The pandemic has already pushed the U.S. to an economic recession, according to data from Bloomberg. The first-quarter real GDP growth was negative as expected, and the expectations for the second quarter are bleak.
As investors, however, the focus should be on the long term as the performance of stocks is likely to be driven by the economic growth of the country in the next few years, not the next couple of quarters.
The minutes of the recent Fed meeting released on June 10 reveals that the committee is of the stance that the lockdown will not have a material impact on the long-term economic growth of the country. This comes as welcome news for investors who are worried that it would take years or even decades for the market to fully recover from this crisis. However, there are worrying signs for the financial services industry, which calls for prudent asset allocations decisions by investors to succeed in the coming years.
The Fed is bullish on the economy
Even after deciding to cut rates multiples times during the bull market in 2019, the Fed continued to categorize such actions as mid-cycle adjustments rather than an adoption of quantitative easing policies. However, things took a drastic turn in March when the committee had to deliver an emergency rate cut but only had 0.25% worth of ammo left.
Even after introducing a plethora of loose monetary policy measures to take the place of interest rate cuts, the Fed expects the U.S. economy to contract by over 6% this year. In 2021, however, the economy is projected to expand over 4%, marking the best year for the country in over three decades.
Source: Minutes of the Fed meeting
To achieve this, however, both monetary and fiscal policymakers need to work in tandem to support the credit growth of the country and inject liquidity into the market to help small businesses survive the downturn, as per remarks by Fed Chair Jerome Powell.
In the March meeting, the Fed did not release economic growth projections, citing the uncertainty surrounding such estimates. These numbers reappeared in the June meeting and, to the surprise of some investors, the long-term forecast had not changed from what was published last December. Powell went on to say:
“What the June SEP shows is a general expectation of an economic recovery beginning in the second half of this year and lasting over the next couple of years, supported by interest rates that remain at their current level near zero.”
The positive news, however, should be absorbed with caution as the risk of a second lockdown has not gone out of the window just yet. Also, the pace of recovery will not be similar for all business sectors alike. Therefore, allocating assets tactically is the right decision.
Banks might take longer to recover
A bank or a financial institution that generates the bulk of revenue from interest-bearing products such loans is better off when the cost of borrowing rises, as this leads to an expansion in profit margins. As illustrated in the below chart, net interest margins of U.S. banks recovered in the latter half of 2015 as the Fed ended quantitative easing and raised the Fed funds rate.
Source: Federal Reserve
The momentum changed direction in 2019 as the Fed funds rate was once again cut in light of the slowdown of the economy that resulted from escalating trade tensions between the U.S. and China. In response to the lockdown and the slowdown to business activities in the country, the policymakers decided in March to adopt a plethora of expansionary measures to boost the economy. One of these initiatives was to keep interest rates at a historic low close to zero, and this clouds the outlook for the banking sector.
The dot plot released by the Federal Open Market Committee on June 10 indicates that rates are likely to remain at the current level at least through the end of 2022, which is a worrying sign for most of the banks.
Source: Minutes of the Fed meeting
Considering this bleak outlook, an investor needs to carefully analyze the prospects and revenue sources before investing in the equity securities of a bank. Bank of America Corporation (BAC, Financial) stands out as one of the top choices for investors focused on this sector, and the bank remains well-funded and has the backing of Warren Buffett (Trades, Portfolio) as well. Shares were trading as high as $36 in February and the market price of around $25 on June 15 implies a price-earnings ratio of 10.11, whereas the five-year average price-earnings ratio stands at 13.76 according to Morningstar data. Convergence with the historical multiple indicates an upside of 36% on top of the dividend yield of close to 3%, which I think is handsome compensation for bearing the risk of investing in a bank.
Tech sector
The information technology sector was the primary driver of market performance in the bull market that has prevailed since the fallout of the financial crisis. Things have not been any different this year, despite the nationwide lockdown that pushed century-old businesses such as Hertz Global Holdings, Inc. (HTZ, Financial) into bankruptcy. The Technology Select Sector SPDR Fund (XLK) has comfortably outperformed the S&P 500 index in 2020.
In the future, tech companies seem likely to continue to gain momentum as a result of increased exposure of consumers to technologically advanced solutions such as e-commerce, content streaming, cloud computing and video conferencing. Industry-leading tech giants such as Apple Inc. (AAPL), Facebook Inc. (FB, Financial) and Amazon.com Inc. (AMZN, Financial) are on firm footing from a liquidity position as well. This will help these companies not only survive a second lockdown but also continue to invest in lucrative opportunities. For instance, while many U.S. companies were focused on remaining solvent in the last couple of months, Facebook invested $5.7 billion in Jio Platforms, the largest telecommunications services provider in India, to help the monetization process of WhatsApp.
Going by Powell’s comments, I think the U.S. economy will continue to grow starting from 2021, and this creates a sound platform for the tech industry to grow exponentially, leading to stellar returns for investors.
Takeaway
The U.S. economy, on the back of trillion-dollar stimulus packages and monetary policy support, is set to resume its growth story in the last couple of quarters this year. Even though 2020 will still be a disappointment, the long-term outlook is promising, in my opinion.
Disclosure: I own shares of Facebook.
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- The Recent Market Performance Is Not Surprising After All
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