The first six months of 2020 will likely go down in history as one of the most extraordinary periods of all time. The COVID-19 pandemic brought the global economy to a standstill in March, and has triggered a slew of subsequent actions by world governments and central banks that, while beneficial in the short-term, could possibly take years to unwind to ensure a complete economic recovery. While long-term prospects remain bullish, the next few quarters are expected to be extremely volatile from both a market and overall economic perspective. Ultimately, there is a tremendous amount of uncertainty and unknowns surrounding the projected length and strength of an eventual recovery, due largely to the uncertainty surrounding virus itself. That being said, there is plenty of evidence to support long-term economic optimism, as long as businesses and investors are capable of continuing to weather the current storm in the short to intermediate term.
As of 7/15/20, the CDC is reporting COVID-19 (“COVID”) infections and fatalities in the US of approx. 3.4 million and 135,000, respectively.vi By comparison, global infections and fatalities currently stand at roughly 13.5 million and 581,000, respectively.vii While the current pandemic has left no corner of the world unscathed, the data reveals that Americans account for roughly 25% of global infections and 23% of global fatalities. Considering that we represent only 4.25% of the world’s population, the numbers are particularly alarming. Furthermore, while nations in Europe and Asia were also hit hard by the “first wave” of coronavirus, the majority have effectively contained the spread, as evidenced by new daily infection rates of fewer than 10 per million. By comparison, the US is currently trending in the opposite direction at new daily cases of nearly 150 per million, or roughly 50,000/day (2nd highest behind Brazil).i
The Fed reacted to market volatility in early February with a fast and aggressive policy response that started with the Global Financial Crisis (GFC) playbook and then went significantly further. These actions included cutting interest rates back to zero and initiating a fresh round of quantitative easing, both of which will continue to have a significant impact on the markets in the coming quarters. Specifically, the Fed has injected approximately $2.9 trillion into the economy over the past three months in the form of Treasury and other fixed income asset purchases (MBS, bond ETFs, etc.). This is arguably the most aggressive stimulus response in the Fed’s history and nearly totals the amount provided over 60 months during the GFC. These actions have been critical to help stabilize markets and address corporate liquidity needs stemming from the pandemic-led economic shutdowns. Furthermore, these actions have signaled to the economy that the Fed stands poised and ready to use its full arsenal to help support businesses during these difficult times, a stance Chairman Powell continues to reiterate verbally. Essentially, the Fed’s actions have monetized federal debt, which in turn has enabled Congress to implement its most aggressive fiscal stimulus packages since World War II.ii At present, the Fed’s balance sheet sits at roughly $4.2T of Treasuries and roughly $1.9T of MBS and other related debt. This is expected to grow at roughly $12B per month and finish the year at approx. $4.7T and $2.2T, respectively.iv
Turning to Congress, through measures like the CARES Act, the federal government has effectively provided financial relief in the form of direct loans to businesses and enhanced unemployment subsidies to individuals. By the end of 2Q20, COVID-related fiscal stimulus totaled $2.4T, representing approximately 11.8% of GDP.ii The first round of stimulus will expire this month, which means that subsequent fiscal aid packages will likely be needed to continue to weather the current storm. Powell has reiterated this sentiment on a regular basis, and will likely continue to urge Congress to follow its lead in utilizing the totality of its resources to smooth the transition out of recession.
Despite the strong Federal response, State and local governments have not fared well. City and state budgets have been decimated by a combination of substantial tax revenue declines and high unemployment benefit payouts. Furthermore, this sector of the workforce has been hit hard by furloughs and layoffs, as local legislators race to cut costs in the face of rapidly rising budget shortfalls.iv Unless future federal stimulus packages include funds for these entities, it is unlikely that municipalities will be able to sustain their current levels of fiscal support for their citizenry without additional tax measures or a decrease in services. The tax revenue gap at the state and municipal level could materially disrupt short-term recovery prospects and dislocate a significant portion of the 20 million workers that local governments currently employ. Additionally, while the federal government is in a much better state of solvency due to the vast array of resources at its disposal, it’s important to note that the federal deficit has also skyrocketed as a result of the COVID crisis. At this time, outstanding federal debt is expected to hit 130% of GDP by year-end (79.2% in 2019).iv While this doesn’t pose significant near-term risks, long-term recovery trends could be materially undermined if tax rate increases are required to offset unmanageable debt levels.
One of the main concerns classical economists have with government monetary/fiscal intervention is the potential for these actions to cause inflation rates to rise to undesirable levels. Although this argument is not without merit, currently the Fed does not deem inflation risk as near-medium term concern. As we’ve mentioned in previous newsletters, inflation rates have remained surprisingly low throughout the expansion, largely due to relatively sluggish wage growth, compared to historical averages, coupled with the disinflationary impact of technology. Inflation (measured by Core CPI) finished the quarter at 1.2%, well below the Fed’s 2% target level, and is projected to finish 2020 at around 1.9%. While still a factor that could eventually impact long-term growth, inflation is expected to remain subdued over the next few years, making it a lower priority concern given the circumstances.viii
Looking back on the first quarter of 2020, real GDP increased a mere 0.3% YoY, and was down -5.0% from the previous quarter.iii While it’s no secret that the economic shutdown is largely to blame for this sluggish performance, it’s worth noting that our economic shutdowns weren’t officially enacted until mid-March. The out-sized negative drag that those two weeks had on domestic output doesn’t bode well for 2Q20 prospects, as the nearly three-month lockdown is expected to result in the weakest quarterly GDP data in our nation’s history. Although it’s still too early to nail down specific numbers at this time, industry analysts anticipate 2Q20 GDP declines of between -20% and -40%.iv However, as local governments have begun to gradually reopen their state economies, productivity is expected to rebound, albeit at a much more subdued pace. While the path of the pandemic is difficult to project, we believe it seems unlikely that another broad nationwide lockdown is in the cards, which leaves at least some room for optimism that output will modestly recover through the remainder of the year. The Fed’s revised economic forecast released in June 2020 further supports this thesis, reflecting YoY GDP growth of -6.5% for 2020. While disappointing, projections over the next two years are more favorable, with annual GDP growth estimates for 2021 and 2022 of 5.0% and 3.5%, respectively.viii
Of course, any projections at this time are somewhat hindered by the unknowns related to COVID-19. If new infections continue to rise, rolling shutdowns at the regional level may be implemented to curb localized outbreaks, further disrupting economic prospects. On the other hand, significant advancements in vaccine development and treatment alternatives could expedite a return to “normalcy.”
As a result of the pandemic and mandated economic shutdown, domestic payrolls declined by over 22 million jobs, due to furloughs and permanent layoffs. By comparison, job losses during the worst 18 months of the GFC (12/2007 – 6/2009) were approximately 7.5 million.iv After peaking in April at 14.7%, unemployment ticked down to 13.3% in May (adding back 2.7 million jobs) and 11.1% (additional 4.8 million) in June (50-yr avg. is 6.2%).v Per their June report, the Fed currently projects unemployment to finish the year at approx. 9.3%.viii Whether or not unemployment rates continue to exhibit positive trends will largely depend on how well small businesses fare. Unlike their larger corporate counterparts, small businesses are more susceptible to economic downturns. A prolonged recession could start to force more small businesses to either reduce payrolls further, or in some cases even close permanently. Given that about 35% of all jobs come from small businesses (as defined by 1-19 employees), a shock to this sector of the economy could substantially disrupt employment recovery prospects.iv
Ultimately, the accuracy of GDP projections and the trajectory of the economy will largely depend on consumers. Specifically, the degree to which people feel safe enough to revisit their normal spending habits will be a primary driver in the pace of the recovery. Roughly 70% of domestic GDP is derived from personal consumption. While local economies may technically remain open going forward, it remains to be seen how eagerly the general public will reengage their pre-COVID lifestyles, or if they’ll continue to opt out of prior consumption activities due to safety or economic concerns.
Despite all the turmoil, there is some good news to report regarding the American consumer. Buoyed by government intervention relating to wage support, the recent shutdown has yet to result in a subsequent deterioration of household balance sheets. On the contrary, heading into 3Q20 consumer savings have surged by 33%.iv This is likely the result of a few factors including the continuity of wages as well as general limitations of spending options due to business closures. That being said, retail sales grew by 7.5% in June, following a strong growth in May of 18.2%. Just two months ago, retail sales were down -19.9% YoY and now, in June, are up 1.1% from June 2019. For more perspective, from February (pre-COVID shutdowns) to the bottom in April, retail sales fell -21.7%. Now, with June’s increase, we are only 0.6% below the February mark, a solid start to the recovery process. While this is certainly a good sign for recovery prospects, it is important to understand the role government has played in driving this trend.v As long as fiscal stimulus continues, and to a lesser degree forbearance on loans and housing, we believe the consumer should be able to weather the current economic climate over the short-term. Should Congress decide to discontinue emergency fiscal measures, shutdowns be reenacted, and the recession last longer than anticipated, consumer balance sheets and spending would likely decline.
2Q20 corporate earnings will likely suffer their worst quarter returns on record thanks in large part to the nearly 3-month government mandated shutdown. While it’s still too early to know the full scope of these declines, S&P 500 companies are expected to see declines of roughly -20% to -25%, with Energy (-105%), Consumer Discretionary (-57%), Industrials (-49%), and Financials (-36%) being among the hardest hit sectors. Additionally, corporate debt has skyrocketed by $1 trillion in response to the COVID crisis, which reflects a YoY increase of nearly 100%.iii
After an unprecedented decline in crude oil at the beginning of the quarter, which even saw WTI Futures temporarily drop to negative territory for a day towards the end of April, oil prices have rebounded considerably since the global economy has reopened. We believe the initial shock was due to a compounding of two events, either of which would likely have been enough on their own to spur a recession. The first event was the obvious dramatic decline in demand due to the virtual shutdown of economic activity on a global scale. The second was more geo-political in nature, as Russia and OPEC+ spent much of the early days of COVID engaged in a production dispute, effectively creating a short-term price war that exacerbated already historic demand declines. As of 6/30/20, oil spot prices stood at roughly $39.27 per barrel.iii Despite being a welcome improvement, more price appreciation will be needed to ensure the stability of our domestic energy sector, which typically requires a spot price of around $45 per barrel to breakeven. Although energy demand is far from pre-COVID levels, gasoline sales for automobiles appear to have recovered sharply after a YoY decline of -48% in April.iv
Financials also struggled in 2Q20, as the rapid reduction of interest rates has resulted in lower than expected revenue generation. We’ve seen the impact of this lost revenue play out in recent days, as many of the top banks, despite higher than expected earnings data, seem poised to consider cutting dividends in 3Q20. Some good news for the industry comes in the form of new mortgage and business applications, which have largely returned to pre-COVID levels, as of the end of June.
Finally, rapid deterioration across the travel and hospitality industry has been perhaps the most publicized of all. Airlines, saw average daily passenger volume of 2.5 million per day drop to as low as 100,000 per day, before finishing Q2 at roughly 500,000 per day, and -80% decline. Furthermore, hotels, restaurants, and live entertainment events are expected to be the last industries to recapture pre-COVID levels, as they are plagued with inherently anti-social distancing characteristics and are discretionary in nature. These industries employ approximately 15 million Americans and are unlikely to see a full recovery for quite some time.iv
Not all economic data has been distressing, however, as a few select industries have seen resiliency and even tailwinds in the face of the global health pandemic. Technology solutions, particularly those supporting the “work-from-home” environment, have performed relatively well throughout the crisis finishing the quarter with positive YoY earnings growth of 1%. Utilities earnings are also up by 1% YoY, due to the inelasticity of their services. Additionally, while the overall health care industry is down -3% YoY, this is a relatively modest amount when compared to other sectors and will likely rebound considerably has new vaccines and treatments are introduced.iii
On March 23rd, the S&P 500 dipped to its lowest point since 2017, down -34% from it’s all-time high, achieved only one month prior. However, the selloff was sharp and short lived. While the health-related effects of COVID-19 were still playing out in the second quarter, stock prices staged one of the most impressive rallies on record as investors attempted to discount the magnitude and timing of an economic recovery. The S&P 500 surged approx. 45% from its low on March 23rd to the Q2 high on June 8th, finishing the quarter up approx. 39% from its March lows. While the rebound has definitely been well received by investors, this remarkable feat is not without caveats. Specifically, it’s hard to recall a time when market prices have been so dislocated from economic reality. While it’s true that stock prices reflect investor sentiment about future recovery and profitability prospects, the most recent run-up occurred against the backdrop of virtually zero economic output and historically high unemployment rates. In fact the majority of the rebound occurred while Americans were still under federally mandated quarantine restrictions.
We believe the current upward trend seems to be driven by two primary factors. The first appears to be a belief that since the economic downturn was self-imposed, a re-opening of the economy might enable a recovery approximating the strength experienced prior to the lockdown. The second is the unparalleled level of support we have seen from the Fed. As mentioned earlier, unprecedented quantitative easing measures have effectively indicated to the investing public that the Federal Reserve will do whatever it takes to prevent markets from unnaturally failing. Thanks largely to aggressive bond purchases and enhanced liquidity measures, investors seem to have mostly dismissed 2Q20 economic data as a mere blip on the radar, and instead have interpreted the Fed’s actions as indication that a rapid recovery will play out in the short-term. However, this doesn’t align with Chairman Powell’s rhetoric, which seems to consistently support the belief that a more protracted downturn and slower recovery are the likely outcomes.
Regardless, the continuity of payrolls, stronger than expected job reports, and a rebound in consumer spending has provided the fuel necessary to drive the near-term market recovery. As of 6/30/20, the S&P 500 was down only -3% YTD, while the Nasdaq 100 actually gained 16.7% for the year. These returns don’t line up with the estimated -28% earnings decline, which has resulted in historically high valuation metrics. S&P 500 companies are trading at a P/E multiple of roughly 21.7x YTD, considerably higher than the 25-year avg. of 16.39x and above valuation levels in February when the market hit all-time highs.iii On a relative basis, equities are more expensive today, at lower price points and with extreme levels of economic uncertainty, than they were pre-COVID. While this data alone is somewhat inconclusive, it seems to imply that a potential correction could be on the horizon over the next 1-2 quarters. Looking deeper into the numbers, we see that most pain has been felt in the sectors most vulnerable to the pandemic. Despite some positive regression, energy stocks are still down -35.3% YTD, while financials and industrials have also experienced significant price depreciation of -23.1% and -14.0%, respectively. Small caps and mid caps have not rebounded as quickly as large caps with both still posting negative returns for the year of -9.1% and -13.0%, respectively. On the international front, the MSCI All Country World Index (ex-US) is still down -11%YTD, with emerging markets finishing the quarter down -9.8% YTD.
Another notable factor driving the most recent market recovery has been the emergence of the mega-cap technology firm. Specifically, six companies (FAANG +) account for nearly 25% of total S&P 500 value, and have returned 19.7% YTD compared to -4.2% for the rest of the index.iv While there is some merit to the sharp price appreciation for this group, it remains to be seen how much further they can continue to carry the broader market. Regardless, it is apparent that the technology sector overall (up 12.2% YTD) was a significant catalyst for 2Q20 returns, and we believe it will likely continue to be a dominant market driving force going forward as companies adapt to a more remote work environment and in this post-COVID world.
The current interest rate landscape has been radically changed by deflationary pressures related to slower global growth rates, dovish monetary policies, and new quantitative easing measures. The 10-year Treasury serves as a stark example of these changes, dipping below 1.0% for first time ever in the first quarter and finishing 2Q20 yielding a mere 0.66%. Despite historically low yields, traditional fixed income investments have rebounded rather quickly from the initial economic shock in March. As of 6/30/20, YTD returns on investment grade corporate debt were approx. 5.0% with high-yield debt lagging at -5.2%, but having recouped a significant amount of its double-digit loss from 1Q20. Despite these favorable trends, analysts believe the bond market may be running out of steam as price appreciation gives way to low income yields. Furthermore, YTD high-yield default rates finished 2Q20 at 4.8%, which is well above the 30-year average (3.6%) and likely to creep up further as stimulus begins to fade.iii While the Fed, has effectively protected the bond market in the short-run, its actions have also severely limited the income stream provided by bonds going forward and heightens the risk of capital losses if and when government intervention becomes less dovish. However, thanks largely to the rapid recovery in spreads, credit market valuations still appear relatively cheap compared to equities.iv
Although short-term economic and market expectations are somewhat murky and unpredictable, it appears to us that long-term prospects for investors remain intact. The Fed has already demonstrated a willingness to aggressively intervene where necessary to mitigate the impact of a worst-case scenario (a protracted recession). While it’s possible that periodic business closures may be implemented at the regional level to combat localized contagion emergencies as they arise, a second national shutdown seems unexpected at this point. Although dovish monetary and fiscal policies are likely to continue buoying markets for the remainder of the year, it remains to be seen whether or not those measures can effectively outlast the COVID recession. As such, we believe investors should likely prepare for volatility over the near-term and lean towards quality in both equity and fixed income markets where possible. Furthermore, while current market dislocation implies there may be buying opportunities down the road, we believe attempting to time the market in an environment of such unprecedented short-term uncertainty is a recipe for disaster.
While conservative investors may be justifiably inclined to hold larger cash positions than usual, history shows us that maintaining a disciplined approach through these periods by staying invested at a suitable level of risk, provides the most upside potential over the long-term. That being said, for those looking to further reduce risk and increase diversification, there are alternative strategies that can be implemented to minimize downside risk, while still providing upside return potential. As always, we strongly encourage clients to revisit asset allocation strategies with their investment advisor to ensure they remain on track to achieve their short and long-term goals and objectives. While face to face meetings are not always an option in times of an historic health crisis, our advisors are available virtually to talk you through the strategies best suited for you and your family.
|Kristofer R. Gray, CFP®, CRPS, C(k)P®, MPA|
|Andrew Mescon, MBA|
VP of Strategy
Chief Investment Officer
Sources: i. J.P. Morgan – Eye on the Market (7/7/20), ii. J.P. Morgan – Economic and Market Update (6/30/20), iii. J.P. Morgan – Guide to the Markets 3Q20 (6/20/20), iv. FS Investments – Q3 Economic Outlook (6/26/30), v. https://www.ftportfolios.com/retail/blogs/economics/index.aspx, vi. https://www.cdc.gov/coronavirus/2019-ncov/cases-updates/cases-in-us.html, vii. https://www.worldometers.info/coronavirus/, viii. https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20200610.htm
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