First Eagle 2Q20 Market Overview: Hoping Against Hope

Key Takeaways

• While current stimulus measures have proved to be an analgesic for economies and markets suffering from the impact of Covid-19, it’s hard to believe that the imbalances built up over a 10-year-plus expansion could be corrected within a single quarter.
• We think the fight against Covid-19 is the key issue investors need to consider at this point. Though financial markets are acting as if the pandemic’s impact has reached an inflection point, epidemiological data would suggest otherwise. The emergence of Covid-19 has produced the greatest blow to demand in a generation, and permanent economic scarring seems likely.
• The “Fed put” has become increasingly massive each time it has been employed. While the utilization of facilities rolled out in response to Covid-19 has varied, their mere existence in many cases has been enough to impact markets. This is especially true in bond markets, where a flood of investors confident in the Fed backstop pushed spreads sharply tighter during the quarter.
• First Eagle believes now is the time for patience and fortitude. Rather than stake everything on change agents that might shape the world of tomorrow, we seek to own businesses with scarce, durable assets that we believe have the potential to generate persistent earnings power over time—and to acquire these businesses at prices consistent with our strict valuation discipline.

“Don’t fight the Fed.” This old adage has been proven right over many short time periods, second quarter 2020 the most recent among them. The powerful equity market rebound that began in late March extended through June, even as the Covid-19 pandemic that inspired mass selling in the first quarter continued to ravage the globe. Driven by a massive influx of liquidity from the Federal Reserve and other global policymakers, investors have piled into risk assets, especially the shares of new-economy companies that largely appear to represent speculative plays on uncertain future potential.

Overall, the markets’ ebullience in the second quarter seemed to reflect broad confidence in a V-shaped recovery from the severe economic dislocations caused by Covid-19. While there have been some encouraging signs in recent months, there are even more that suggest the hoped-for V may devolve into something less clearly legible.

Markets Surge as Pandemic Tightens Its Grip

We think the key issue investors need to consider at this point is where we stand in the fight against Covid-19. Though financial markets are acting as if the pandemic’s impact has reached an inflection point, epidemiological data would suggest otherwise. Confirmed cases have exceeded 12 million worldwide and deaths more than 500,000, and these numbers continue to grow.1 Emerging and low-income countries now appear to be the epicenter of the disease, though developed countries—the United States chief among them—are by no means out of the woods. Cases are accelerating in Arizona, California, Florida, Georgia, Texas and elsewhere, and a number of states are slowing or reversing plans to reopen their economies. While we can’t know the future trajectory of the virus, we believe there is a long road ahead to herd immunity or a vaccine—possibly in the 2022 time frame.

In June, the National Bureau of Economic Research made official what most observers had intuited: The US economy entered recession in February, as the Covid-19 outbreak began to intensify on these shores. From a global perspective, pandemic-related shocks to supply and demand are expected to result in a recession of historic proportions. The World Bank is forecasting that more than 90% of the world’s economies will be in recession in 2020, which would represent the most broad-based contraction of the past 150 years. The World Bank also expects the current recession to be the deepest in per-capita terms since the Great Depression.

The performance of financial markets in the second quarter seemed to reflect expecta-tions of a V-shaped economic recovery; i.e., a sharp decline followed by an equally sharp rebound. Though there have been some promising signs in recent data as economies worldwide have begun to reopen, we do not share the markets’ confidence in the snapback of output. The emergence of Covid-19 has produced the greatest blow to demand in a generation, and permanent economic scarring seems likely. Even if the public health elements of the crisis were to be contained, the headwinds remain significant. After peaking at 14.7% in April, the US unemployment rate fell to 11.1% in June, still well above the high of 10% in the global financial crisis.2 Though the credit cycle has only just turned over, we have already seen bankruptcies by such well-known brands as Hertz (HTZ, Financial), Neiman Marcus and Brooks Brothers. With restaurants, airlines and lodging companies operating at partial capacity for an indeterminate length of time, we don’t know how large the hit to output ultimately will be. Further, the recovery may wane as fiscal stimulus moderates and the marginal benefit of additional monetary stimulus declines. Factors like these can turn a V into something less clearly legible.

Perhaps learning a lesson from their hesitant reaction to the global financial crisis in the late 2000s, central banks worldwide have responded rapidly and forcefully to the disloca-tions of 2020. Policy rates were slashed, massive levels of quantitative easing were pushed out, and programs to ensure market liquidity were introduced. With policy rates at the lower bound in most advanced economies, central banks have been notably aggressive with their asset purchases, and the combined balance sheets of the Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England now amount to approximately $20 trillion, up about $5 trillion since the beginning of the year.3 The expansion has come primarily from increased purchases of government securities, as well as from special lending programs and purchases of risk assets. This has not been a mere easing of policy; it’s been a step function. M2 money supply in the United States, for example, expanded 23% over the 12 months ended May 2020, driven by a 16% increase from February to May.4 Already-planned quantitative easing suggests that double-digit money supply growth is likely to persist into 2021 or later.

Fiscal policy has been similarly assertive, as governments have spent freely to fund healthcare, support household incomes and bolster the corporate sector. While more fiscal support appears likely in the near term, governments cannot carry the private sector indefinitely. Already-high sovereign debt levels have continued to climb as these programs are implemented, expanding deficits in the face of falling nominal GDP. Economic recovery eventually will help narrow these deficits somewhat, as revenues rebound and automatic stabilizers decline. However, the debt incurred to rescue the economy will persist.

The “Fed put” has become increasingly massive each time it has been employed. In response to Covid-19 the Fed has rolled out all the facilities it implemented in response to the global financial crisis, as well as new programs to support the corporate bond market, the municipal market, small and medium-sized enterprises and, most recently, nonprofits. While some of these facilities have not yet been launched and the utilization of others remains very low, their impact has already been significant, especially in the bond markets, where the Fed backstop attracted investors and contributed to pronounced spread tightening. Wary of promoting moral hazard, the Fed likely would claim that such extreme measures are appropriate only during crises of the current magnitude, but it is not unreasonable to expect the central bank to intervene similarly in the next down-turn. Government and corporate debt levels are going to be much higher after this crisis, making the Fed’s dual mandate of stable prices and full employment vulnerable to any dysfunction in the bond markets. We think this increases the likelihood that the Fed will serve as a buyer in size to maintain functioning markets, as necessary.

With the extraordinary policy accommodation introduced to combat the impacts of Covid-19 unlikely to be unwound anytime soon, we expect the quality of man-made money will continue to deteriorate, underscoring gold’s historical role as a long-duration potential hedge against the myriad risks facing investment portfolios. Insofar as inflation has remained muted, the opportunity cost for holding gold, as reflected in real interest rates, has continued to decline globally at the same time fundamentals supporting fiat currencies deteriorate. Gold’s recovery from its brief mid-March swoon continued in the second quarter, sending the price of the metal to a new seven-year high in nominal US dollar terms and record nominal highs in all the other curren-cies we track. The strength in the price of gold during the quarter also was generally supportive of gold-related equities, whose performance historically has been leveraged to the gold price.

Aside from Covid-19, relations between the US and China are another important consideration for the return of global economic growth. There are signs of increasing tensions here. While the phase-one trade agreement appears likely to hold through the November elections, the United States has continued to impose a high effective tariff rate on imports. Further, we have seen deterioration on other fronts in recent months. The US government has limited companies and third countries from supplying Huawei with goods that contain US technology and has placed many Chinese orga-nizations and individuals on its “entity list,” which limits their ability to acquire US technology. More recently, the United States has issued financial restrictions on China. Though these restrictions are small currently, bills making their way through Congress could substantially expand their scope, potentially resulting in the delisting of Chinese companies from US exchanges and the placement of sanctions on individuals and entities that undermine Hong Kong’s autonomy—as well as the banks that do business with them, which would represent a significant escalation by the United States. China’s recent passage of the National Security Law for Hong Kong could serve as additional motivation for Congress.

Finding Value in Today’s Markets

While current policy has proved to be an analgesic for economies and markets suffering from the impact of Covid-19, it is hard to believe that the imbalances built up over a 10-year-plus expansion could be corrected within a single quarter. It seems more likely that only time will heal these wounds. The price of the S&P 500 troughed in March at around 15 times trailing peak earnings—well above its usual level in a recession—and at quarter’s end the index was trading at nearly 22 times trailing peak earnings.5 Forward earnings expectations, meanwhile, continued to deteriorate even as the market rally gained momentum; the consensus estimate for 2020 MSCI World Index earnings stood at -24.3% at the end of June, down from -3.4% in March. Though strategists forecast year-over-year growth of 28.1% for 2021, such a scenario would still leave 2021 earnings below their 2019 level.6

The current equity market rally has been notable for its lack of breadth; the proportion of stocks in the MSCI World Index outperforming the index as a whole stood at 37% at the end of the second quarter, a low not seen since before the bursting of the dot- com bubble.7 Perhaps not coincidentally, a new breed of technology stocks is leading the charge this time around, both well-established (the so-called FANG stocks) and less so. In the latter category, we would include Square (SQ, Financial) (which traded at about 175 times trailing 12-month earnings at quarter’s end), Zoom (ZM, Financial) (which traded at about 1,500 times trailing 12-month earnings) and Shopify (SHOP, Financial) (which had no trailing 12 -month earnings).8 IPOs were also hot in industries as diverse as biotech and insurance, as well as in special purpose acquisition companies (SPACs or, sometimes, “blank-check companies”).

Clearly, there have been outsized returns to be gained in these market darlings, assuming an investor knows exactly when to buy and to sell ahead of the thousands of others trying to do the same. Moreover, as the prices of these stocks continue to climb faster than improvement in fundamentals can support, arithmetic suggests that their expected future returns will be lower unless they can capture market share at an extraordinary rate or further expand their already-high multiples.

This is not a game in which we’re interested in testing our luck. Now is the time for patience and fortitude. Rather than stake everything on change agents that might shape the world of tomorrow, we prefer to humbly accept that the future is unknow-able. In that spirit, we seek to own businesses with scarce, durable assets that we believe have the potential to generate persistent earnings power over time—and to acquire these businesses at prices consistent with our strict valuation discipline. Supported by prudent management teams and robust capital structures, such compa­nies, in our view, generally should be poised to deliver shareholder value over the long term—perhaps more slowly than growth stocks but likely more surely. To these positions we add ballast in the form of gold and cash and cash equivalents. Gold serves as a potential hedge in our diversified portfolios while also providing longer-term purchase optionality.

1. Source: Johns Hopkins University.
2. Source: Bloomberg.
3. Source: Federal Reserve, European Central Bank, Bank of Japan, Bank of England.
4. Source: Federal Reserve.
5. 6, 7, 8. Source: FactSet.

The opinions expressed are not necessarily those of the firm and are subject to change based on market and other conditions. These materials are provided for informational purposes only. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Any statistics contained herein have been obtained from sources believed to be reliable, but the accuracy of this information cannot be guaranteed. The views expressed herein may change at any time subsequent to the date of issue hereof. The information provided is not to be construed as a recommendation or an offer to buy or sell or the solicitation of an offer to buy, hold or sell any security. The information in this piece is not intended to provide and should not be relied on for accounting, legal, and tax advice.

There are risks associated with investing in securities of foreign countries, such as erratic market conditions, economic and political instability and fluctuations in currency exchange rates. These risks may be more pronounced with respect to investments in emerging markets.

The principal risk of investing in value stocks is that the price of the security may not approach its anticipated value or may decline in value.

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