Quarantine, Economic Downturn, And The Risk Of Deflation

The outbreak of the coronavirus highlights how easily and quickly market sentiment can change. Having reached all-time highs in the S&P, NASDAQ, and Dow just over a month ago, the sell-off in stocks has been sudden and severe with record-level volatility. While future moves in stocks are unpredictable, as is the timing of the containment of the virus, it is reasonable to expect that the panic will fade and business will eventually return to normal. Eventually being the key word.

The spread of the coronavirus has caused legitimate concerns about global economic growth. Undoubtedly, significant damage has already been done to the real economy with more to come as businesses are forced to lay off workers and struggle to stay solvent. It would be pure speculation to try to estimate the extent of the damage and how quickly markets will recover once the situation is stabilized. But even once this crisis passes, markets will still be facing the challenges of high unemployment, ballooning government debt, negative economic growth, and potentially negative interest rates.

The impact of slower or negative growth will be felt in numerous ways. In addition to potentially weaker stock returns, energy prices, and the profitability of energy producers, are also likely to continue suffering. The weakness in energy prices combined with slower growth is likely to keep a lid on inflation at least for the foreseeable future. As a result, interest rates are also likely to remain at low levels or even go negative. Over long periods of time Treasury yields and GDP growth are positively correlated. If that relationship continues, then based on the move lower in rates, it is reasonable to expect growth to decline as well. In this case, the Treasury market is reflecting the expected impact of quarantining and shutting down large portions of the economy.

Although it is possible that inflation will rise in the future due to stimulus efforts by governments around the world, in the short and intermediate terms it seems more likely that it will remain at low levels. The real risk may in fact be in heading into a deflationary environment. The recently announced efforts by the Federal Reserve and the $2 trillion rescue package from Congress are a good start to avoiding a tailspin into deflation and depression, but depending on the length of the shutdown of our economy to stem the spread of the virus, more stimulus will likely be needed in the future. In other words, these first steps do not eliminate the risk of deflation or a protracted and severe economic downturn.

Deflation is also a long-term risk as economic fundamentals will be driven by demographics, specifically an aging population combined with slowing global birth rates. The widespread adoption of automation and A.I. technologies will help ease the burden of a shrinking workforce, but will do little to increase aggregate demand and drive prices higher as a result.

While investors may be well-served to adjust their return expectations lower across asset classes, there are strategies that can be implemented now that can add value in the current environment as well as during a future of slow growth and potential deflation.

What to Avoid

As already stated, the energy sector is likely to perform poorly. The demand for hydrocarbons is unlikely to outstrip supply to the extent required to push prices higher and a low or no growth economy will add to that headwind. For these and other reasons, I suggest avoiding energy producers focused on oil and gas. While there may be pockets of opportunity from time to time, they will be few and far between. Investors will be better off pursuing returns from renewable energy producers and related infrastructure plays.

What Has Worked Will Continue to Work

As I’ve discussed in other articles, I believe that technology will continue to perform well. Specifically, companies built around intangible assets, automation, artificial intelligence, and data would be expected to thrive. The companies that were performing well prior to this crisis are likely to perform well (relatively) during the crisis, as well as afterward. Specifically, those that create content and provide the platforms to distribute that content will excel. Furthermore, those that facilitate working remotely, avoiding crowds and reducing in-person chores are also likely to do well.

Amazon (AMZN) will benefit from multiple business lines in the current environment and would be expected to continue to do so even if we face deflation. Delivering anything and everything to your doorstep is an increasingly important offering while millions are quarantined, Prime Video provides in-home entertainment, and AWS provides the cloud capacity as more and more content of all types is created and shared. During periods of crisis and panic, particularly those with uncertainty where finding reliable information is critical, Google (NASDAQ:GOOG) (GOOGL) searches will rise as will viewership of YouTube videos for both instructional (homeschooling) and entertainment purposes. Similarly, Netflix (NFLX) will also do well as more people are staying in rather than dining out and going to movies not just during quarantine, but afterward to save money during shaky economic conditions. Perhaps the largest content creator and provider, Disney (DIS), has other challenges that might offset its gains from Disney + and its other assets. With sporting events cancelled, ESPN will struggle to provide fresh and interesting content. Park attendance will be significantly lower even after the virus is contained as economic uncertainty and high unemployment limit discretionary dollars for those pricey admission tickets. Furthermore, movie theater attendance will also be lower for an indefinite period of time, likely causing future box office revenue for Disney’s studios to decline significantly as well.

These dynamics are already playing out in the market with Netflix and Amazon the best performers during the rout, followed by Alphabet and Disney.

Connectivity is Critical

All this content cannot be distributed without the connectivity provided by the telecommunications companies. Comcast’s (CMCSA) Xfinity is the largest internet service provider in the country, followed by AT&T (T) and Verizon (VZ) Fios. None of these three companies have been spared in the recent market sell-off, although Verizon has performed significantly better in relative terms year-to-date. All three also have attractive and safe dividends as measured by their cash dividend payout ratios. As growth rates and Treasury yields fall, the present value of those stable dividends will become more valuable. Furthermore, whether it’s due to remote working or just convenience, internet access anywhere you go is not only expected, but also treated as an essential service.

Profiting from Power

Finally, all of the above need power to work. The utility sector becomes more attractive during economic downturns and periods of low interest rates. Like with the internet service providers discussed above, the stable dividends become more valuable as interest rates fall. In a deflationary environment in which the rates collapse to zero or below in order to spur investment and growth, shares in well-capitalized utilities would be expected to outperform as their stable cash flows become more valuable.

One caveat when buying utilities is to understand the company’s balance sheet. The overuse of debt to increase returns on equity and returns on investment in an attempt to boost earnings is common. Because of this, I suggest gaining exposure to utilities through a low-cost and diversified sector ETF. The Utilities Select Sector SPDR ETF (XLU) is invested across about 30 holdings with NextEra Energy (NEE) the largest single position at about 14%. The fund has an expense ratio of 13 basis points and currently yields over 3%. The Vanguard Utilities ETF (VPU) costs 10 basis points and is allocated across nearly 70 holdings. Again, NextEra is the largest single holding at nearly 13%. Despite their perceived relative safety, utilities have not been immune to the drastic sell-off in recent weeks.

Looking Forward

I anticipate publishing an article in the near future that will be more optimistic, focusing on how to position portfolios during the recovery. Although that might seem far away now, it will happen. Capitalism is not broken; it is simply being put on hold to some extent as we collectively choose the health of our fellow citizens over short-term economics. The recovery will provide exceptional opportunities for investment dollars as this crisis has highlighted numerous vulnerabilities in our economy, our infrastructure, our healthcare system, and many other areas of our daily lives. Creating solutions to these problems and reducing those vulnerabilities will be a profitable endeavor that will reward investors for years to come.

Final Thoughts

The ideas I described above can be interpreted as being tactical given the suggestions to add to specific styles and sectors. Using the above strategies should be looked at within the broader context of the global financial markets and sized appropriately. These suggestions are intended to be incremental moves that tilt the complexion of portfolio assets in a way that may improve investment outcomes. Any overweight or underweight position to an asset class, sector, equity style, or individual stock needs to be considered carefully to understand its impact on long-term total returns. I look forward to your feedback and answering your questions in the comment section below.

Disclosure: I am/we are long AMZN, CMCSA, DIS, GOOG, GOOGL, NEE, NFLX, T, VPU, XLU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Mosaic Advisors (“Mosaic”), including the author, or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level, be suitable for your portfolio or individual situation or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from Mosaic or the author. Mosaic is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the Mosaic’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.

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