quity markets in April posted their best monthly gains in more than 30 years, with the S&P 500 rising more than 13%. Investors ignored increasingly grim economic statistics, including the largest jobless claims figures ever recorded, and instead focused on unprecedented balance sheet expansion by the Federal Reserve.
As shown on the chart below, the Fed’s apparent embrace of Modern Monetary Theory (MMT) has ignited the fastest growth in Federal Reserve assets in history. The Fed essentially prints money to fund these asset purchases, and we believe equity markets were pushed higher by trillions of newly printed dollars flooding into financial markets.
The massive tailwind from the Fed’s MMT policies will persist in May. However, the consequences of COVID-19 for the aerospace and energy industries could hit the US economy particularly hard. These headwinds to growth suggest that US economic recovery will take time and will face inevitable setbacks.
In the upcoming weeks, investors will confront a tug of war between the aggressive policy response from Washington and an increasingly difficult outlook for major sectors of the US economy. The nonstop party of April could transition to a more volatile market environment in May.
As low skilled manufacturing has been offshored to China, Mexico and other low wage countries, US manufacturing has become increasingly dependent upon the skilled labor and specialized expertise required by the aerospace and oil fracking industries.
For example, Boeing’s decision to suspend production of one plane, its troubled 737-Max, is estimated to have lowered US economic growth by about 0.5%. COVID-19 has devastated the global travel industry. Boeing could be forced to make more sweeping production cuts with even bigger negative consequences for the US economy.
The recent collapse in oil prices might have an even more pronounced negative effect on US economic growth. Gas prices have fallen so much that each time we fill up our tanks feels like a call for celebration. Despite this benefit to US consumers, $20 per barrel oil is likely to cause more pain than gain for the US economy over the coming year.
As shown on Chart 1 below, the fracking revolution pushed US oil production up about 60% in recent years, peaking at about 13 million BPD in early 2020 before declining in recent weeks (as seen by the green box on the chart).
This dramatic increase in oil production over the past 6 years has made the US the world’s largest oil producer. As a result, the US is poised to lose more than it gains if oil remains below about $50 per barrel. When oil rocketed to over $100 per barrel from 2011 to 2014, consumer comfort measures soared along with oil prices (see the first green line on Chart 2 below).
High paying jobs in energy extraction and related manufacturing industries (e.g. pumps, drills, specialty steel, etc.) more than offset the pain every American felt at the pump.
By contrast, oil falling below $50 per barrel in 2015 prompted a decline in oil production of about 1 million BPD (shown by the red circle in Chart 1). That drop in oil production cut US economic growth in half, from close to 3% in 2015 to just over 1.5% in 2016. Consumer comfort measures stagnated during that period despite dramatically lower gasoline prices (the red line in Chart 2).
Part of the acceleration in economic growth since 2016, in our opinion, resulted from oil rising to a $50 to $70 trading range for most of that period. Consumer comfort measures skyrocketed as higher oil prices and new, lower cost fracking technology led to big increases in oil production and high paying energy related jobs (second green line in Chart 2).
With oil prices currently near $20, oil output in 2020 has already fallen about 1 million BPD. US oil production is likely to fall much further if oil prices do not recover soon.
American oil companies recently approached the Texas Railroad Commission, which regulates Texas oil production and was the inspiration for OPEC, with a request for a mandated 20% production cut from all Texas producers. Based on the 2016 experience, such steep reductions to oil output and associated high paying jobs will be a formidable headwind to the US economic recovery.
The Fed is expected to pump over $3.5 trillion in newly printed dollar bills into financial markets over the coming months. Equity markets have floated higher on this wave of liquidity.
Despite this monetary boost and the stimulus programs it has funded, equity investors may have to accept that the US economy is unlikely to snap back to pre-coronavirus levels anytime soon. We expect the US economy to lose a great many aerospace and energy dependent jobs, which could weigh on economic growth.
We believe the US economy will ultimately power through these obstacles. Manufacturing is only 20% of the US economy, and some manufacturing sectors such as home building are poised to benefit from the current policy environment. Most states appear ready to lift shelter at home requirements and allow businesses to reopen over the next several weeks.
Encouraging progress is being made on treatments for COVID-19 patients. More importantly, the President and Congress have made it clear that they will spend whatever it takes to get the economy back on its feet. Fed Chairman Powell has been equally clear that he will print as much as it takes to finance this spending spree.
We firmly believe the old adage ‘don’t fight the Fed’. In our opinion, by giving Congress an unlimited printing press to finance government spending, the Fed has assured an eventual economic recovery.
Despite our long term optimism, we think investors should expect the period of steady market gains to end along with April showers. The good news of policy stimulus will soon confront the bad news of growing economic dislocations.
Markets are no longer so cheap that bad news can be ignored, in our opinion. We will not “sell in May” because the Fed is injecting so much liquidity, but investors should be prepared to ride through several uncomfortable market pullbacks and frequent bouts of market volatility.
We believe a pullback to 2750 is likely and would not be surprised to see a pullback all the way to 2400 (markets frequently retest the lows before the end of a bear market). Provided that the key support level of 2100, we will remain bullish about the long-term prospects for US equity markets.
