The Economic Tug of War

Which side will win the tug of war?The economic future hinges on the answer to that question. On the one side is the unprecedented cessation of economic activity, but on the other side is the large infusion of fiscal and monetary liquidity. The Federal Reserve and the federal government flooded the markets and economy with new money to offset the income and liquidity that were lost when economic activity was reduced.

One factor to watch is what some economists call the second- and third-order effects of reduced economic activity.While many businesses didn’t close, and some even did well, over time the overall drop in economic activity could drag them down. All businesses depend on income from the closed businesses circulating through the economy.

Another worry is that Congress and the Federal Reserve might not adequately offset all that lost income or might stop their efforts too soon. To a large extent, market and economic fundamentals won’t determine the near-term future of investments and the economy. They’ll depend more on science, medicine and politicians.A scientific breakthrough would cause a new surge in growth.

Mismanagement or lack of progress could cause a fresh decline.As always, future investment returns only partly depend on what happens in the future. What matters more is what’s already priced into the markets relative to what happens.It appears to me that stock markets are pricing in an optimistic scenario. Most analysts abandoned hope for a V-shaped recovery but still sanguinely expect a less steep bounce called the “swoosh-shaped recovery.” Stock market valuations remain very high by most measures. Projections for earnings and economic growth, except in the hard-est hit industries, assume solid growth later this year.

Overall, it appears investors expect gross domestic product (GDP) and earnings to return to prior highs in short order.Yet, there is a much wider range of potential outcomes, perhaps wider than any time in most of our lifetimes.My expectation is that it will take longer to return to the previous level of GDP than is priced into the markets. Entertainment and sports activities that involve large gatherings won’t be allowed for some time.

Other crowded indoor businesses, such as bars and restaurants, will face continued legal restrictions after governments allow them to reopen.Customers also have been hesitant to return to many types of businesses after they reopened, just as people were slow to return to travel and tour-ism after 9/11. There are reports that some employees will decline to return to work because they fear contracting the virus.

We can look at the Asian countries that experienced the virus first and were the first to reopen their economies. Though considered success stories, their economies bounced higher and then seem to have stalled at only about 70% of previous GDP levels. In short, we might have a quick vault in economic activity as some restrictions are eased. But, absent a scientific solution, GDP will be well below 2019’s level for some time. Even a historic growth surge from April’s lows would leave GDP significantly below previous highs.Because a number of outcomes are similarly probable, I don’t see a margin of safety in the broad stock indexes. Recovery will be uneven across industries and countries.

Also, investment dislocations and imbalances were created in the volatility of the last few months. Margins of safety were created in some assets that are oversold, while prices of other assets are too high.In our portfolios, and especially in stocks, selective diversification now is more important than broad diversification.I prefer to have a significant margin of safety instead of betting on a particular outcome to this pandemic.