The elephant in the room right now seems to be the upcoming election and the potential market volatility that could follow. If there is one thing you take away from this update, we hope it will be the knowledge that trying to time markets around this event is a mistake and a losing proposition. When and how you invest should not be predicated on what happens on November 3rd. That doesn’t mean that there won’t be market fluctuations surrounding the election, but rather that those fluctuations are temporary, extremely unpredictable, and historically settle down within a relatively short period of time. Hundreds of years of historical data supports this, and while one can cherry pick certain snapshots in time to try to prove one party is more favorable for markets than the other, the performance gap between Democrat and Republican governments evaporates as the sample size grows.
If we examine historical market returns during election years dating all the way back to 1860, we see that a traditional 60/40 portfolio (60% equities and 40% bonds) experienced average election-year returns of 8.9%, compared to 8.1% in nonelection years. Furthermore, average volatility for the S&P 500 in the 100 days leading up to elections and 100 days following elections are exactly 13.8%, respectively. ix For those who remain adamant that one party is better for financial markets than the other, it’s worth noting that since 1926, the S&P 500 has averaged returns of 14.5% during the 13 years Republicans have controlled all three houses of government, and 14.5% in the 34 years Democrats have controlled all three houses of government. viii All this data seems to point to something most investors have an extremely difficult time accepting, which is that markets are not political and simply do not care who controls the government over the long run. Despite the data, this particular election does come with a whole bag of “never happened before” that is worth noting. In the middle of a global pandemic and on the heels of an economic shutdown, the extreme level of political divisiveness permeating the general population, coupled with the relatively high likelihood of a contested election, seems to put a slight wrinkle into the “elections don’t matter” axiom. Derivative markets are currently reflecting unusually high demand for market “sell-off insurance,” while volatility metrics are extended out further than is typical around elections. Again, this is largely due to the fact that investors believe there is a good chance the election will be contested, rather than a decision about whether one candidate would be better for markets than the other. iv While it is possible, and even likely, that volatility around this particular election will be more pronounced and potentially longer than usual, long-term market performance is driven by fundamentals rather than sentiment. The uncertainty of a contested election will eventually subside once a winner is ultimately determined, and markets will likely follow suit shortly thereafter. That said, as we will discuss in the economic section, our nation’s current financial condition requires certain economic policy remedies (such as additional fiscal stimulus in the short-term, and tax increases at some point further down the road) that both parties will be forced to come together to implement in one fashion or another.
While it’s true that past performance does not guarantee future results, there are some general principles to investing that we believe have proven reliable since the inception of financial markets. Specifically, deploying a disciplined dollar-cost averaging strategy, even during temporary periods of market distress, provides the highest probability of favorable long-term investment returns. To the contrary, implementing market timing strategies, particularly around unpredictable geopolitical events, underperforms the former approach more often than not.
While the pandemic has left no corner of the world unscathed, Americans account for roughly 20% of global infections and fatalities, yet comprise only 4.3% of the world’s population. i That being said, we did begin to see progress in 3Q20, as daily infection rates finally started to trend downward for the first time since the pandemic began. Although this reversed slightly in September as schools began to reopen, and is expected to be further exacerbated by the beginning of flu season, it seems that Americans are increasingly taking the necessary precautions to limit viral spread. Furthermore, daily reported deaths have fallen consistently throughout the quarter. ii Advancements in treatment and safety protocols appear to have curtailed effective fatality rates, with recent estimates checking in at around 0.5%. iii
More good news appears to be on the horizon as more than 200 vaccines are currently in development, 11 of which are in final testing and development stages. While a specific timeframe is difficult to nail down, most estimates project a handful of these vaccines to be approved by year-end. If true, this could result in a target for full public accessibility by the middle of 2021. Of course the effectiveness and availability of any vaccine is still difficult to project with any level of certainty at this time. Furthermore, even with a vaccine, it appears that most economists believe a return to “normalcy” will take all of 2021 to achieve, as the pandemic is likely to continue to have a residual dragging effect on economic activity until the virus is substantially flushed from the global population. iii
The Fed reacted to market volatility in early February with a fast and aggressive policy response that started with the playbook from the Global Financial Crisis (GFC) and then went significantly further. These actions included slashing interest rates back to zero and initiating a fresh round of quantitative easing, both of which will continue to have an enormous impact on the economy and investors in the coming quarters. iv Specifically, since the start of 2020, the Fed’s balance sheet has grown by nearly $3 trillion. This is arguably the most aggressive stimulus response in the Fed’s history and nearly totals the same amount of stimulus provided over 60 months during the GFC. These actions have been critical in helping to stabilize markets and address corporate liquidity demand related to the COVID economic shutdown. More importantly, it signaled to the economy that the Fed stands ready to use its full arsenal to help support businesses during these difficult and unprecedented times. 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. iii At present, the Fed’s balance sheet sits at roughly $4.4 trillion of Treasuries and $2.0 trillion of MBS and other related debt (approx. 15% increase from the previous quarter), and is expected to finish the year at approximately $5.4T and $2.5T, respectively. v The Fed’s two primary stated responsibilities are supporting employment and stabilizing long-term inflation. The massive monetary stimulus has been intended to address the former, which it seems to have aided at least over the short-term.
In regards to its second objective, inflation control, the recent aggressive actions have created a scenario that could potentially be problematic over the long-term, but is currently less concerning due to abnormally low rates of inflation leading up to the recession. Already low inflation rates, coupled with a collapse in oil prices, continued to decline in 2Q20, with YoY change in the CPI falling as low as 0.2% in May (1.2% excluding food and energy). Since then, inflation has somewhat stabilized, with YoY CPI rising to 1.3% overall (1.7% excluding food and energy). With inflation still well below the 2% target level, the Fed amended its prior position on interest rates, which is its primary tool to for implementing inflationary control policies. After slashing the federal funds rate down to the 0-0.25% range in March, the Fed announced in August that it would pursue a policy of “Average Inflation Targeting.” Essentially, this means that rather than raise interest rates once inflation hits the 2% target rate, it will look to maintain the current rate posture for a while after the target has been met, until it appears inflation is on track to moderately exceed 2% going forward. While the duration of time before rates are eventually increased again is unknown, the Fed indicated it has no plans to raise rates through 2023, and will likely wait until the U.S. labor market achieves “full employment” before implementing new rate hikes. iii
On the international front, global central banks appear to be following the Fed’s lead, as many have implemented similar easing measures to support their respective economies. Specifically, nations like Canada and the U.K. have set their equivalent rates within the same 0-0.25% range, while the European Central Bank and Bank of Japan have actually moved into negative rate territory. In fact, of the largest international central banks, only China has maintained interest rates comparable to pre-COVID levels, with its loan prime rate currently sitting at 3.85%. vi While it remains to be seen which economies emerge first from the current recession, the overall posture of their central banks indicates that a V-shaped recovery is not anticipated to occur in the short-term.
Turning to Congress, through measures like the CARES Act, the federal government has provided financial relief in the form of direct loans to business and enhanced unemployment subsidies to individuals. By the end of 3Q20, COVID-related fiscal stimulus totaled $2.4 trillion, more than double the 2009 stimulus package, and representing approx. 11.8% of GDP. vii However, despite continued insistence from the Fed and leading Wall Street analysts that additional stimulus will be required in order to achieve full recovery, Congress has thus far been unable to agree to a second package, with Democrats seeking roughly $2.5-$3.5 trillion of additional support and Republicans holding firm at $1.0-$1.5 trillion. While it’s not unusual for the Left and Right to be at odds when it comes to government spending, the urgency to come together seems to have evaporated. The stock market’s recovery, better Q3 data than expected, and heightened political tensions have caused current negotiations to stall as neither side seems compelled to come to terms prior to the election. This is somewhat unfortunate, as the majority of analyst recovery estimates incorporate at least $1 trillion of additional stimulus, and the Fed continues to rail that additional fiscal stimulus is imperative for a full recovery. In particular, enhanced unemployment benefits (direct payments) are considered to be a critical component of the recovery and potentially capable of pushing GDP growth up by 1% over the next several quarters. iv
Of course, further fiscal stimulus is not without its own complications. Federal debt, already trending at uncharacteristically high rates, skyrocketed further following the first stimulus package in March and is expected to exceed 120% of GDP by the end of 2020. iv When government debt reaches these levels, corrective measures must be taken, typically in the form of future tax increases. For more insight into how tax policy may unfold, many have begun looking towards the November election to provide further guidance. However, assuming that future tax rates hinge on this one event is somewhat misguided. While it’s true that Democrats have stated their intent to repeal the 2018 tax cuts, doing so in the middle of a recession may not prove to be politically expedient. Furthermore, while Republicans have vowed not to raise taxes in the near-term, the current tax cut is set to expire in 2025, at which point an unchecked federal deficit might be too large to ignore. Regardless of which party gains control of Washington for the next two years, it is realistic that tax increases will probably be a necessary evil over the long run that neither party will be able to avoid. Although it’s difficult to project when and how this will occur, we believe it strengthens the argument for inclusion of after-tax investments vehicles (Roth, Real Estate, Investment Grade Life Insurance, etc.) in a well-diversified portfolio.
At the regional level, state and city budgets have been decimated by both an extreme drop-off in tax revenue, due to business closures, and the subsequent spike in unemployment payouts to their respective constituents. Unless future federal stimulus packages include funds for these entities, it is unlikely that regional governments will be able to sustain their current levels of fiscal support for their citizenry, which could materially disrupt short-term recovery prospects and dislocate a significant portion of the 20 million workers that local governments employ. 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 state and local governments are required to balance their budgets annually and are therefore not afforded the luxury of carrying large amounts of balance sheet debt from year to year. To be clear, the financial health of municipalities will be critical to our overall economic recovery, as state and local governments accounted for 10.6% of GDP in 2019 and employ significantly more people than federal government. iv
As expected, 2Q20 was one of the worst quarters for economic growth in our nation’s history. Real GDP growth declined -31.4% from the previous quarter and was down -9% year over year. v That being said, economic activity surged in 3Q20 as economies reopened across the country. Although the overall economy is far from its pre-COVID levels, consensus forecasts for 3Q20 GDP growth estimate an increase of 19.1% from 2Q20, and could reach as high as 30% when all has been accounted for. iv Despite the impressive rebound, GDP growth estimates for the remainder of the year are much more subdued, as some temporary business closures become permanent, and industries most directly impacted by mandated public health safety measures continue to remain stagnant until a vaccine is introduced. While our recovery has further to go and it’s still too early to tell when economic growth will return to pre-COVID levels, the pronounced bounce back in 3Q20 provides some optimism regarding overall recovery prospects.
After shedding 22.1 million jobs between February and April, the labor market recovered nearly half those jobs lost from April to August. This brought the unemployment rate down from an 80-year high of 14.7% in April to 7.9% by quarter end. While the partial recovery has been more robust than expected, the pace of recovery is expected to slow substantially in 4Q20, as much of the remaining employment decline is from sectors that will have a difficult time reopening until a vaccine is widely available (energy, leisure, hospitality, airlines, retail, food services, etc.). As of 9/30/2020, the CBO is projecting unemployment of 8.8% by end of year, which implies an increase from today’s levels, possibly due to an increasing amount of temporary furloughs becoming permanent. Additionally, the strain on state and local government balance sheets has hindered their ability to maintain payrolls at already depressed levels. If future fiscal stimulus does not include provisions to support these entities, government unemployment will also continue to be a drag on the recovery. iii
Fed Chairman Powell indicated he believes it will likely be many years before the U.S. labor market returns to pre-COVID levels. In general, unemployment is a lagging indicator, primarily because rehiring of permanent positions doesn’t typically occur until after companies have regained their financial footing following a recession. For example, after the 2009 recession, permanent employment didn’t achieve pre-recession levels until 2015. iv That being said, it still remains to be seen whether this recession will mirror traditional ones, or whether it’s unique “shotgun” beginnings will result in a more expedited recovery.
In the United States, consumer spending will continue to serve as the primary driver of economic growth and the most important variable in determining the length and scope of the current recession. Thanks largely to government stimulus and enhanced unemployment benefits, personal consumer savings rates began 3Q20 at 33.6%. When economies reopened these assets satiated pent-up demand, as consumers were eager to reengage “normal” spending habits. Specifically, spending on consumer goods rebounded sharply (30%+) surpassing pre-COVID levels. However, consumer services spending, which account for approximately $8 trillion of aggregate demand, remains challenged. This trend highlights a significant distinction, as consumer services spending accounts for roughly 60% of consumer spending and 42% of entire economy. To further illustrate this point, even if services spending recovers 90%, that still leaves $1 trillion shortfall in aggregate demand. It appears that in order to achieve a full recovery in consumer spending, additional fiscal stimulus will be necessary to replenish individual coffers, as personal savings rates have already significantly declined since expiration of the initial CARES Act stimulus package, finishing 3Q20 at 14.1%. iv
The recession hit most economic sectors extremely hard in 2Q20, despite somewhat recovering in 3Q20. As of 9/30/2020, year-end corporate earnings for S&P 500 companies are expected to decline by nearly 19% YoY, from $160M in 2019 to $130M in 2020. v While some industries rebounded nicely in 3Q20, we are starting to see evidence that many businesses might not return at all. Specifically, business closures once considered temporary in 2Q20 are increasingly becoming permanent, with 60% of closures in September considered permanent compared to 21% in April. The concern here is that, while the recession began in an extraordinary way, with front-loaded job losses and economic dislocation occurring very rapidly, it now appears that the recession is evolving into a more typical one, which means longer timeframes for recovery and a V-shaped recovery less likely. Business closures naturally cause banks to tighten lending standards, while job losses reduce personal savings and consumption, resulting in weaker corporate profitability, and therefore lower rates of rehiring. iv Given that consumer spending is such a large portion of total GDP, a sluggish recovery in labor markets constrains consumption and would neutralize the primary ingredient needed for a rapid recovery.
As mentioned above, some sectors have fared better than others, which makes a deeper dive more valuable in determining overall economic health. As was the case last quarter, service industries, such as travel, hospitality, and restaurants, continue to be the hardest hit sectors and will likely require a fully available and effective vaccine before returning to pre-COVID levels. In contrast, goods industries, such as automobiles and consumer staples, have rebounded nicely. Perhaps most surprising has been the recovery in real estate, which has had an unprecedented return to pre-COVID levels. In August, existing home sales hit 6 million, its highest level since 2006. While an encouraging indication that consumer and lender appetite for large purchases have rapidly improved, it’s worth mentioning that the housing industry is a relatively small part of the overall economy, accounting for only 3.3% of GDP over past 5 years. iv
Equity markets continue to be somewhat ignorant of economic realities on the ground, as the S&P 500 grew 8.9% in 3Q20, up 5.3% YTD as of 9/30/20, and continues to set new all-time highs even as the pandemic continues to plague global economies. While the investment community is largely pleased that equities have come roaring back since their massive sell-off in March, this remarkable feat is not without caveats. In particular, valuations have elevated again and appear to be considerably dislocated from economic reality. As of the end of Q3, the average forward P/E ratio for S&P 500 companies was 21.5x, which is notably higher than the 25-year average of 16.5x. iii Additionally, the S&P 500 is currently trading at 7x the next 3 years of earnings, a level not seen since the early 2000s. This unprecedented market run-up has primarily been driven by historically dovish monetary and fiscal stimulus, as well as the emergence of mega-cap tech companies. Specifically, the “Big 6” tech firms now account for 25% of S&P 500 market cap, up from 11% only four years ago. iv For the second consecutive quarter, equity returns don’t seem to line up with actual corporate earnings. As mentioned earlier, earnings for S&P 500 companies are expected to decline about -19% in 2020, while S&P 500 stock prices are up nearly 7% YTD. This essentially means that equities are more expensive today, with lower profits and extreme levels of economic and unemployment uncertainty, than they were pre-COVID. While this data alone is somewhat inconclusive, it does seem to imply that some level of correction could potentially be on the horizon in the short term.
Looking deeper into the numbers, we see a large dispersion of results with most of the pain being felt in the same sectors that were hardest hit back in March. Despite some positive regression, Energy stocks are down -48.1% YTD, while financials have also experienced significant price depreciation of -20.2%. Airline and hospitality industries continue to feel the brunt of COVID’s wrath, as both sectors are down -45% on the year. In contrast, technology and consumer discretionary stocks continue to be the biggest winners thus far, with YTD returns of 28.7% and 23.4%, respectively. On the international front, the MSCI All Country World Index (ex-US) has improved from last quarter, but still remains down -5.1% YTD, and emerging markets finished the quarter down just under -1% for the year. On a relative basis, international equities are currently less expensive than U.S. equities from an overall valuation standpoint. v
Fixed income returns have been strong thus far in 2020 and continued to move higher in the 3rd quarter with positive returns in almost every sector. The Bloomberg Barclays Treasury 5-10 Yr. Index rose by 0.35% for the quarter, up 10.0% YTD in 2020. US Intermediate term corporates grew by 1.8% in Q3, up 7.2% YTD. High yield securities made an impressive comeback posting a return of 4.3% for the quarter and reducing their YTD loss to -1.1%. This sector is often correlated with equities and was the fixed income sector hit the hardest by the economic shutdown and liquidity crunch back in March and April. Municipals also had a strong quarter, with gains of 1.2%, bringing YTD returns to 3.0%. Going forward, there is cause for concern in this sector as fundamental conditions for municipalities have deteriorated. As mentioned previously, the COVID pandemic and related shutdowns have put extreme pressure on state and city budgets due to plummeting tax revenue, business closures, and unemployment payouts. Prices of non-US fixed income securities also moved higher during the quarter. Emerging Market bonds returned 2.3% for the quarter and are now down just -0.32% for the year. x
Despite the favorable performance of most fixed income categories in 2020, returns have been largely driven by price appreciation, as yields have dropped dramatically and remain historically low. Consequently, income returns have decreased sharply as the Barclays Agg Index now yields only 1.18%. iv Indeed, 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. As a result, 10-year Treasury yields fell below 1% for the first time ever in March and currently sit at 0.69%. With the new Fed framework, even if jobless rates improve significantly, policymakers are likely to hold short term rates at zero for an extended period of time. As such, it will be difficult for income investors to generate meaningful yields from traditional fixed income, as the current low interest rate environment is expected to remain in place until at least 2023. iii That being said, despite a substantial downward shift resulting from Fed rate cuts, the yield curve is starting to slope upward ever so slightly and is no longer exhibiting inversion characteristics that typically precede a recession.
After a nice rebound in 3Q20, economic growth is expected to continue, albeit at a much more subdued pace, as some of the temporary business dislocation caused by COVID gradually becomes permanent. Although short-term volatility will likely surround the presidential election, recovery prospects should improve once the election is determined and Congress can come to an agreement on another round of fiscal stimulus. For short-term and conservative investors, it’s important to realize that traditional income investments are poised to produce considerably weaker yields over the next few years, and it will likely be necessary to identify alternative safe-money and income-oriented investments. Strategies such as investment grade life insurance, equity-indexed annuities, and private credit or real estate funds, will likely provide more favorable returns over the medium-term. For equity investors, while much uncertainty still exists regarding the pace and scope of economic recovery, long-term investors should continue to pursue disciplined dollar-cost-averaging strategies and block out the noise surrounding election-related volatility narratives. As always, we strongly encourage you to connect with your financial advisor to ensure your current investment strategy is in line with your personal financial needs and risk tolerance and that you are on track to accomplish both your short and long term goals.
|Kristofer R. Gray, CFP®, CRPS, C(k)P®, MPA|
|Andrew Mescon, MBA|
VP of Strategy
Chief Investment Officer
Sources: i www.worldometers.info/coronavirus, ii. www.covidtracking.com iii. J.P. Morgan – Economic & Market Update (9/30/20), iv. FS Investments – Q4 2020 Economic Outlook (9/30/20), v. JP Morgan – Guide to the Markets Q4 2020 vi. BlackRock – Fixed Income Overview (Sept. 2020) vii. U.S. Department of Treasury, Congressional Budget Office viii. https://www.mcleanam.com/are-republicans-or-democrats-better-for-the-stock-market/, ix. Vanguard – Elections Matter, But Not So Much to Your Investments, x. Evestnet PMC – Economic and Market Overview (Q3 2020)
Disclosure: Past performance is not indicative of future results. The opinions expressed are those of the Integrity Financial Corporation (“Integrity”) and should not be taken as financial advice or a recommendation to buy or sell any security. Integrity is a registered investment adviser. Registration does not imply a certain level of skill or training. Any forecasts, figures, opinions or investment techniques and strategies described are intended for informational purposes only. Past performance is not indicative of future results. Investing involves the risk of loss of principal. Investors should ensure that they obtain all current available information before making any investment. Indices cited in the information above are intended to support the opinions expressed and are shown as general examples of market trends. It is not possible to invest directly in an index and the volatility of the index may vary from that of an investor’s actual account. Note that index performance shown does not take into account management fees and is not intended to be indicative of future results. Additional information about our investment strategies, risks, fees, and objectives can be found in Integrity’s Form ADV Part 2. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions. There is no guarantee of the future performance of any Integrity Financial portfolio. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies.