July 2020 Market Review
An unprecedented response begets an unprecedented response
Paul Dickson, Director of Research
Mark Stevens, Chief Investment Officer
The shutdown of the economy due to the Coronavirus pandemic led to millions of workers without jobs in the most rapid decline in economic activity since the Great Depression. At one point, 25 million workers had been displaced from their jobs and even now initial jobless claims exceed 1 million every week. Actions taken by the US Government and Federal Reserve at the end of the first quarter of the year to confront the economic shock of the Coronavirus pandemic led to the fastest recovery of financial markets ever witnessed. This recovery largely continued through the second quarter of the year even as new Congressional efforts stalled but as Federal Reserve action was implemented in earnest. Not only did the Fed continue its latest bond buying efforts, but also extended those to include corporate and even High Yield securities to force down interest rates and ensure liquidity would not be a limiting factor for the functioning of the economy.
At the end of March, Congress passed the CARES Act, a $2 trillion relief package designed to help displaced workers and small businesses. Policymakers added another $483 billion to the Paycheck Protection Program on April 24 and there was agreement to extend the loan program to August 8 but since then there has been a division between the House and Senate on how to proceed. The House passed a $3.3 trillion HEROES (Health and Economic Recovery Omnibus Emergency Solutions) Act, which would have included $1 trillion in assistance to municipalities, added another stimulus check for families, and loosened restrictions and repayment rules on the Paycheck Protection Program, among many other things. That bill stalled in the Senate as it was considered potentially excessive and negotiations have been underway for a more constrained bill.
There is some sense of urgency regarding a follow up package from Congress as several aspects of the previous CARES Act are set to expire. The enhanced unemployment insurance of $600 a month expires at the end of July, as does the eviction freeze on “federally backed” properties (Fannie Mae/Freddie Mac). Other expiries later in the year include the aforementioned Paycheck Protection Program (August 8) and the stay on student loan payments (September 30). There is also significant debate on whether there will be an additional stimulus check distributed to families and what the size could be. The HEROES Act proposed a figure that could reach $6,000 per family.
The markets appear to be taking the uncertainty largely in stride. Whether that is because it is assumed that some form of additional stimulus will be forthcoming or that given the Federal Reserve’s actions it is unnecessary. It is probably not a stretch to say that the Fed’s policies of extremely low interest rates and a tremendous injection of liquidity into the markets—especially where the Fed has directly intervened—have done even more than the Government in stabilizing the situation.
The Fed’s balance sheet has grown from under $4 trillion as previous bouts of Quantitative Easing (QE) were set to be “rolled off” to more than $7 trillion in a matter of a few months. The earlier periods of Quantitative Easing in response to the Great Recession were considered unprecedented and had numerous critics. The current effort puts those previous ones in context, and few do not believe that at least a good portion of it is necessary.
One of the more controversial aspects of current Fed policy has been the decision to intervene more directly in the financial markets rather than simply lower rates through the buying of Treasuries and Mortgages. Instead, the Fed announced the funding of major lending programs to backstop the “real” economy and then announced it would be buying private securities, both ETFs and corporate bonds, on both the secondary and primary markets.
The table highlights the balances of the new Fed programs established to assist the real economy recovery from the Crisis. The figures have changed considerably over time. The Money Market facility grew to $53.2 billion as the Fed stabilized that market and has since dialed down the assistance. The Primary Credit Facility at a paltry $2.5 billion was once $31.5 billion in size. That funding is less important as the Fed has begun buying securities outright. In terms of the latter, within the Corporate Credit Facilities the Fed has bought $6.8 billion in bond ETFs, including High Yield, and $429 million in Investment Grade Corporate Bonds. The ETF program was launched on May 19 and the first bond was bought on June 16. On June 29, the Fed announced that it would also be participating in the primary bond market, purchasing new issues as they come to market. The Fed will be able to be the sole investor in a bond issuance or purchase as a participant with other investors. The initial allocation will be $50 billion and combined these credit facilities could reach $750 billion.
Don’t fight the Fed
There is a common saying among bond traders which is simply, “don’t fight the Fed,” by which it means that if the Federal Reserve believes that higher or lower interest rates are needed then it is going to happen regardless of the mood of the market or where traders think rates should be. This idea was tested in the first half of 2019 following the final interest rate hike of the cycle in which the market saw the act as one too many, forced an inversion of the interest rate curve, and helped convince the Fed to start easing. Now in 2020, that phrase is more in vogue than ever. Regardless of experiencing the sharpest economic slowdown in history, corporate and even high yield bonds have performed very well. The Fed averted a market liquidity crunch and followed up with facilities to deter defaults and allow firms to continue borrowing, either from one of the Fed-backed facilities or via the public markets since rates there have been pushed to attractive levels. Thanks, again, to the Federal Reserve.
While it is the case that the yield spreads (difference between) on both High Yield and Investment Grade bonds over US Treasuries have grown considerably, the actual rise in underlying yields is muted by the fact that US Treasury yields have fallen so dramatically. In fact, in some cases the yield of an investment grade bond may well be lower now than it was before the pandemic and economic collapse. The Fed buying these now will only help to lower corporate spreads further.
In terms of the Municipal Market, there were great fears early on that the pandemic and crisis would impact municipalities disproportionally. First, there was the concern that the municipal finance market would seize, and borrowers would face an illiquidity crisis that could lead to default regardless of underlying creditworthiness. The Fed’s intervention by providing immediate liquidity for bond payments has reduced that concern considerably. The second concern was that the economic collapse might lead to an insolvency crisis, as tax payments and other service fees would collapse. The ability to borrow has reduced this concern somewhat but what the market was looking for was the support from Congress that was stitched into the HEROES Act. Such support may not be forthcoming, so municipalities are relying on a number of strategies to weather the storm. In some cases, they have funds set aside they can spend down. In others, they are leasing out property, selling property seized via tax foreclosure, enacting spending freezes, and delaying or cancelling investment projects. The longer this goes on, however, the more stressed municipal finance will become.
Market Review: COVID vs. Stimulus
The Q2 rebound is a reminder that market action and news headlines are not always related. Early in the quarter, COVID cases grew, businesses closed, unemployment was hitting all-time highs, and civil unrest in much of the US was prevalent. The S&P 500, on the other hand, managed to post the best quarterly return (20.5%) since 1998. The fastest drawdown in the history of the index (Q1) was followed by the best quarter in over 20 years—all in the first six months. The market was undoubtedly more focused on the response to the pandemic in Q2 than it was on the data behind it.
Unlike the financial crisis in 2008, the US reaction to the pandemic was much quicker, and the support was more than three times the size. In total, fiscal and monetary stimulus to fight this pandemic has grown to nearly 20% of US GDP. Much of the developed world followed suit as fiscal measures totaled 6% of global GDP by quarter-end. The financial support was swift and the size extraordinary.
The tone of the market also shifted as better COVID data, a bounce in manufacturing activity, a rebound in retail sales, and back-to-back jobs reports (April & May) that were better than expected helped fuel investor optimism for much of Q2. The idea that an economic reboot was well on its way, and the idea that recent economic data supported that theory, gave the market much needed incentive to re-engage.
While interest rates were largely unchanged, the decline in credit spreads helped push bond returns higher in Q2. Total return for most blended fixed income categories finished the quarter up over 2%, with credit sensitive categories like municipals (2.7%), and high-yield corporates (10.2%) benefiting the most.
While the S&P 500 continues to perform well (20.5%), performance continues to be dominated by a small group of names. The top five names in the S&P 500 (Microsoft, Apple, Amazon, Google, Facebook) now represent 21% of the index, the largest since the Tech bubble in the late 1990s. The Russell 1000 Growth Index (+27.8%) outperformed the Russell 1000 Value (+14.3%) again in Q2. Growth has now outperformed Value in one of the worst quarterly declines in history (Q1), and one of the best quarterly advances in history (Q2), proving that it has both defensive and offensive characteristics in a COVID influenced market environment. The 26.1% difference in year-to-date performance represents the biggest six-month spread between the two indices since 1999.
Small Cap stocks are volatile and most levered to local economies. They were most affected by the work stoppage and it is of little surprise that Small Caps would perform well (Russell 2000 +25.4%) when investor sentiment shifts positively.
Evidence that regions outside of the US were more successful re-engaging, especially in Europe and Developed Asia, helped International stocks outperform in June. However, that was not enough to keep the MSCI EAFE (+14.9%) from underperforming in Q2. The MSCI Emerging Markets Index was up 7.4% in June and 18.1% year-to-date due, in part, to relative strength in China and the ability to restart their economy sooner than other regions.
The best performing sectors during the quarter were Consumer Discretionary and Technology, both benefiting from the gradual reopening of the economy. Energy (+30.5%) was also helped by OPEC agreeing to major production cuts to offset declining demand. Defensive groups like Utilities (+2.7%) and Consumer Staples (+8.1%) trailed as capital moved toward economically sensitive groups. Financials remain in a difficult spot with lower rates and concerns over credit quality hampering the group.
Looking forward: The Good, The Bad, and The Ugly
The market's meteoric rise in Q2 certainly reflects a high level of optimism. Progress toward a vaccine will be an important catalyst in reigniting economic growth. There are dozens of treatments for COVID-19 in the works from palliative care to vaccines and even with only the additional knowledge about the disease gleaned to date, survival rates, even among the vulnerable, are improving. Many economies have seen dramatic success in tamping down the disease and in a few places, completely eradicating it. Most of Asia and Europe have seen their economies start opening back up with normalization in their sights.
However, some parts of the world are still deteriorating when it comes to handling the pandemic. Much of Africa is seeing a dramatic increase in cases and Latin America is rife with hot spots including the regional economic superpower, Brazil. The US has also seen a worsening of the crisis as a too soon reopening of much of the economy led to a spike in cases.
Finally, even if a vaccine is discovered, it may not provide long-term immunity, much as with the seasonal flu. Recent studies have cast doubt if there can be “herd immunity” against this virus as it does not seem to have happened yet in any population so far studied. Even with a high infection rate, the incidence of those who continue to carry antibodies against the virus months later is very low. This means that an effective vaccine will be all the more important if catching the pathogen does not result in immunity to it. Several vaccines are entering Stage 3 trials, the final stage, and should any of these pass muster, then the work of creating and distributing the vaccine to hundreds of millions of people will begin.
A re-acceleration of COVID cases that force a second “shutdown” remains the biggest risk to the economy. Several states (Florida, Arizona, and Texas) have curtailed their restart plans and if others follow suit, economic data could worsen. To date, the market has assigned a low probability to another shutdown and remains steadfast in its belief of a swift recovery.
A slower economic restart could further dampen the earnings prospects of US companies. Earnings per share (EPS) of the benchmark S&P 500 Index are expected to decline 45% year-over-year in Q2. Forward looking estimates would indicate that S&P 500 EPS will not return to pre-pandemic levels until Q3 2021. The rally in stock prices and decline in earnings has pushed equity valuations (especially in the US) well past 2019 levels. Assuming Congress maintains some form of support for the most vulnerable, the Fed continues to provide adequate liquidity, and we have no major setback with COVID, that seems reasonable. Without all of that, it probably doesn’t.
The challenge for investors is how to manage their money in an environment where stock prices and the economy seem to be going different directions. Taken over the long-term, few trends seem to be developing. First, massive fiscal stimulus, while necessary, has led to a significant increase in government debt levels. Governments increased role in the post-COVID world will likely keep growth below historic norms for the foreseeable future. Second, the global economy has taken a huge hit and central banks across the globe have pushed rates to near-zero. While this could prove inflationary in the long run, the slack in the economy makes it unlikely that it will be anytime soon. Interest rates should remain lower for longer. Lastly, profit margins had peaked before the pandemic and are likely to feel even greater pressure after. US/China trade wars and the parochial nature of fighting a pandemic (food and healthcare supply) have put global supply chains at risk. Profit margins could be squeezed as supply chains become more localized.
Subpar growth and contracting profit margins hardly seem like an environment for successful investing. Long-term valuation indicators like the Market Cap to GDP ratio are also pointing to an overextended market. So why stay invested if these risks are apparent? Because interest rates are near-zero, the Federal Reserve is willing to “do whatever it takes,” and a lack of alternatives offset the risk. The phrase “Don’t fight the Fed” applies to equities too—and it has never been more true than the last 3 months.
We believe market risk is balanced and investors should remain invested. However, better opportunities might lie within subclasses of the broad market, where returns have been diverging for years. Value, Small Cap, and International stocks have been in secular declines relative to US Large Cap/Growth stocks for many years. Cumulative returns are 35%-55% less over the last 5 years and they have been largely left behind in 2020. The discounts available in Value stocks haven’t been this low since the internet bubble in 1999. The relative performance ratio of Small Cap vs Large Cap stocks is the lowest in 17 years. Developed International stocks have underperformed US stocks in 9 out of the last 11 years. The narrowness of the market has left these sub-asset classes cheap on a relative basis and the probability of them outperforming over the long-term grows as the disparity persists. This could prove an opportunity in a low interest rate world where less-than-stellar growth makes excess returns harder to find. A simple rebalance of a portfolio back to normal weights remains a logical first step to taking advantage of these asset class dislocations.
Volatility will undoubtedly rise in the coming months and it is imperative that investors stay true to their investment discipline. Economies across the globe are gradually re-engaging with mixed results. Congress will soon be faced with the decision to remove the financial safety net that has been partly responsible for investor confidence. And the Presidential election in November has the potential of reshaping the balance of power in US politics. However, there are just as many reasons to be optimistic. The most obvious? If we manage to avoid a second wave of the outbreak the current recession would likely end in September and represent one of the shortest recessions in history.
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