Global financial markets have staged a remarkable rebound from their depths in late March. A combination of deeply oversold conditions, extraordinary monetary and fiscal support from central banks and governments and hopes for an economic recovery as infection rates were curbed and businesses started to reopen, have all led to an impressive rebound in the prices of most risk-oriented assets during the second quarter.
We think this recovery in markets has come too far and too fast, and now reflects an overly optimistic view of the current reality. We still favor stocks for long-term investment but believe that prices are currently ahead of the fundamentals. Without an effective vaccine close at-hand and a resurgence of Covid-19 infection rates in the U.S., plus a host of other geopolitical challenges, we generally see more risk than opportunity in most markets. We are therefore maintaining a defensive asset allocation with higher-than-normal levels of cash.
One remarkable aspect of the Covid pandemic is how disproportionately it affects some countries, populations, economies, sectors and markets versus others.
The Pandemic is first and foremost a humanitarian disaster impacting tens of millions of people around the world and especially those in more impoverished, densely populated areas with limited healthcare and economic resources.
From an economic perspective, it has thrown another wrench into the gears of globalization, lifting industries like information technology and healthcare while decimating others like energy, basic materials, travel and hospitality. It has accelerated trends and widened the divide between winners and losers and haves and have-nots. It has also exposed the limitations of elected officials and government institutions as well as shown us contrasting and inspiring examples of selflessness and competence, especially among healthcare professionals.
Location, Location, Location.
As Chart I below shows, so far, U.S. markets have fared the best among global stock markets, going down less and rebounding more. Year-to-date, U.S. markets, as measured by the S&P 500 are only down about 3.1% versus -11% for the rest of the developed world and -9.8% for emerging markets.
This makes sense given the United States’ fundamental virtues relative to the rest of the world including a lower reliance on global trade, an economy and markets more driven by technology and innovation, and having the World’s reserve currency and largest and deepest capital markets. The U.S. has also benefitted from a quick and massive amount of fiscal and monetary stimulus, totaling almost $6 trillion dollars in combined extraordinary monetary and fiscal support to backstop financial markets and provide economic relief to people and businesses.
European markets are more heavily dominated by financial and industrial companies, and emerging market indices are also weighted by economically cyclical industries like manufacturing and commodities, all of which dragged on their relative performance.
Economically sensitive commodities and especially energy have had an especially tough year. Energy prices collapsed prior to the Covid pandemic and the additional loss in demand as a result of the pandemic has only made matters worse, especially for oil exporting countries and highly leveraged energy companies.
On the other hand, Gold and precious metals along with government bonds have provided a safe harbor from the storm, posting positive returns year to date. High Yield and Emerging Market Bonds are still down for the year.
Taking a look under the hood of the U.S. stock market, Chart 2 shows the remarkable divergence in fortunes between sectors. Despite a 33% rebound in the second quarter, energy stocks are still down 35% year-to-date. Financial stocks are down 23.7% and industrial stocks are down 14.6%. Conversely, technology stocks are up 15% year to date, a good return for any year, let alone this year. Although the index of consumer discretionary stocks is also up for the year, this is largely because of the presence of Amazon (+49%) in the index. It does not reflect the carnage among many traditional retailers and travel companies within the sector.
This concentration issue also holds true for the broader markets. In U.S. markets,
Technology represents 21% of the S&P 500 Index, and five companies – Microsoft, Apple, Amazon, Facebook, and Alphabet (Google) represent 22% of the S&P 500. Year to date, they are up about 24% on average, meaning that the other 495 companies in the index are still collectively down about 11% for the year. International markets, as we noted earlier, have a higher exposure to more economically sensitive sectors and this contributed to their underperformance versus the U.S.
In early April we wrote about an environment of winners and losers and this has clearly been the case.
Weighing Positives and Negatives:
Stepping back to look at the forces at work, we see a complex set of crosscurrents:
Global markets have rebounded in part on optimism surrounding the reopening of the global economy and hopes for a return to normalcy. In the U.S., we have seen a particularly strong rebound in economic data. This is good news but the data needs to be looked at on an absolute as well as relative basis. A car accelerating from 1 mph to 10 mph, will show a great improvement in speed, but is still traveling well below the speed limit and a resurgence of the virus will cause people to step on the brakes yet again.
Without an effective vaccine, the economic recovery will be slow at best and very unevenly distributed. Businesses that have been able to do well during the shut-down (technology, professional services, healthcare, consumer products, and essential services) should continue to do well. Other businesses that barely make money under normal circumstances (airlines, cruise lines, retailers, restaurants) will face a zombie-like existence where they are operating at reduced capacity and incurring large losses to do so. Companies with a lot of debt will have greater challenges servicing their debt and banks will likely see a rising tide of defaults in their loan portfolios.
A key determinant in the success of economic reopening is what happens to infection rates. Unlike Europe and Canada which acted sooner and more uniformly to shutter their economies and curb the spread of the virus, the U.S. denied, delayed and then delegated the problem to the states. This resulted in an uncoordinated 50-state solution. Some states, especially in the South, were slow to shutter businesses and require social distancing, and too quick to reopen. The result is that while Europe and Canada, along with Northern Asia appear to have Covid-19 largely in check, we are seeing an alarming surge in new cases in the U.S. If unchecked, this surge could easily overwhelm the healthcare system and put the U.S. economy back into recession.
Fiscal and Monetary Stimulus.
In contrast with the 2008 Great Financial Crisis, the Federal Reserve and Congress have acted massively and decisively to shore up the economy and financial markets.
Since March, the Federal Reserve has enacted programs to purchase $2.9 trillion in Treasury bonds, Mortgage Backed Securities and corporate debt. In addition, Chairman Jerome Powell has signaled that the Federal Reserve is prepared to do whatever it takes to keep the economy and markets afloat.
Meanwhile Congress has passed over $2.4 trillion in legislation to offset the impact of the recession including rebate checks, PPE loans, additional unemployment benefits, coverage of Covid-related health expenses, deferral of tax payments, and direct aid to state and local governments. Much of this aid is coming to an end and will likely need to be supplemented with additional support in the coming months.
For the time being, the U.S. seems to be able to borrow, print and spend all the money that it wants, and deflation appears to be more of a near-term challenge than inflation. At some point, deficits do matter, but not today. It does help to have the world’s reserve currency and to be able to print as much of it as you want.
There are a number of promising vaccines in the works, but it currently seems unlikely that we will have one that can be widely deployed until year-end at the earliest. There are other therapies that can help to mitigate the severity of the virus, but until an effective vaccine is developed, mass produced and successfully deployed, economic growth will be severely curtailed. A key variable in the effectiveness of treatment is the volume of cases. If hospitals are overwhelmed by a new wave of critical cases, their ability to offer effective treatment with current resources will be significantly diminished.
The upcoming presidential election has the potential to be messy and create uncertainty in financial markets. President Trump is currently trailing Joe Biden in the polls and the president’s support has been damaged by his handling of the Covid pandemic, especially in key states like Florida, Texas and Arizona where new infection rates are spiking. In addition, incumbent presidents do not tend to get re-elected during a recession.
A lot can happen between now and November, but the prospect of rising infection rates makes voting in person more challenging. President Trump meanwhile has been undermining the legitimacy of voting by mail and may question the legitimacy of any election that he does not win, especially if the results are close. Joe Biden needs to win by a decisive margin to prevent this from happening.
Another big unknown is whether Democrats will take control of the Senate. It is presumed that they will retain control of the House. Any major changes in legislation including a repeal of the Trump tax cuts for corporations and wealthy individuals or an expanded public healthcare option would require the approval of the Senate to take effect.
If the Democrats do take the House and Senate, a repeal of the Trump era corporate tax cuts could reduce profits of the S&P 500 by about 15% on an ongoing basis, meriting a reduction in U.S. stock prices. These reductions might be offset by additional spending on healthcare and infrastructure which would provide stimulus to the broader economy.
Other Geopolitical risks.
Finally, beyond the political dysfunction in Washington, we see rising divisions around the rest of the country and throughout the world centered around race, nationality and inequality. The trends towards nationalism and populism sow seeds of distrust between and among nations and have the potential to hamper global trade and economic growth.
Putting it all together:
Putting it all together, we think that financial markets have become overly optimistic relative to current fundamentals and potential risks, especially here in the U.S.
There is always room for additional good news: perhaps an effective vaccine sooner than expected; perhaps the rising tide in U.S. infection rates will reverse course as more people wear masks and practice social distancing; perhaps Congress will pass additional funding to support individuals and businesses.
But current valuation levels have a lot of good news baked into current prices and do not adequately reflect the risks that we have outlined.
We therefore think that it makes sense to err on the side of defense, rebalance into some areas that have lagged, and to hold a larger-than-usual reserve of cash to deploy back into stocks if prices fall and/or fundamentals improve.
Having said that, we believe that stocks offer the most compelling long-term prospects for investment, especially relative to Government bonds which offer almost no return at all. Absent compelling alternatives, money should gravitate towards financial assets that can sustain and increase their intrinsic value like stocks and real estate.
We continue to focus on areas of long-term growth including technology and innovation, healthcare, life sciences and medical technology, and emerging market consumer and technology companies. These areas have all done well this year and have become fully valued. We have done some pruning of overweight positions, but continue to believe in their long-term potential.
We redeployed some excess cash into targeted European and Emerging market stock exposure. Both look relatively more attractive than the U.S. in terms of fundamentals and valuation. Europe, in particular is having much greater success than the U.S. in re-opening their economy while controlling infection rates, suggesting that the European recovery may be able to continue unimpeded by a second wave. Our Emerging market stock exposure is mostly focused on Chinese technology and consumer-oriented companies.
We continue to hold gold in client portfolios as a hedge against inflation and stock market volatility.
Corporate bonds, including high yield offer more attractive returns than government debt, but investors need to tread carefully. Corporate debt issuance is at record levels and there are a lot of heavily leveraged businesses that are going to have trouble servicing their debt. There are also many businesses that should be fine, creating opportunities for skilled managers to sort the good from the bad.
Municipal bonds also offer reasonably attractive yields, especially on a tax-equivalent basis. The Covid crisis has hit state and local governments particularly hard as costs have risen and revenues have fallen sharply. The Federal Reserve has put some backstops in place to support short-term municipal finances and Congress will likely pass a bill to provide up to $500 billion in additional support to state and local governments. As with corporate bonds, investors need to be selective and/or use skilled managers, but with skilled management, we think the municipal bonds offer an attractive option for a taxable investor.
Over the long-term we continue to invest with a global focus; balancing investments targeted at areas of long-term growth and innovation with more defensive equity, alternative, and fixed income strategies aimed at mitigating volatility and risk.
As always, please let us know if you have any questions and/or if there is anything we can help you with relating to your financial life. And, if we can ever be of any help to a family member or friend, we always welcome referrals from our clients.
Jurika, Mills & Keifer,