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To start off the new year, we want to thank our clients for having the courage to stick with their investments during the pandemic. COVID-19 has been a very personal and very serious health
epidemic. Much like the outbreak of the Spanish Flu of 1918, no one had immunity to COVID-19, and it has proven highly infectious. Community spread has been rampant, and, amazingly, the wearing of masks has remained the main line of defense (pre-vaccine). In the early stages most of us barely knew anyone who had caught the virus. Today, with a death total that exceeds U.S. combat deaths in World War II, knowledge of loss of life due to COVID-19 is commonplace. Sadly, this includes many KCM clients. Our thoughts and prayers go out to their families.

As we will analyze in this newsletter, the impact of the virus has also been seen in job losses, the closure of small businesses, Real GDP, consumer spending, corporate spending, and corporate profits. The impact on states, local governments, and schools has been severe as well. Also, we will discuss the medium-term ramifications of trillions of relief dollars handed out by the Federal government, with potentially more to come. Government debt is simply exploding to the upside.

While most of the above is quite concerning and in some cases tragic, there are bright lights on the horizon. First, despite the plunge in economic activity, the stock market has soared to record highs. Why did such bad news produce positive returns? With FDA approval of two vaccines (and possibly more on the way), the market sees a “back to normal” world relatively soon. It will take time to get the majority of America vaccinated, and the death toll, job loss, and economic activity will likely worsen in the interim. However, during the post vaccination period, (hopefully this summer if all goes well), pent-up demand for virtually everything outside the home will provide a springboard for a dramatic economic recovery in the 2nd half of 2021. Under this scenario, payrolls, personal income and spending, GDP, and corporate profits should all return to or exceed pre-COVID levels.

In more detail it will be certain industries and sectors of the economy that are likely to see dramatic recoveries starting in Q3 2021. These include leisure airline traffic, hotel occupancy, oil demand, concerts, movies and sports attendance, business conferences, health club attendance, restaurant same store sales, cruise line occupancies, elective surgical procedures and mall traffic, among many others. These areas could very well go from recession/depression conditions to boom times.

We believe the mainstay of a healthy stock market in 2021 will be profits, not lower interest rates and their accompanying higher price-to-earnings ratios. Nor will it be lower tax rates. We believe a big improvement in corporate profits is likely, due to a possible secular decline in certain costs. The most obvious savings would be much lower business travel and entertainment expense, lower occupancy / rent expense (due to stay-at-home workers) and lower payrolls as businesses are careful to rehire.

Regarding interest rates, we believe they will rise in 2021. However, we are not yet convinced bond rates will rise enough to compete with stocks. A rise in the 10 year Treasury to 2-2.5% is likely in our view and would be a big move from 1%. However it would still be historically low. This is our base case on rates at present. However, strong arguments could be made that long term Treasury rates will rise much more than our base case. The most common sense argument is that investors will start to demand a real return on bonds. Sometime this year COVID-19 risk will fade, relations with our allies and rivals will improve, global GDP growth will rise sharply, and a pickup in inflation could become a possibility. In other words, the dollar (and Treasury bonds) may no longer be viewed or needed as a safe haven as global risk subsides. To attract future capital, Treasury rates may again have to follow some semblance of a 2% real return plus inflation (the historical pricing model for bonds). This would put the 10 year Treasury rate at 4.5%, a far cry from the current 1.10%.

Another strong argument for higher long-term Treasury rates is the shocking rise in U.S. government debt outstanding. If we get another stimulus package, debt could rise by trillions more. New records have been set in several popular measures of U.S. credit worthiness, which continue to worsen. These include the ratio of government debt/GDP and in government debt per U.S. household. While these numbers alone do not guarantee higher rates, when combined with a changed psychology as described above, the chances get higher. Finally, there is also the possibility that the ratings services could look to downgrade U.S. treasury debt, if there is no plan to lessen the country’s debt burden.

To summarize our thoughts, we see robust U.S. economic growth starting the second half of 2021. We believe the stock market will produce a positive, but more modest return this year. It will be profit driven with no help from P/E expansion, lower interest rates, or lower tax rates. Historically, interest rates need to rise some 300 basis points before stock returns are negatively impacted. We believe long-term (10-year) Treasury rates will rise to 2.5% from around 1.1% currently. The rise will be investor-driven, not Federal Reserve driven as they control short term rates. As global risks subside, U.S. Treasury bonds will no longer trade at large premiums to their intrinsic value. Their demand as safe havens will fade and they will be priced accordingly.

We want to again thank all our clients for trusting KCM to successfully navigate your investments through this difficult period. KCM remains in a very strong position, and we plan to begin hiring more professionals in investment research, portfolio management, and client relations. We will announce new hires as they occur. We believe a broader and deeper team will be a positive for current clients and will allow us to take on new clients. Please keep this in mind as you come across others looking for an experienced, service-oriented money manager with a strong long-term track record. We appreciate your continued support.

KCM Portfolio Management Team

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These are certainly challenging times in which we live. Over the many decades we have been serving clients, it feels like we have seen everything. There have been wars, oil price spikes and crashes, mild recessions, deep recessions, computer-driven bear markets, and tech and real estate bubbles, but we have survived all these events, coming out better than the decline.

Given the significant amount of uncertainty that has kept the market pundits worried over the course of the past decade, such as Brexit, the Trump Presidency, healthcare reform, North Korea, Russia-gate, and trade wars, it took a virus to bring the global economy to its knees and end the historic bull market. Such is the case with a “black swan” event, where an unpredicted crisis comes out of nowhere. The swiftness of economic devastation, not to minimize lives lost to COVID-19, has been extensive. In the U.S. over 38 million workers lost their jobs because of the forced lockdown of businesses and stay at home edicts implemented by cities and states. The unemployment rate spiked from under 4% to near 15% in a matter of months, but has recently fallen to 11% as businesses reopen.

In response, the avalanche of grants, loans, and government stimulus provided to businesses and individuals, as well as massive bond purchases by the Federal Reserve, has been unprecedented. The world’s central banks are committing stimulus funds that far exceeds, by multiple times, what was done during the financial crisis of 2008/2009.

The tug of war between investors that foresee a v-shaped recovery and those that expect a slow and drawn out recession, produces the extreme volatility exhibited in the stock market. As cities and states began reopening, the market rallied.

However, a myriad of potential negatives exist including a sustained spike in coronavirus cases and hospitalizations, higher federal and state taxes needed to pay for debt accumulation, a fading of optimism for a coronavirus vaccine, uncertainty surrounding the Presidential election, and a potential “new normal” of lackluster spending by consumers. While the healthcare system is important to society, consumer spending is a critical engine of the global economy, providing more than two-thirds of U.S. Gross Domestic Product (GDP). Small businesses account for approximately half of U.S. employment, and it will take time to fully recover.

Significant industry changes are occurring and some businesses might be permanently displaced. Even with massive help from the government, it is uncertain if many small businesses will survive. However, this will cause many new entrepreneurs to start businesses, thinking this crisis is an opportunity.

While ecommerce has been taking market share from brick-and-mortar retail for years, the closing of “nonessential” businesses, which are primarily consumer discretionary retail stores, solidifies the major online retailers as the go-to source for shoppers. Video calls have become the new normal, and bandwidth demand will continue to increase, as a growing acceptance of remote working may become a reality. More regulations to keep employees safe in the workplace will be enacted at a time when companies seek to lower infrastructure costs.

The list of changes goes on. We are also anticipating that sporting events will come back soon, as most sports junkies, desperate for fresh content, like seeing history being made rather than reliving it in reruns.

Though there are so many uncertainties flowing through the market, these are truly exciting times to be an investor. At Kornitzer Capital Management (KCM), our core strategies are based upon identifying long-term trends that provide the “hunting areas” for companies that are the beneficiaries of those trends. We do this so our investments have a potential long-term tailwind pushing their business strategy regardless of the current economic conditions. For us, long-term trends are decades or more.

The changes adopted over the past several months, since “social distancing” has become the norm throughout the world, are hopefully a once-in-a-lifetime event. New “normal” social behaviors, that otherwise would have taken a generation to adopt are being widely accepted overnight. It will take more time to determine if this is indeed the “new normal” or not, but regardless, when one’s life or loved one’s life is in peril, inconveniences are more readily adopted.

As we learn more about the COVID-19 virus and how to treat, prevent, and attack it, society will return to normal. Black swan events come and go, but human ingenuity prevails long-term.

MARKET OUTLOOK
As the daily case count of the COVID-19 virus in the U.S. has shifted back into its growth phase, following the reopening of the economy, many regions are re-instituting lockdown measures in response. This could disrupt what has been an improving outlook for consumer sentiment, consumer spending, and unemployment.

However, weighing these outstanding risks, with valuation trading near all-time highs, leads us to be cautious with our near term outlook. The broader risk / reward setup seems challenged without more clarity on the trajectory of the virus or a medical breakthrough on the vaccine or treatment front.

At KCM we will continue to be selective in our portfolio holdings and own stocks with great long-term outlooks that can manage through this current environment.

We, like everyone else, CANNOT predict what is going to happen. The only thing we can do is do our best at research and execution to achieve the best results long-term. We encourage all our clients to look at their budgets, to come up with a realistic spending pattern going into the tough times ahead. It is certain that without a vaccine, or a drug that will prevent death, life and spending are going to change until this happens. God bless you all and stay safe.

KCM Portfolio Management Team

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During these trying times, we are reminded of an old movie called “Mrs. Miniver” that was set in World War II-era London. The sacrifices and challenges the world faced, as seen in the movie, is very reminiscent of what we are experiencing today. Thankfully, more often than not, troubling times bring out the best in people. America and our fellow human beings around the world will show up to fight, endure, and overcome the coronavirus. These are adverse circumstances in which we find ourselves in. No government was prepared for this unfortunate outbreak. Even though we are a democracy with freedom for all, we know 100% observance of shelter-from-home orders is not easy.

However, we must all do our part if we want this outbreak to pass. We believe the recently approved coronavirus stimulus package combined with the Federal Reserve’s ability and willingness to print trillions of dollars should help cushion a longer and steeper downturn. Roughly half the money will benefit individuals directly (checks in the mail and greater unemployment benefits) and indirectly (forgivable loans to small businesses who keep their workers on the payroll). To gain proper perspective, the $2.2 trillion package (if it is all spent) would roughly offset a 10% drop in annual GDP. Will this be enough? No one knows for certain.

The impact on the financial markets has been dramatic. The stock market declined 34% from its peak to its recent trough, making it the third worst decline in the past 45 years. In a flight to safety the ten-year Treasury yield dipped below 0.5%, but corporate bond yields rose sharply due to concerns over rating downgrades, possible bankruptcies and reduced liquidity. The stock market gained back some ground in recent weeks as the economic stimulus bill was passed. Also, the Federal Reserve dropped their lending rate to 0% and pledged trillions for open market purchases. These included investment grade corporate bonds, Treasury bonds, asset and mortgage backed securities, commercial paper, municipal securities, bond ETFs — and they guaranteed the safety of money market funds.

Finally, as part of the stimulus package, the Federal Reserve will provide funds for low interest loans to large corporations in financial distress. These actions greatly improved confidence and liquidity and allowed numerous large corporations to issue a record number of bonds at reasonable interest rates. This is very good news. However, nobody knows the extent of damage to small businesses or the speed at which they will recover, or what percent of these business will recover.

What should we expect in the coming weeks and months? In our earlier communications we suggested a steep but short-lived recession was most likely. We also hinted that no one could predict the stock market bottom but the recovery would be V-shaped and prices would be marked up very quickly. We still expect a full recovery but getting there may take a bit longer.

During this difficult period, it is important to put things in proper perspective. Beating the coronavirus outbreak requires some personal sacrifice, as we are all in this together. Most people in the U.S. will remain healthy, and we expect individuals will resume their normal lives in a matter of months, or up to one year for elderly individuals.

We expect a national lockdown will work and new case growth will slow and eventually peak. This expectation will be reinforced by a clear peak in Europe. The market will then begin a slow but steady rise with reduced volatility.

Our investment strategy with your money is to gradually buy more shares of great companies on down days. During any period of weakness, we will also upgrade the quality of existing holdings when it makes sense to do so. We want no impediments to the upside when the recovery takes hold. We will continue to research each company we own to verify its safety and ability to pay dividends, if needed.

We welcome your questions and comments and we will continue to keep you apprised of our thoughts in future communications as needed.

KCM Portfolio Management Team