett once again explains his long-term investment strategy and why most investors should follow his approach and own primarily stocks of well-run businesses.

The letter also goes into some detail about the future of the company and Buffett’s estate plan. He gives his executors and trustees specific instructions on what to do and not do with his Berkshire holdings.

The letter is interesting reading throughout.

The Data

Consumer Sentiment, as measured by the University of Michigan, remained strong in February. The index was reported as 101, which is the second-highest reading since the financial crisis. There were increases for both current conditions and expectations. Most of the survey was conducted before the spread of the coronavirus became a major concern.

There are mixed signals from the service sector.

The ISM Non-Manufacturing Index increased to 57.3 for February, up from 55.5 in January. That’s a 12-month high for the index. There were significant increases in new orders and orders on backlog.

The PMI Services Index, however, turned down to 49.4 in February from 53.4 in January. That’s the first contraction in four years for this index. A reduction in demand from abroad was the main cause of the decline. Business confidence also declined.

There was some improvement in the Kansas City Fed Manufacturing Index, despite more than 40% of firms reporting negative effects from the spread of the coronavirus.

The index rose to 5 in February, up from negative 1 in January. It was the first positive number for the index in eight months.

Business in the Chicago region also is picking up, according to the Chicago PMI. The index increased to 49.0 in February, compared to 42.9 in January. This is the index’s highest level since August 2019.

But national manufacturing surveys weren’t as positive, though they still indicate the sector expanded in February.

The PMI Manufacturing Index declined to 50.7 from 51.9. Likewise, the ISM Manufacturing Index declined to 50.1 from 50.9. That’s the second consecutive month above 50.0 for the ISM Index, which was below 50.0 for the previous five months.

Almost all manufacturing sectors reported that the coronavirus is adversely affecting their supply chains and having a negative impact on their businesses.

Factory Orders in January declined by 0.5%, compared to a 1.9% increase in December. That’s two months of decline in the last three months. Shipments have been down for three consecutive months.

Excluding transportation, orders declined 0.3% in January. Some good news is that orders for machinery increased 0.6% in January and orders for computers and electronics increased 0.3% for the month.

In January, Personal Income increased by 0.6%, according to the Personal Income and Outlays report. That compares to a 0.1% increase in December. Wages and salaries increased 0.5% in January.

Personal consumption increased only 0.2%, which is down from a 0.4% increase in December.

Inflation declined, according to the Personal Consumption Expenditure Index. That index increased only 0.1% in January and 1.7% over 12 months. Excluding food and energy, the price index increased 0.1% in January and 1.6% over 12 months.

So far, the coronavirus doesn’t seem to be affecting hiring. Private sector payrolls increased by 183,000 in February, according to the ADP Employment Report. This was higher than expectations. But January’s new jobs were revised down to 209,000 from 291,000. The initial number was the highest monthly gain in five years. The 12-month average is 154,000 new jobs per month.

New unemployment claims declined by 3,000 to 216,000 for the latest week.

The Markets

The S&P 500 rose 0.44% for the week ended with Wednesday’s close. The Dow Jones Industrial Average gained 0.43%. The Russell 2000 lost 1.51%. The All-Country World Index (excluding U.S. stocks) dropped 0.26%. Emerging market equities edged up 0.43%.

Long-term treasuries rose 3.10% for the week. Investment-grade bonds increased 1.78%. Treasury Inflation-Protected Securities (TIPS) added 1.56%. High-yield bonds gained 0.74%.

On the currency front, the U.S. dollar declined 1.53%.

Energy-based commodities fell 1.22%. Broader-based commodities lost 0.24%, while gold gained 0.19%.

Bob’s News & Updates

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