With the first half of 2020 in the rearview mirror, this month’s commentary has a forward-looking angle to it. The first part of the year was unlike anything we have seen. A pandemic swept across the globe, creating nearly unprecedented health concerns, not to mention massive dislocations in the labor markets and financial markets. As we try to make sense of what has happened, we look forward to what feels like even more uncertainty.
The Second Half of 2020: Headwinds We Face
Limiting the spread of COVID-19
Some of the movement in the equity markets (exactly what portion is too difficult to define) appears to be driven by the changing sentiment relating to the relative containment or spread of COVID-19. As we saw in June, financial markets reacted negatively to the news that early vaccine studies were not going as well as had been expected and that infections were on the rise.
Tensions between the United States and China
This item has been a top concern for years now, and all indicators point to it remaining a source of anxiety. Relations between the US and China have deteriorated significantly as of late, with several issues causing friction. It is easy to see global trade suffering as these tensions escalate, heading into the US elections.
The upcoming US Presidential election
Election years, by their very nature, tend to carry more uncertainty than other years. As we look forward to the November election, plenty of theories abound as to which candidate will be of more help to the economy and the financial markets. Despite many studies displaying the relatively benign impact that politicians have on markets, we tend to overrate the importance of politicians. That said, any sweeping legislation, like the Tax Cuts and Jobs Act of 2017, could again lead to tangible effects being felt from both an economic and financial market standpoint.
The speed of the economic recovery
The economic recovery remains more muted and ambiguous, even as financial markets have rebounded rapidly. While virus containment remains paramount, we are also keeping a close eye on labor markets and corporate earnings. The markets are currently pricing in corporate profits in 2021, equal to or slightly greater than those in 2019. Further, the market appears to be assuming that most temporary job cuts will remain temporary, and most individuals that were furloughed or temporarily laid off will have their jobs back in the near future.
Additional Questions Being Asked
Will domestic equity leadership change?
Large-cap stocks and growth-oriented stocks have been in favor for quite some time now. Is there any chance small and mid-sized companies will become glamorous again? What about value companies? With their valuations rarely being more attractive, what are the odds that value stocks go from being unloved and overlooked to leading the way?
Will U.S. leadership finally give way to international developed or emerging markets?
Many believe the US will have another, even more, vicious wave of the pandemic. If this happens, could it finally open the door for international developed and/or emerging markets to lead the way? This may be the catalyst, as many overseas countries seem to have done a better job containing the pandemic. This difference may finally give international markets the opportunity to have an improved growth outlook relative to the US and allow them to close the economic and corporate profitability gap.
Will interest rates ever move higher?
It feels like we have been asking this question for more than a decade now. The answer remains unclear. Lower rates for longer have driven investors searching for income into risky corners of the high yield bond markets and even into equities. On June 10th, Fed Chairman Jay Powell said, “we’re not thinking about raising rates. We’re not even thinking about raising rates.” This gives investors reason to believe a reasonable yield on fixed-income investments will remain elusive.
Global central banks rose to the challenges presented by the virus and pledged to do “whatever it takes” to beat the virus while keeping the global economy afloat. Even after several trillion dollars of global stimulus, it is a consensus opinion that more is needed. Questions that remain are “for how long?” and “when and how will we pay the price for this unprecedented stimulus?”
Reasons to be optimistic:
- Economic activity continues to pick up as the most stringent lockdown measures are being lifted. It stands to reason that the low point for many economies has likely passed.
- As violent as the economic downturn was, the economic uptick has the potential to be just as sharp to the upside.
- The global central bank response has been nothing short of remarkable. Central banks flooded consumers with liquidity. This liquidity had to go somewhere. Much of it ended up in equity markets, which explains a lot of the rapid rise that has been seen.
- From a health standpoint, there will likely be a renewed focus on personal health. From a corporate perspective, there is a high probability that even more emphasis will be placed on being socially responsible and operating as sustainably as is possible. There is a high likelihood that Environmental, Social, and Governance (ESG) practices will come into focus. This should make for not only a healthier society but also a more sensible and responsible corporate world.
Reasons to be cautious:
- The recovery is unlikely to be smooth. The markets seem to be pricing in optimistic recovery scenarios. Any setbacks that occur could result in a repricing of risky assets.
- There is reason to be cautious simply because we are in an election year, and that carries heightened political risk.
- The current struggles that we are all facing may be around a good bit longer than any of us prefer to believe. The realities of the global pandemic will remain.
- It is a consensus that bankruptcies will rise, perhaps rapidly, as companies realize it is better for them to shutter their doors than to continue losing money.
Individuals and businesses are making very difficult choices between health uncertainty and economic uncertainty. The vast majority of people and business leaders seem to be doing their best to maintain the delicate balance of doing everything they can to stay healthy and safe while also doing what they can to keep their households and businesses viable.
As we have stated before, we continue to believe in the resiliency and the ingenuity of humankind. The downturn was perhaps the steepest and sharpest we have ever witnessed; much health and financial devastation have occurred. Yet, as difficult as it is to fathom now, with businesses failing and jobs being lost, many new opportunities will emerge out of this crisis.
There are always going to be a multitude of reasons why it does not seem like a good time to invest. We do our best to encourage our clients not to time the market and help them in constructing a portfolio that is comfortable enough for them that they are able to stay invested through the good times and the bad. Equity investing is inherently risky. That is why our team, as equity investors, are paid an equity risk premium. This is the premium that we receive for putting our hard-earned money at risk in hopes of achieving a rate of return above the risk-free rate. Typically, equities have a real return of 4-7% over inflation. When taking a long-term perspective, we believe that the rate of return will continue.