Quarterly Market Review: Q3 2020
The Sound of One Hand Clapping
Paul Dickson, Director of Research
Mark Stevens, Chief Investment Officer
The Coronavirus pandemic remained the dominant economic and social issue throughout the third quarter of the year albeit accompanied by improvements in the economy as some reopening took place. That reopening coincided, unfortunately, with a continued spread of the virus and varying responses by state and local municipalities. It also took place under a winding down of Federal Government support with the expiration of several measures in the CARES Act and growing uncertainty over the odds of additional economic assistance given a deadlock in Congress over a new economic relief bill. The Federal Reserve, on the other hand, maintained its zero-interest rate policy and continued its intervention in the bond markets. As additional congressional action was delayed, the Federal Reserve was left to stimulate the economy alone. The markets held up remarkably well given the circumstances, holding out hope for additional help from the Federal Government at some point. For some, this hope seemed to hinge on getting past the elections, although that could mean significant economic turmoil as many of the protections of the CARES Act expire. By the end of the quarter, an urgency surrounded the sunset of the last package and negotiations for the next.
Among the provisions of the CARES Act that expired during the quarter, the $600 per week additional unemployment benefit ended at the end of July, and while that was extended by the Administration with a $300 a week benefit drawn from FEMA funds that, too, is winding down. A compromise bill (the HEALS Act) that would have provided an extension of the payments at $200 per week was under negotiations but failed. Provisions that suspended foreclosures, evictions and some debt payments have also started to wind down, although the CDC did move to delay evictions until the end of the year and the FHA did the same for eligible foreclosures. There are too many additional parts of the expiring CARES Act to cover here. Suffice to say that the removal of the stimulus and protections provided by the legislation threatens to delay, or even deter, the economic recovery. Members of the Federal Reserve Board have gone to great lengths to advocate that Congress come up with additional fiscal measures or risk the economy falling back into recession.
For its part, the Federal Reserve has continued to pump liquidity into the economy, purchasing billions in US Treasury bonds and participating in the corporate bond market as well. As of the end of the quarter, the Fed had bought $4.3 billion in individual corporate bonds and another $8.6 billion in fixed income exchange traded funds. While those figures sound like a lot, they are dwarfed by the Fed’s purchase of $2.1 trillion in US Treasuries since the beginning of the year. This has kept interest rates low and provided plenty of liquidity for the financing of the fiscal deficit, which reached 15% of GDP this year.
One of the clear economic benefits of low rates has been in the housing and construction sectors. After a stunning—but unsurprising—drop in home sales in the peak of the COVID-19 crisis, the market has surged with sales volumes reaching a level last seen in 2006 on the tail end of the housing bubble. Some analysts are already stating the current pace seems excessive. But with mortgage rates at all-time lows, current exuberance might not be irrational.
Another bright spot is the continuing recovery in employment. Despite concerns that government checks would keep people from returning to work, the improvement on that front has been steady. From a peak at almost 15% of the labor force and 25 million continuing claims those two figures have fallen to 7.9% and 11.7 million, respectively by the end of September. Behind those numbers are a couple of trends, one positive and one somewhat worrisome. The positive trend is the recovery of private payrolls, which have stepped up remarkably. The worrisome one has been the shedding of jobs in the municipal sector as states and cities have had to cut spending to cope with the impact of the pandemic and economic shutdown. If public finances were in better shape—or had the $1 trillion set aside for municipal finance in the House bill passed—the employment picture would look even better.
Relatedly, the municipal bond market has held up well in the face of the hit to public finances. Part of that is the continued negotiations and efforts in the House to pass a large municipal relief package. Another is the Federal Reserve standing by with its new Municipal Liquidity Facility to backstop public finances and avert a market closure to public finance. To date, the Fed has only lent to two entities: the State of Illinois ($1.2 billion) and the Metropolitan Transportation Authority of New York ($450 million). The relatively small amount of credit and the few borrowers were raised at a Congressional hearing to which the Fed replied that the mere presence of the Municipal Facility has meant that the market has remained open for normal business. This would appear to be the case as municipal bond issuance has been strong this year.
The actions of Congress and the Federal Reserve served the economy well through Q3. Although, as mentioned, the Fed believes that without further Congressional action, new economic weakness looms. One more interesting sign of the health of the economy also points to the dark side of doing nothing over the coming few months. The chart here shows a dramatic decline in the average household’s Debt Service Ratio. This figure includes payments on credit cards, auto loans, mortgages and the like. On the face of it, the trend before the pandemic hit saw a steady improvement as interest rates have fallen, debts and mortgages have been refinanced and as incomes have improved following the end of the Great Recession. The final data point in which debt service seems to have collapsed captures a lot of worrisome potential futures. This is because it captures the CARES Act “accommodations” that allow for payment deferrals on credit cards and auto loans, suspension of student loan payments, and relief for cell phone bills and other utilities so they won’t get shut off during the crisis. This does not mean these obligations disappear; in many cases they mount. Therefore, one often hears that if there is no comprehensive package that can kick the can further down the road, there will be significant hardship for many in the near term once short-term savings are depleted.
All the World is a Stage
The United States tends to take most of our focus and while it is the largest, most dynamic, and important market for us, we are global investors. Other countries have also faced the economic impact of the pandemic, though in more varying degrees. The chart on the right shows the response by a number of major economies in terms of percentage of GDP spent or lent in response to the crisis. In terms of budgetary impact, the US has spent the most as a share of GDP while many other countries have relied more on loans. We should note that this is from the International Monetary Fund’s Fiscal Monitor Database, and so does not capture all the programs employed by the Federal Reserve aside from indirectly via Treasury debt purposes.
The US has spent the most, but we also have had the most infected people and were slower to flatten the curve compared to most others. Another thing that stands out as a difference between the US and, in this next chart, the larger countries in Europe is the structural differences in our respective labor markets, which meant a much more rapid shedding of jobs and rise in unemployment. In much of Europe jobs cannot be shed so quickly. There are programs such as Germany’s famous Kurzarbeit, where employers reduce hours instead of laying off employees and the government covers 60% (more if there are children) of lost income. This is not to imply that the European systems are better, only that it may depict a shallower recession and a quicker path to recovery. Of course, one could easily argue that the lack of flexibility in the European labor market is one reason unemployment for so many appears to be structurally higher over time.
Then there is the reality that COVID-19 is making a comeback in Europe where initial success had given way to complacency and a resurgence of the virus. As the quarter drew to a close, the rate of infection started to soar, and the region’s governments began debating another round of closures. Daily new confirmed cases of the Coronavirus in Europe have risen to match those of the US. In both cases the pandemic continues to infect tens of thousands of people every day.
Between now and the distribution of an approved vaccine, likely many months from now, the virus will continue to wreak havoc on the global economy. In fact, as badly as it is impacting the developed markets, many poor and emerging economies are suffering greatly. The outbreak in Brazil seems to mirror our own but without nearly the resources to save seriously ill individuals. In India, the outbreak exceeded 80,000 cases per day at one point. While that has come down, India’s rate of contagion still exceeds our own.
And then there is the economic dislocation inflicted on the emerging world as a result of the recessions of developed markets. The World Bank Group believes that upwards of 150 million people will fall into extreme poverty because of the pandemic, wiping out years of tremendous gains. The sooner we can recover from this scourge the better it will be for everyone.
Investor Optimism Proves Resilient
Major stock market indices registered strong gains in Q3, but with it came a new bout of volatility not seen since the market collapse in March. Second quarter earnings were the primary driver of outsized returns in July and August. Though the 32% decline in S&P 500 Q2 earnings was the worst since 2009, it was well ahead of market expectations. FactSet reported that 84% of S&P 500 companies beat analyst expectations in Q2—the highest number since 2008.
Markets got a further boost in August when Federal Reserve Chairman Powell announced a more dovish approach to monetary policy—essentially using an “average” inflation target, allowing the Fed to temporarily overshoot on inflation to maintain a longer-term average of 2%. This only reinforced the “we’ll do whatever it takes” philosophy the Fed took in the early stages of the pandemic. The S&P 500 hit an all-time high on September 2, 2020, 60% above the March 23 low, representing the fastest recovery from a bear market in the history of the index.
However, there were emerging themes that made the rally vulnerable. First, a byproduct of this market’s recovery was the narrowness of its leadership. The top 5 names are all technology stocks (Apple, Microsoft, Amazon, Alphabet, Facebook) and account for 24% of the index, making it ripe for profit-taking. Second, a resurgence in COVID-19 cases stoked fear that a second wave of shutdowns could be looming. Finally, as we moved into September it became clear that Congress reached a stalemate on another stimulus package and the idea that it might be a post-election exercise was becoming a reality. Collectively, these factors ignited a selloff that pushed the S&P 500 down 10% from an all-time high (9/2/20) in only 14 trading days; the tech-heavy NASDAQ was down over 10% in only three. Eventually, investor optimism won out, the market bounced off the September lows, and the S&P 500 finished Q3 up a very impressive 8.9%.
For most of Q3 a few common themes continued—US stocks (8.9%) outperformed International (4.8%), Large Cap Stocks (8.9%) outperformed Small Caps (4.9%), and Growth (13.2%) outperformed Value (4.9%). However, the selloff in September diligently reversed this trend as the market looked to unwind some of the excesses from prior months. Whether this continues will be a major focus for investors in the days ahead.
Near-zero short-term rates and continuous bond buying helped keep interest rates low across the curve. The 10-year Treasury yield vacillated between .50% – .75% but ended the quarter at .68%, exactly where it began. Total return for the Bloomberg Barclays US Intermediate Aggregate Bond Index was a paltry .50% for Q3. High Yield, Municipals, and Global Bonds all rebounded nicely in the quarter.
Sectors that have been chronic underperformers like Utilities, Real Estate, and Consumer Staples, performed better in September but failed to keep up with the index for the entire quarter. Groups that benefited more from low interest rates and are more sensitive to the COVID-19 recovery like Technology, Industrials, and Consumer Discretionary led the markets generally in Q3.
Climbing a Wall of Worry
The herculean effort to keep the economy from imploding has been well documented and early evidence would suggest a reasonable impact on the economy and an extraordinary impact on investor optimism. Yet, as we exit the “snapback” stage of the recovery, investors are still questioning if the economy can withstand a second wave of COVID-19 cases, if it will need further stimulus to keep it going, or if the results of the pivotal election in November could sidetrack the recovery.
COVID-19 cases are growing as we enter the winter flu season, flaming fears that a second wave of the virus is just around the corner. News on vaccine development seems promising, and the low death toll would indicate we may be better at treatment, but the economic disruption of another lockdown would be damaging and remains a risk that the market must consider.
Congress has failed to agree on another stimulus package as many pieces of the CARES Act have expired. The direct/indirect hit to consumer incomes is estimated at roughly $1 trillion absent another stimulus bill. Fed Chair Powell himself has stated that more fiscal stimulus is critical at this stage in the recovery. The market fully expects a major stimulus package soon and anything otherwise would likely trigger selling.
Regardless of what party is in charge, market anxiety is usually high going into Presidential elections and this time is no different. The odds of a second term for President Trump have dropped and the betting odds of Democrats gaining a majority in the Senate are growing. As of October 4, 2020, Predictit (https://www.predictit.org/), a trading site that allows betting on political outcomes, placed a 63% probability that Democrats will win the White House, 66% that they will take the Senate, and 88% that they will retain control of the House of Representatives. If a “sweep” comes to fruition, experts question whether it would lead to an immediate shift in policy or if there would be a major financial impact.
We recognize that a sweep would bring with it the possibility of major policy shifts in healthcare, immigration, climate change, taxes—all the usual suspects. In this election, you can throw in the Supreme Court and the Filibuster also. The government was set up to make major policy changes difficult. Parties have ambitious political platforms but effecting change through legislation is much harder. Another idea to consider, regardless of the winner, is that either side is likely to contest the results, bringing unwanted discourse and market volatility.
The financial impact of tax policy is probably more relevant and easier to quantify. At a high level, Joe Biden’s plan calls for raising the corporate income tax to 28% (from 21%) and pushing the individual income tax rate for high earners (above $400,000) back to 39.6% (from 37%)—still at or below levels before the Trump tax cuts. The biggest shift would be in capital gains, where the Biden plan calls for a 39.6% long-term rate (now 23.8% all-in) and the elimination of the step-up in basis at death.
History has shown that the market performs best under a divided government, no matter what party is in charge. History also suggests that elections have little effect on long-term investing. Until we are on the other side of this pandemic, the passing of major legislation that would have a negative financial impact on the economy at a time it is most fragile seems like political suicide. A major infrastructure bill and/or a second stimulus bill is more likely—meaning the argument may be less ideological and more about how and where to spend money.
The S&P 500 currently trades at 22x forward earnings. That compares to five and ten year averages of 17x and 15.3x times respectively. The narrowness of the index makes valuation misleading as most of the companies in the index are below 22 times next year’s earnings. The near-zero level of interest rates, and the likelihood of them staying there for some time, also allows equity markets to trade at a higher multiple.
The S&P 500 (on a P/E basis) looks less expensive when compared to other asset classes. The Equity Risk Premium (ERP) subtracts the 10-year Treasury yield (currently .77%) from the S&P 500 earnings yield (4.55%)—the difference is the ERP. As shown in the accompanying chart, the ERP has been at or near historic highs (meaning stocks are cheap relative to bonds) ever since the Fed pushed interest rates to historic lows during the Financial Crisis. This helps explain, at least in part, why equities tend to be the asset class of choice in a near-zero rate environment. We also believe that as we move past the current snap-back recovery, and the global expansion gains strength, investment leadership will broaden beyond the narrow focus of today, making global equities, small cap stocks, and other cyclical subsectors more attractive.
The long-term outlook for stocks is still positive, but we expect greater volatility in the future, as the economy and markets have little room for error. The market remains steadfast in its optimism. It continues to anticipate a vaccine sometime this year or early next, assign a low probability to another lockdown, and assume that the Federal Reserve will support the markets through aggressive monetary policy. It also considers a new stimulus package essential to bridge the gap between today’s economy and what might be “normal” in 2021.
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