Market Commentary
July 2020
By: Pat Guinet, CIMA®
2nd Quarter Market Recap
Equity investors have been on quite a roller-coaster ride this year. After hitting an all-time high on February 19, the S&P 500 Index plunged a gut-wrenching 34% over the next month, marking the quickest bear market in U.S. history. Smaller company stocks did even worse during that period, losing more than 40%. Investors who remained strapped in as we did—keeping our arms and legs inside the car at all times, of course—then experienced an equally surprising and gravity-defying upturn. From the March 23 low, the market soared nearly 40%, notching its best return ever over any 50-day period. Talk about whiplash. For the full second quarter, larger-cap U.S. stocks gained 21% and smaller-cap stocks climbed 25% (Vanguard 500 Index and the iShares Russell 2000 ETF, respectively). Despite the medical, economic, and social turmoil all around, the U.S. market is down just 3% year to date and is only 8% below its all-time high on February 19. (As a reminder, after a 34% drop it takes a 52% gain to get back to breakeven.)
However, there is a major bifurcation beneath the surface. The Russell 1000 Growth Index is up 10% on the year, but its Value sibling is down 16%. That’s a stunning 26-percentage-point difference in only six months. Viewed from another angle, the tech-heavy Nasdaq Index is up 13%, while the Dow Jones Industrial Average languishes, down 8%. One more perspective: The S&P 500 technology sector is up 12% on the year, while the financials, industrials, and energy sectors are down 24%, 14%, and 35%, respectively. So for many companies, things are not nearly as sanguine as they may appear looking only at the market overall.
Looking overseas, developed international stocks rose 17% (the Vanguard FTSE Developed Markets ETF) and emerging markets (EM) stocks gained 19% (the Vanguard FTSE Emerging Markets ETF) in the second quarter. For the year, they are down 11% and 10%, respectively. As in the United States, growth stocks are crushing value stocks overseas as well. The U.S. dollar depreciated slightly during the quarter, providing a modest tailwind to foreign market returns for dollar-based (unhedged) investors.
Moving on to the fixed-income markets, core bonds gained almost 3% for the quarter (Vanguard Total Bond Market Index), as Treasury yields dropped slightly (falling bond yields imply rising bond prices) and investment-grade corporate bond spreads narrowed, rallying along with the equity markets.
As the market continued to drop, we were prepared to add another increment to U.S. stocks. But, (no) thanks to the Federal Reserve’s massive “whatever it takes” monetary interventions, we didn’t get the chance. We don’t rule out the possibility U.S. stocks will revisit their March lows (2,237 on the S&P 500) and we are ready to act again when a compelling opportunity arises.
The Economy
As always, we see a range of potential economic and financial market outcomes looking ahead over the next six to 12 months and beyond. What’s unique about the current environment is how dependent the outcomes are on the course of COVID-19. Significant uncertainty remains as to the virus’s progression, even as economies around the globe start to reopen and relax social distancing standards. The timing, availability and effectiveness of treatments and vaccines are also highly uncertain but crucial variables for the economic outlook.
In our view, the key risk to the economy and financial markets is the potential for a widespread second wave of COVID-19 infections, hospitalizations, and deaths that force another large-scale economic shutdown. In that event, stocks could re-test their March lows. We are prepared for that dire scenario with our portfolio holdings in core bonds, Treasuries, and alternative strategies. But absent a severe second wave (or some other major exogenous shock), and even assuming there are smaller localized outbreaks, we think an uneven but steadfast economic recovery is the most likely scenario looking out over the next six to 12 months at least.
While we view the progression of COVID-19 as the most important driver of the near-term economic and market outlook, monetary and fiscal policy are second-most in importance. And, in the policy sphere, the Fed is key. After the Federal Open Market Committee (FOMC) meeting in June, Fed chair Jerome Powell made it very clear the Fed intends to keep monetary policy extremely accommodative for the foreseeable future. In addition, 15 of 17 FOMC participants expect the federal funds policy rate to remain near-zero at least through the end of 2022. Moreover, the Fed restarted large-scale quantitative easing (QE). The Fed is leading the way for other global central banks to enact their own extremely loose monetary policies. Moreover, the Fed restarted large-scale quantitative easing (QE), committing to purchase $120 billion per month of Treasury and agency mortgage-backed securities. According to Ned Davis Research, 97% of all central banks are now in an easing cycle (cutting rates), and 87% of central banks have their current target interest rate at a record low level.
On the QE front, global central bank balance sheets, in aggregate, have increased to a record 38% of global GDP. The Fed’s balance sheet stands at a record 33% of U.S. GDP and climbing. Similarly, for the European Central Bank at 44% of GDP and the Bank of Japan’s balance sheet at a whopping 118% of Japan’s GDP.
On the fiscal policy side, global fiscal stimulus and support programs have also been unprecedented, much larger than during the financial crisis of 2008–09 for most countries. Another trillion-ish dollar fiscal stimulus package in the U.S. seems likely later this summer as both the White House and Democrats (if not yet congressional Republicans) favor additional government spending to support households and business to get through the medical crisis.
This monetary and fiscal support helped prevent a depressionary spiral from taking hold as the pandemic crisis peaked in March/April. It now looks like the U.S. and global economies may have bottomed in April and are on the upswing, albeit from severe recessionary levels. Recent U.S. economic data have been much better than expected—most notably the surprisingly strong May payrolls (2.5 million jobs added) and retail sales reports.
But as Guggenheim Investments recently wrote (and we agree): “Ultimately, monetary and fiscal policy will take a backseat to public health policy. Progress in testing, treatment, non-pharmaceutical intervention and vaccine development will be the biggest determinants in the shaping of the [economic] recovery.”
Given All This Stimulus, Is Inflation a Risk? Not Now, Maybe Later
We’re seeing a lot of discussion in the financial press about the risk of inflation in the United States given the massive stimulus from the Fed along with the multi-trillion-dollar debt-financed fiscal support programs. We don’t see inflation as a near-term risk given the strong disinflationary impact of the pandemic. But we can envision a scenario where the current reflationary policies set the stage for an inflationary environment a few years down the road.
It’s true that the Fed’s aggressive stimulus has caused the growth rate in the money supply (M2) to soar to an extraordinary 24% year over year rate. This is unprecedented. But it shouldn’t be immediately inflationary because the velocity of money (how often a dollar changes hands in economic transactions in a given period)—which Friedman ignored—has dropped to an all-time low. Falling money velocity offsets the surging money supply.
The Fed is also apparently content to effectively monetize the debt created by government deficit spending. If the Fed continues these policies beyond the COVID-19 crisis, it runs the risk of falling behind the inflation curve. This could lead to an inflationary surprise and a sharp repricing of assets
Other Risks
Besides a resurgence in the pandemic, there are several other macro risks to be aware of. We’ll name the four at the top of our list:
Financial Markets
Given this economic backdrop, we see both risks and opportunities for financial assets. In addition to the list cited above, the primary market risk we see is overvaluation, which implies poor forward-looking returns for both core bonds and U.S. stocks.
Closing Thoughts
So where does this leave us? We believe our portfolios are prepared for a resurgence in the coronavirus as economies start to reopen and also potentially due to seasonal factors later in the year. Of course, there are other uncertainties looming in the near distance that could disrupt financial markets as well, such as the November election and U.S.-China geopolitical frictions.
But we also hold a cautiously optimistic view that even with an inevitable uptick in COVID-19 cases in coming months, the overall social policy response won’t need to be as draconian, and therefore the economic impact won’t be as bad as during this first wave.
If the latter public health scenario plays out against a backdrop of extremely loose fiscal and monetary policy, there is a good chance we’ll get a sustainable, albeit uneven, global economic recovery. It’s unlikely to be a sharp V-shaped recovery, but something more gradual, with fits and starts along the way and some sectors and industries doing much better than others. If so, corporate earnings are likely to rebound as well. Measured against very low interest rates—and with fears of severe recession (or worse) off the table thanks to the policy response.
In sum, we see several ways for our portfolios to “win” looking out over the next five to 10 years. But we should also prepare ourselves for a potential double-dip back down to the late-March market lows, most likely caused by disappointing developments on the virus/medical front. As always, it is so important to be invested in the right portfolio aligned with your risk tolerance and financial goals. This should enable you to keep a healthy long-term perspective and to remain disciplined and “stay the course” through the inevitable downdrafts when fear in the markets is palpable.
