2020 Second Quarter Review of the Markets

Investment Commentary

In an abrupt shift from the previous quarter, the S&P 500 increased 20.5%, its eighth best quarter since 1928. Fiscal and monetary policy in the U.S. and globally, in conjunction with measures to slow the spread of COVID-19, provided a backstop to the decline in markets and sent risky assets higher.

International stocks also did well. The MSCI ACWI ex USA IMI returned 17%, with emerging market stocks slightly outperforming developed market stocks.

Despite starting the quarter within basis points of the lowest 10 year U.S. treasury yield in history, the Bloomberg Barclays Aggregate Bond index also was positive for the quarter, returning 3%. This was due in large part to “spread tightening”, meaning the prices of the riskier bonds in the index such as corporate bonds rose more than the prices of lower risk U.S. Treasury Bonds reflecting some level of optimism (or at least dissipation of pessimism).

Economic Outlook

It seems we’re in a period where “economic outlook” and “virus outlook” are synonymous. Unfortunately, that means global investors are still working with a totally different set of unknowable variables than normal. At the current June unemployment rate of 11.1%, which is well off the 14.7% level observed in April, we are still more than 1% above the highest unemployment rate observed during the global financial crisis period in late 2009. However, it seems that while large swaths of the U.S. workforce are still unemployed, furloughed, or at the very least working remotely, the trend in employment is beginning to improve after weeks of unprecedented jobless claims early in the quarter.

Last quarter we highlighted an overwhelmingly consensus view that the National Bureau of Economic Research, the keepers of “official” business cycle records, would declare the United States to be in a recession. That proclamation came out in early June. The expansion from 2009 to 2020 was the longest on record since tracking began in 1854. The committee cited typical factors: a clear peak in employment and a clear peak in aggregate production.

What does this mean for the economy going forward? We have seen a huge surge in employment since April. The largest fall in nonfarm payrolls on record has been followed by the largest increases. 7.4 million of the 22 million jobs lost came back in May and June. This suggests that as businesses reopen there is still demand in many sectors of the economy. Many employees and employers have had to change the way they do business, but they are still able to deliver goods and services to consumers. As companies and consumers adapt to new methods, this will likely persist. In the event of a vaccine or other development that decreases the prevalence of COVID in daily life or the mortality rates for those who become infected, there will certainly be a more rapid economic acceleration.

The Fed has signaled a willingness to remain extraordinarily accommodative for a significant period of time. Forward guidance from the Fed suggests that it will be years before they consider raising rates above zero. Indeed, Chair Powell famously stated that they (The Fed) are “not even thinking about thinking about raising rates” earlier this quarter. Furthermore, the Fed have continued to emphasize a willingness to remain accommodative even if inflation does begin to rise above their 2% target for a period, especially after an extended period of inflation well below that 2% target.

Monetary policy has extended beyond lowering the Fed Funds rate to zero – they have also meaningfully increased the size of their balance sheet through purchases of a number of fixed income securities (also known as QE or “Quantitative Easing”). For more details about the various QE programs please see our Q1 Review of the Markets. The size of the Fed’s balance sheet hovered just above $4 trillion at the beginning of 2020. By the end of June, the Fed’s balance sheet had grown to over $7 trillion. During the global financial crisis and subsequent economic recovery, it took over 5 years of QE for the Fed’s balance sheet to expand by $3T. During the coronavirus crisis period the Fed’s balance sheet expanded at a staggering rate growing by $3 trillion in just three months.

Transitioning from monetary to fiscal policy, it seems likely that further fiscal stimulus, especially direct to consumers (read “constituents”), is likely to show up again early in the third quarter given that this is an election year. Unfortunately, it looks like the bipartisan support for the stimulus bills passed early in the crisis will not repeated this time around.

Speaking of the election, we are getting more questions about this as it approaches. We plan to write about it in more detail in the third quarter. For now, it seems Biden has an edge over Trump in the polls. The primary way this is likely to impact markets is some level of reversal of corporate tax cuts. This has been estimated to impact S&P 500 earnings by a range of 7% to 15%. Everything else held constant, this would be a negative for markets. The lessons from the 2016 presidential elections are still valid: “everything else held constant” is not a particularly useful set of assumptions, and polls can be misleading.

Investment Strategy

The path to escape velocity for the economy has always been known: slow the spread, improve the treatment of those infected, and then eventually vaccinate. Unfortunately, shutting down the economy was not sufficient to stop the spread of the virus in the United States as it was in other parts of the world. In the short term it seems that we’re left with a number of options, none of which seems particularly palatable. However, while the timing of the resolution of the coronavirus crisis is still unclear, we do feel confident that it is a matter of when, not if.

Clients in many cases have asked us to explain the seemingly irrational disconnect between markets (which have come roaring back) and the economy (which is coming through perhaps the worst period we’ve seen since the Great Depression). Markets, as they often do, reflected the recession before it was clear that there was one by dropping over 30% in a one month period from late February to March 23. In late March, once the horrible state of the economy was clear, fear peaked and we saw truly unprecedented fiscal and monetary stimulus. Since March 23 the market has increasingly moved not on data about this recession, but on expectations about the coming recovery. We think that news and data that suggest the recovery is either imminent or already underway will continue to push markets upward while data or news flow that suggests the recovery is further away or is in doubt will likely cause short term drawdowns in risk assets. That said, we believe it is unlikely that markets retest the lows of the first quarter.

Fortunately for markets, interest rates are so low, especially relative to dividends in the stock market, that investors can disagree in their opinions of the timing of an earnings recovery by multiple years and still arrive at similar fair value estimates for today’s market. This is a primary reason that we have not taken steps to meaningfully lower risk allocations in client portfolios, even after the significant rebound in equity markets. We continue to maintain a constructive view towards stocks over the long-term but we do have concerns that in the short-term we could see a return of volatility as a result of a number of potential concerns. These concerns include the surge in COVID-19 cases and potential future lockdowns, increased trade tensions with China, and the coming presidential election.

Within U.S. stocks, we have rotated some growth exposure to even “growthier” names. We added significantly to investment grade corporate bonds early in the second quarter using proceeds from U.S. treasury positions. The decision to add to corporate bonds, an area that we had been underweight entering the year, was a result of what we felt were very attractive valuations, especially given the Fed’s ability to step in and provide liquidity in this and other credit sectors. The riskier high yield corporate (“junk”) bonds have also rallied significantly since late March. We continue to have concerns about the potential for heightened default activity in junk bonds so the extra yield may not be sufficiently compensating investors for taking the risk of loaning money to riskier borrowers.

Overseas, we rotated a portion of our international equity exposure, which is already more cyclically-oriented than the U.S. at the index level, into managers we felt were better equipped to take advantage of a cyclical rebound.

Take a deep breath. While there are glimmers of hope, we are not totally out of the woods. Careful management consistent with your risk profile is imperative, and we are privileged to be able to provide this to our cherished clients. Stay safe!

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