Economic and Financial Market Outlook 3Q 2022
Almost all the largest world economies, including the United States, are experiencing a growth slowdown and troubled financial markets. Consumers and businesses continue to grapple with soaring inflation, which in the US and Eurozone has topped 8.0%. The focus is now on the response of central banks to combat inflation and whether they can do so without excessively damaging their economies. While prices in the US likely will remain uncomfortably high throughout the summer, our view is that inflation is peaking and will ease to below 5.0% by year-end. This would permit the Federal Reserve to stop raising the Fed funds rate, which will pave the way for an economic rebound and a turnaround in slumping stock markets. The major risk is that the Fed will raise rates too high for too long and trigger a recession of increased severity. Even if this scenario occurs, we think that in its severity it will be typical of the average recession in the past 70 years. Similar to previous recoveries, we expect large equity gains in the first months, or even weeks, of the rally.
US first quarter GDP came in at –1.4% and forecasts for the second quarter show an increased likelihood of consecutive quarters of negative growth. There will be a debate over whether this constitutes a recession (we note that NBER is the official judge of the beginning and end of recessions, and typically give their opinion long after the fact). Rather than laboring over semantics, it is most useful to acknowledge that the economy is weakening: the high rate of inflation is taking a toll on the economy and Fed rate hikes are intensifying pressures on growth. We pointed this out in our May 12 blog, “The Risk of Recession is Rising.” Since then, several leading economic indicators soured, including new orders in purchasing manager surveys, the Conference Board Leading Economic Index, job openings, auto sales, and home sales. A turnaround will require substantial moderation in inflation to restore confidence and spending. Recent developments have been constructive on this front: a sharp decline in industrial commodity prices and even gasoline have contributed to a recent easing of input costs. An improvement in supply chain bottlenecks would provide further relief. But the key to decreasing inflation in the coming months will be the cooling economy.
The major US stock indices are officially in a bear market: the NASDAQ composite plummeted 22.4% in the second quarter alone and 29.5% for the half year, while the S&P 500 dropped 16.1% in the second quarter and produced the worst first half returns since 1970. Many of the leading US corporations have suffered major first half stock price plunges:
|Stock Ticker||1H22 Performance|
Our view is that for equities to reverse this downward trend, there needs to be a sign that the Fed will end its anti-growth policy of monetary tightening. As we mentioned above, this will only happen once inflation is deemed to have been sufficiently subdued. If our forecast that inflation will moderate over the next several months is correct, and, in response, the Fed indicates an end to their rate hike cycle in a timely manner, then there is a strong probability that the stock market will bottom in the second half of the year and commence a new bull market. There is solid historical evidence to expect the eventual market recovery will be fast and strong. The past three bear market lows in 2020, 2009, and 2002 were followed by 3-month advances of +35.1%, +40.2%, and +20.0%, respectively.
We acknowledge that there is a rising risk that the US economy will suffer something deeper than a modest recession. The major threat is a policy error from the Fed. Historically, the full impact of higher interest rates has not become evident until six to nine months later. This means that the Fed will be raising the benchmark interest rate based on an assumption of future conditions, which will make it easy to overshoot. On the other hand, if the Fed wavers too soon and does not sufficiently tackle the inflation problem, a prolonged period of stagflation and market turmoil could result. We are monitoring closely the US labor market for evidence of a wage-price spiral, which inflamed the inflation problem in the 1970s but has yet to occur this year. Another risk is the geopolitical threat of Russia further upending the global energy trade. Russia is one of the top three oil producing nations and provides most of the natural gas the EU consumes. A disruption in the flow of these natural resources could cause another massive spike in oil and natural gas to record highs.
Most developed international economies are experiencing the same threat of inflation and economic deterioration as the US. From The latest inflation data in the EU is 8.1% year-over-year, Britain is 9.1% and Spain has reached double-digits. The only exceptions are China and Japan, at 2.1% and 2.4% respectively (The Economist 7/2/2022). Like in the US, the European Central Bank, as well as the central banks of Britain, Canada, and Australia, have telegraphed their intention to tighten monetary policy. The consequence has been a growth slowdown in these countries with the additional threat of an energy shortage in the Euro Area, which may make consumer hardship worse than in the US. Indeed, the euro has declined to a 20-year low and reached parity with the US dollar. In contrast, Chinese policymakers, spared from high inflation, are taking steps to stimulate their economy and growth has recently accelerated back above 5.0% despite rolling COVID-19 lockdowns. We recommend investors focus on individual companies benefiting from long-term secular trends with strong fundamental growth opportunities in the Euro Area, Canada, and Australia. While Chinese equities are attractive from a valuation and earnings perspective, the regulatory risks remain elevated.
The benchmark US Treasury bond has continued its march higher, reaching above 3.0%. This has by some measures resulted in the worst first half ever on record for US Treasuries (index inception 1973). While higher yields appear tempting to bond investors, real returns (inflation adjusted) are worse now than when interest rates were near zero. We reiterate our view that bonds do not offer a competitive medium- or long-term return profile compared to inflation and stocks. We think the principal benefit of bonds is their role in portfolios as a volatility stabilizer and continue to emphasize quality and short duration in bond selection.
Economic and Financial Market Outlook 2022 Q2
Entering the second quarter, the outlook for the global economy is uncommonly uncertain. The result is above average volatility in financial markets and rapidly shifting investing trends. In the US, the key issue is rising inflation and the response of the Federal Reserve as it attempts to pilot a soft landing (raising interest rates without causing a recession). In our March 2 blog and January 13 Outlook, we expressed confidence that the Fed would be successful. We still adhere to this view but acknowledge that inflation has proved to be more intractable and economically disruptive, which makes the Fed’s task more difficult. In addition to rising inflation, international markets will need to cope with the negative economic consequences of the Russian invasion of Ukraine as well as potential hurdles impeding a pickup in China. Although our forecast carries less conviction than usual, the most probable scenario is that 2022 US GDP will remain positive in the coming quarters, inflation will gradually subside below 5.0% by year-end, corporate profits will rise around 10.0%, and the S&P 500 will be higher at year-end than it is now.
The US economy currently faces persistently high inflation. Monthly readings of core CPI (ex-food and energy) have risen each month since last September, with the latest reading at 6.5%, the highest in 40 years. In response, the Fed has indicated that it is ready to push through faster rate hikes and balance sheet reductions, which will slow the economy in hopes of dampening upward price pressures. We are intensely focused on the success of this course of action. Achieving a soft landing will enable the economy to continue its growth trajectory and prolong the post-pandemic recovery. However, if inflation continues at a high pace without relief, consumers and businesses will have to curtail spending and the Fed will take even more aggressive measures, increasing the likelihood of recession.
The exceptional strength of the US economy has thus far blunted the negative impacts of high inflation. The unemployment rate of 3.6% has only been lower once in the past 50 years (3.5%, Oct. 2019). GDP grew 5.7% in 2021, the fastest year since 1984. The US consumer, the backbone of the economy, is solid; balance sheets are healthy, credit utilization is low, and wages are rising. Household cash exceeds debt for the first time since the early 1990’s. Nevertheless, two recession indicators occurred in the first quarter: a spike in oil prices and the inversion of the yield curve (when short-term rates go above long-term rates). Of these two, we are less concerned about oil as it has already stabilized well below the peak. The yield curve inversion, on the other hand while a more reliable predictor, has in the past delivered false signals and on other occasions preceded recession by as long as three years. The robust US economy, in particular the consumer, provides some room for error to navigate a soft landing or, at worst, fend off recession for at least 12-18 months. We expect GDP growth to remain positive every quarter this year, measuring 3.5% for the year.
US stock markets swooned in the first quarter in response to escalating threats to the burgeoning economic expansion. Major benchmark indices are still mired in a correction, with the S&P 500 producing the first negative quarterly returns in two years. The forward P/E ratio of the S&P 500 index has dropped to 19.0 from the 21.3 recorded at the end of last year, with growth stocks experiencing an especially large multiple contraction. This indicates that current equity valuations are not alarmingly high considering the expected double-digit rise in 2022 corporate profits. If investors gain confidence in the resilience of corporate earnings and/or a successful soft landing, stock markets should make a sharp advance. However, if the Fed makes a policy error and leads the US toward recession, additional negative returns can be assumed before equities begin a new bull market cycle.
Investing in international equity markets carries additional uncertainties and risks. In the EU, in addition to a more acute impact on consumption from higher energy and food prices, Russia’s invasion of Ukraine has dragged down sentiment, even while economies enjoy a boost from the lifting of COVID-19 restrictions. Alternatively, China is still imposing a “zero COVID-19” policy, which is negatively impacting growth. Encouragingly, however, China policymakers have pivoted to stimulating the economy and committed to achieving a 5.5% GDP growth rate in 2022. This stimulus may serve as the bedrock for a continuation of a strong global economic expansion. China and the US, in combination, account for 42% of global GDP. Our projection is that global GDP will slow to 3.8% in 2022 from 5.9% last year. The concern is that some economies may experience hard landings though the consensus view remains optimistic. The most recent forecasts cited in The Economist (04/09/2022) are encouraging:
Region 4Q2021 GDP 2022 GDP
China 6.6 5.5
Euro Area 1.0 3.3
Japan 4.6 2.8
Canada 6.7 3.8
If the forecasts are correct, policymakers will have avoided a hard landing scenario and equity markets will rise.
In the bond markets, the strong economy, surging inflation, and anticipation of aggressive Fed rate hikes has swiftly pushed yields higher. The benchmark 10-year Treasury rocketed from 1.52% at the beginning of the year to 2.77% on April 11. Many investors fear that high inflation will result in a further updraft in interest rates, which could result in negative real (inflation-adjusted) returns on bond investments. In our view, bonds still do not offer a competitive return profile compared to inflation and stocks, though if held to maturity they offer portfolios protection from volatility. We normally emphasize quality and short duration in bond selection, and we think this advice is especially relevant now in order to protect principal in these uncertain times.
Economic and Financial Market Outlook 1Q 2022
Uncertainty and volatility dominate the 2022 outlook for global and US economic growth and financial markets. Investors agree that the major issues include inflation, COVID-19, central bank activity, labor and supply chain disruptions, the potential for international upheaval, and developments leading up to the US midterm election. What is hotly debated is how these issues will interact to impact the investment results for the year. The three most prominent scenarios currently debated in the media are highly divergent and range from strong optimism to alarming pessimism: moderate growth, hyperdrive economy, and recession risk. As the year progresses, we expect incoming data to change the prevailing viewpoint, resulting in sudden and dramatic shifts in financial markets. At this point, we do not think any one of the three scenarios warrants a greater than 50% probability for the year, and we advise against excessive reliance on any one of these investment narratives occurring comprehensively. Rather, our recommendation is that investors focus on their long-term strategy, exercise patience and discipline, emphasize quality and diversification, and avoid the temptation of market-timing or chasing short-term trends.
We assign a 50% probability to the moderate growth scenario, which most closely reflects our current US outlook of 3-4% GDP expansion, a 10-15% rise in corporate earnings, and an advance of 8-12% in the S&P 500 Index. The “Goldilocks” forecast, which we consider the most correct, anticipates meaningful progress in the COVID-19 battle in the first quarter; we do not expect the Omicron variant to significantly damage the economy for the rest of the year. This will permit a boost to employment, consumer and business spending, and corporate earnings. The most likely threat to the recovery will come from the potential emergence of a new virus variant. We also agree with the moderate growth scenario’s assertion that inflation will rise early in the year, but then stabilize. A modest decline in inflation could occur as supply chain disruptions are ironed out, pent-up consumer spending during the COVID-19 period is satisfied, demand shifts from products to services, the more restrictive policy of the Federal Reserve takes hold, extraordinary fiscal stimulus policies lapse, and a gradual decline in labor shortages reduces the risk of a wage/price spiral. A relaxation in the threat of runaway inflation will permit the Federal Reserve to initiate its highly awaited rate hike cycle in a gradual and non-threatening way to the stock and bond markets.
The second scenario, which we accord a 35% probability, assumes that the economy becomes overheated, and inflation spirals out of control. As in the moderate growth scenario, the expectation here is that the virus situation ceases to impact negatively the economy. However, labor shortages and wage gains persist, and consumers and businesses adopt inflation as a major consideration in their decision making. Supporters of this scenario also point to the likelihood that a concurrent reopening of international economies will elevate commodity prices, including oil. The result will be a rise in both GDP and inflation, somewhat reminiscent of the 1970s. In the meantime, the Federal Reserve will confront a rising criticism that they have responded too slowly, too indecisively, and in short, that they are behind the curve.
The most pessimistic scenario, which we designate a 15% probability, projects the likelihood of a surprise recession and bear market. Here the thinking is that inflation will rise dramatically and prompt the Federal Reserve into aggressive and repressive rate hikes. This is a development which has punctuated the US economy several times over the past 50 years. While we think this scenario is unlikely, we are carefully watching recession indicators including the Treasury yield curve, the unemployment rate and initial jobless claims, the price of oil, corporate profit margins, manufacturing and services PMIs, consumer confidence, and housing prices.
Each of the three above scenarios is associated with distinctive investment style outperformance. If the moderate growth forecast is correct there will be a double-digit stock market gain and a modest rise in bond yields. Growth stocks in the technology and consumer discretion industry sectors will lead the market higher, much as they have over the past decade. The hyperdrive economy scenario will produce a surge in the economy and corporate profits. The tide will be strong enough to lift all equity boats, but the leaders will be value stocks in the financial, materials, and industrial sectors. In the recession risk scenario, the market could well drop 20% or more and the best place for investors to limit losses and avoid volatility will be in the consumer staples and utilities sectors. Our current view is that investors should stay diversified and emphasize stocks of industry leading companies with strong management, and attractive recent earnings momentum and future potential.
Conditions in the international economies and financial markets resemble the US. The IMF projects 2022 GDP to increase about 5.0% in both the developed and emerging country groups. We predict, however, considerable divergence as countries battle COVID-19 with mixed success. China and Europe will be the keys to the general outcome. The situation in China is worrisome: the government is taking ever more severe steps to impose its control over significant sectors of the economy, and at the same time, adopt restrictive policies to combat the virus. Also looming is a potential real estate crisis which could threaten a national financial upheaval. These myriad challenges are expected to slow the recovery and further exacerbate supply chain disruptions. On the other hand, if the government is successful in its virus containment measures and simultaneously stimulates the economy, there could well be a large boost to global demand. The stocks of Chinese companies were severely damaged in 2021 and we think a period of improved credibility is necessary to restore long-term investment prospects.
The economies and equity markets of Europe have been underperformers relative to the US for so long that it would be easy to dismiss the possibility of a renaissance. Yet, this may happen in 2022. European companies and economies are in the best position relative to the rest of their international competitors as they have been in years, sporting solid GDP growth, higher vaccination rates, strong corporate balance sheets, and healthy consumers ready to spend. The political authorities and the European Central Bank are determined to keep economies open and vibrant. European stocks, particularly in the financial, industrial, and consumer sectors, could well provide positive earnings and stock price surprises.
A major factor influencing all financial markets, in particular the bond market, will be the response of investors to the new policies of the Federal Reserve. We think that a key component of a moderate growth scenario will be a rise in bond yields, with the yield on the benchmark 10-year US Treasury Note topping 2.0%. In the hyperdrive economy scenario with higher inflation, the 10-year US Treasury Note could even top 3.0%. We do not consider these yields to be competitive with the total return potential of common stocks, and bonds with maturities more than 10 years could well experience a negative total return. The major attractiveness of bonds will be to provide portfolio stabilization in the event of a surprise recession and bear stock market.
Economic and Financial Market Outlook 4Q 2021
We expect the global economy to continue its rebound from the COVID-19 Recession of 2020, fueled by reopening economies, unprecedented fiscal and monetary stimulus, and pent-up demand. However, recent developments have tempered the heady optimism from the first half of the year. The Delta variant’s rapid spread, worldwide supply chain disruptions, a sudden rise in inflation, a deteriorating Chinese economy, and the possibility of a US debt default and government shutdown have eroded confidence in the recovery’s duration and strength. Investor sentiment turned pessimistic in response to these developments; for the month of September, the S&P 500 Index slumped -4.8% and the international benchmark MSCI ACWI-ex US Index gave back -3.7%. Despite the recent pullback, looking forward we think that the positives still outweigh the negatives. The most probable outcome is that the global and US economic expansion will continue through 2022, though at a less robust pace than previously forecasted. Fundamentals supporting higher equity returns remain intact and investors should stay disciplined and focused on their long-term strategy.
When we wrote our last Outlook in early July, the Delta variant had yet to significantly affect the US. Since then, Delta has brought upon another wave of the pandemic, infecting millions and causing tens of thousands of deaths. The human cost has been profound. Although the virus surge caused immense human tragedy, the economic impact in the US has been relatively limited in contrast with other countries. Despite escalating COVID-19 cases and hospitalizations, restrictive shutdowns were limited, and consumption stayed high. Bolstered by stimulus measures, household savings and balance sheets improved to record highs and debt servicing payments as a percent of income reached record lows.
Consumption remains about 70% of the US economy, and consumers are the wealthiest they have been in decades. With the economy reopening, competition for labor has been fierce, resulting in huge employment gains, job openings, and rising wages. The likelihood of a recession is remote. However, inflation, supply chain and labor shortages, political uncertainty, and Federal Reserve policy have combined to limit growth. We anticipate progress on these issues in the fourth quarter and that they will not be as large of a drag in 2022:
- Inflation: We are in the middle innings of an above-target inflationary period, beginning in the spring. It appears that the initial pent up demand surge is waning, but inflation remains high and tends to go up faster than it comes down. The inflation rate will decline, but prices are not likely to retreat to prior levels.
Commodities like copper and wood have returned to more normal levels following a large spike, and demand for certain big-ticket items, like automobiles, have pulled back from peaks. Higher inflation than the 2008-2019 period may persist, but if this moderating trend continues the specter of excessive inflation will recede. Nevertheless, we acknowledge that the near-term impact is troublesome. The September University of Michigan Surveys of Consumers Report stated the problem concisely:
“Even if transient, higher inflation has already decreased living standards, and further damage is anticipated as just 18% of all households anticipated income gains would be larger than the expected inflation rate.”
- Supply chain and labor shortages: The global supply chain has not been able to adjust adequately to the surge in demand. It has not been uncommon to see empty shelves in stores or to experience month-long waits for household durables, like refrigerators. Semiconductors and shipping containers are a notorious headache. Supply chain issues and labor shortages are being cited more often in corporate earnings reports as a factor negatively impacting margins and profits. If production can ramp up and deliveries can accelerate, then the economy can grow higher for longer. The global supply chain is not static; it will adapt. The question is how quickly it can overcome major bottlenecks.
- Political uncertainty: The situation here is simple, though the stakes are high. If the US defaults on its debt, which would be without precedent, the consequence would be perilous. Fortunately, congress can avoid this ominous fate by simply raising the debt ceiling. Until there is an apparent path toward addressing this serious matter, this risk will remain at the forefront. A government shutdown is an additional potential hurdle, but the consequences are less dire than a default. We think that cool heads will prevail, a budget will pass, and essential government services will remain operative. As in the past, it may take a last-minute, highly contentious compromise, and our expectation is that these obstacles will be cleared before the end of the year.
- Federal Reserve policy: There is speculation that the Federal Reserve will commence a tapering policy (a reduction in its $120 billion per month bond purchases), which will result in a stock market setback. We expect the Fed will taper late in the fourth quarter, but we think it will be gradual, widely anticipated, and not upset the stock market. There is also speculation that runaway inflation will force the Fed to prematurely hike short-term interest rates, but we think the Fed will stick to its timetable of late 2022 or 2023.
The uneven nature of the recovery is likely to continue, but the powerful trend of economic expansion remains the strongest argument in favor of higher stock markets. While US equities have recently pulled back from highs, the 2021 calendar year has thus far produced solid returns. We expect the bull market to continue before year-end, buttressed by strong corporate profits, pro-growth monetary and fiscal policies, and large cash positions on the sidelines. As in the recent past, the primary investment alternatives to stocks, in particular money markets and bonds, remain unappealing.
The most notable feature within international economies is the wide gulf between developed and emerging countries in their ability to combat the virus, recover from last year’s downturn, and provide positive equity market returns. In stark contrast with their emerging market counterparts, wealthy countries benefited from mature healthcare infrastructure, purchased and administered vaccines effectively, and provided fiscal stimulus directly to their citizens. This difference is reflected in the year-to-date 6.9% return of the developed markets ETF iShares MSCI EAFE compared to –2.5% in the emerging market ETF iShares MSCI EEM. Emerging market economies have endured additional stress from a softening Chinese economy, which has been weakened by a fresh round of anti-business policies from its government. Our view is that the prosperity gap between emerging and developed economies will persist for several quarters. Europe, Australia, and Japan have high vaccination rates and are reopening their economies; they will quickly catch up to where the US is now in the recovery process. It is worth noting, however, that this will unleash pent-up demand, which could put further strain on global supply chain issues. Emerging economies and stock markets will struggle until they make substantial improvement in their ability to handle the virus.
As in past outlooks, we continue to recommend the best approach to international equity investing is to focus on the ability of individual companies to thrive despite current economic realities. For example, some commodities companies will benefit from rising global inflation and some semiconductor companies will profit from huge demand. Investments in China, in the past so beneficial, now have higher risk and should be considered only with considerable caution despite strong earnings potential. Also attractive are European companies strongly positioned to profit from the reopening trade as virus concerns recede.
Rising concern for inflation is putting upward pressure on bond yields despite the Federal Reserve’s policy of maintaining a low interest rate environment. For example, the yield on the benchmark 10-year US Treasury has risen from a low of 1.17% as of Aug 4, to a current 1.58%. The yield may well rise further (and the price decline) in the short term as the general economy continues to improve and the Federal Reserve begins to unwind its bond purchasing policy. We thereby recommend that investors emphasize short-maturity bonds despite their relatively unattractive yields.
Economic and Financial Market Outlook 2021 Q3
Our 2021 forecast, which we have held since our first quarter Outlook, remains intact: a synchronized global economic expansion is underway, will extend into 2022, and will support another year of rising stock markets. The International Monetary Fund in April projected 2021 global GDP growth of 6.0% and The Economist projects this gain will be led by the US (6.0%) and China (8.5%). We acknowledge that the extent of economic progress for most countries, including the US, will be determined by their ability to secure and distribute COVID-19 vaccines, sustainably reopen their economies, and successfully implement fiscal and monetary policies. We observe significant divergence in the speed and magnitude of country recoveries, but overall growth should provide solid opportunities for equity investors.
The US economy is experiencing a stronger than expected vaccine-powered recovery, led by consumer spending. In response to recent indications of strength, on July 1 the IMF raised its 2021 US GDP estimate from 6.4% to 7.0%. Going forward, extremely accommodative monetary policies adopted by the Federal Reserve in combination with highly stimulative fiscal spending by the US Congress and Administration will be a major support. A bulge in household savings rates during the pandemic coupled with employment gains in the millions and rising wages will further boost consumer spending. Another development is a potential surge in home equity loans arising from the large increases in property prices at this time of very low interest rates. Additional positives include the pent-up demand in capital expenditures and a pickup in international economies.
The US stock market continues to be highly attractive. Corporate earnings have mushroomed far above analyst expectations so far this year: based on consensus analyst projections (FactSet, 6/17/21), we expect 2021 year-over-year S&P 500 profit growth of 61.9% for the second quarter and 34.8% for all of 2021. Public companies are eager to restore share buyback programs and raise dividends, both of which are positives for their stocks. There is still $4.5 trillion in money market funds on the sidelines (Investment Company Institute, 7/1/21) that could flow into equities as investors reallocate their portfolios. The S&P 500 Index currently trades at a forward P/E ratio of 21.7x, which is reasonable compared to the 5-year average of 18.0x. In other words, the forecasted rise in corporate profits will allow for stock price appreciation without stretching valuations.
Most international economies are not as far along in the recovery process as the US, with some faring better than others. This divergence is reflected in investment returns: Euro Area stock markets year-to-date are up 14.7% versus a more meager 5.4% gain for emerging markets. Another example is Japan, with expected GDP growth of only 2.2% this year and a corresponding equities gain of 5.2%; in contrast, France is anticipated to grow 5.5% and its stock market has soared 18.0% (The Economist, 6/26/21). Political developments are having a negative impact on equities in certain countries, including China, Hong Kong, and Brazil. Although some markets may prosper and others may falter, many individual companies will capitalize on the strong global expansion. Moreover, countries currently struggling with the virus will prevail eventually and subsequently experience an economic recovery. With billions of vaccines already manufactured, we think this will occur sooner than later.
Risks to a global stock market advance which we consider noteworthy include:
- Runaway inflation in the US: indicators are for longer-term inflation to remain low, but surveys show that individuals are becoming increasingly concerned.
- Policymaker errors by central banks and/or government authorities.
- A new virus or variant outbreak, which will lead to a restoration of restrictions.
- Supply shortages of labor and goods, slowing the rate of economic progress and seriously hampering certain industries and companies.
- Deteriorating international relations, particularly between the US and China, which would negatively impact trade and the ability to fight the virus.
Each of these challenges already exist to some extent, with the possible exception of excessive inflation. However, their severity hasn’t reached the point to derail the current bull market. We do not expect these threats to fade completely, and as always, we will keep a close watch regarding their impact on the positive case.
Investors are highly sensitive to the yield on the US 10-Year Treasury Note because it is an indicator for the outlook for inflation, future Federal Reserve policy, prospects for the overall US stock market, and the relative return on industry sectors and growth versus value styles. We anticipate the Federal Reserve will resist pressures to taper or raise short-term rates at least through 2021, and thus we expect only a gradual rise in the 10-Year yield from the current 1.32% to 1.50-1.80% by the end of the year. As competitors to equities, money market and bond yields continue to be unattractive. Bonds remain important as portfolio stabilizers but are less appealing as a source of income.
We wish all our readers a safe and pleasant summer.
The Marietta Investment Team
Economic and Financial Market Outlook 2021 Q2
We continue to hold to our January 6th forecast that a synchronized global economic expansion in 2021 will support another year of rising stock markets. The International Monetary Fund recently (04.06.2021) projected 2021 global GDP growth of 6.0% led by the US (+6.4%) and China (+8.4%). Similarly, JPMorgan expects U.S. GDP growth of 6.4%. Both forecasts revised upward their growth targets from earlier in the year. We are more optimistic; U.S. GDP growth will be at least 7% if the pace of reopening continues. This acknowledges that the economic path forward for most countries, including the U.S., will be determined by their ability to secure and distribute COVID-19 vaccines, sustainably reopen their economies, and successfully implement effective fiscal and monetary policies. In 2020 there were investor fears of a severe and prolonged virus-related recession, global GDP shrank by -3.3%, and every major economy except for China suffered negative growth. Now, all major regions are expected to grow at above average rates, COVID-19 cases are well off their peaks (though concerningly rising in some parts), and staggering amounts of financial relief is breathing life to the economy. We are closely watching the progress to overcome the pandemic as well as any signs that recovery efforts trigger excessive inflation, but we believe we are in the early stages of a new bull market. At this time, we recommend investors take a disciplined approach and stay with their long-term strategy.
The US economy will enjoy a strong rebound this year as the COVID-19 threat subsides and economic restrictions lift, with monetary and fiscal stimulus providing additional support. The COVID-19 situation has clearly improved: over 3 million vaccine doses are administered on average each day, over 25% of the US adult population has now received two doses, and hospitalization rates continue to decline. As a result, states and cities have further eased emergency restrictions. As the entire country has begun its long-awaited “reopening,” the labor market has drastically improved. The unemployment rate has come down to 6.2% from a high of nearly 15.0% and the US added over 900,000 jobs in March. Besides benefiting from reopening, US households have been supported by monetary and fiscal policies. The $1.9 trillion stimulus passed in March and the Federal Reserve’s commitment to keep interest rates low have put the US economy on steadier footing. While many people have not felt the recovery yet, consumer confidence is on the rise and average household savings rates are at elevated levels (see chart).
The US is further along in its vaccination efforts than most, but as other countries undergo a similar process and reopen with increased immunity in the coming quarters, the US economy will further benefit from the virtues of a broad-based, synchronized global economic expansion. This optimistic outlook assumes that vaccines stay effective against the prevalent COVID-19 strains and new coronavirus variants do not spread to an extent that lockdowns are brought back.
At the other end of the spectrum, we must be watchful that the stimulus and easy monetary policy does not lead to an overheated economy with excessive inflation. At this juncture we do not think inflation will be a drag on the economy. We have already seen reports of short-term higher prices, but we think this is due to businesses trying to catch up to growing demand with pandemic-idled production capacity. The March Producer Price Index (PPI) showed 1.0% month over month price increases, the second highest on record. These are extraordinary numbers but we expect that once producers can increase hiring and production capacity, the inflation pressures will subside. Over the past decade, the greater threat has been disinflation rather than inflation and we should not lose sight of the fact that it is healthy for inflation to run at or slightly above the Federal Reserve’s 2.0% inflation target.
The fundamental backdrop is positive for US stock markets. The Federal Reserve has promised to continue accommodative policy and a faster-than-expected recovery should enable companies to report stronger earnings and give better guidance. FactSet estimates full-year corporate earnings will surge over 23% year-over-year, which we consider conservative. This large increase in profits will moderate what currently appear to be lofty P/E multiples. Moreover, alternative investments to equities, such as bonds and money market funds, provide low and unattractive potential returns, further justifying elevated stock market valuations. Coming off a deep but short-lived recession, the market is experiencing a period of transition. Historically stock market recoveries from recession have resulted in a change in leadership. Whereas growth and momentum stocks, led by information technology industries, are favored leading up to recession, value and economically sensitive stocks found mostly in the financial, consumer discretion, and energy/commodity sectors come to the forefront during recoveries. This has been the case since the positive vaccine news broke on November 6, 2020 with the Russell 1000 Value Index surging 23.1% while the Russell 1000 Growth Index improved a more modest 6.0%. Similarly, stocks of businesses that were depressed or even shut down during the pandemic have been catching up to the companies that were minimally affected over the past year. The worst stocks of 2020 performed the best in the 1st quarter of 2021. It is possible that this trend will continue near term, but we prefer companies that can demonstrate earnings and revenue growth from pre-pandemic levels. Certainly, investors should hold some investments with improving prospects due to the reopening (travel/leisure, entertainment, manufacturing), but we continue to emphasize companies with strong fundamental attractiveness that benefit from trends that will run long past the point of full recovery.
The pace of recovery across regions is striking. Nevertheless, IMF forecasts that every major economy will recover from recession this year and continue growing in 2022. We think this will create numerous and significant investment opportunities across countries and industries. The Eurozone should bounce back to 4.5% growth in the second half and the UK will see full year output at 5.0-6.0%. In the near-term we favor developed economies as they will likely recover more quickly. These regions also have value-oriented sectors like financials and industrials. China and India are bright spots in the emerging world and are expected to grow at 8.4% and 12.5% this year and moderate in 2022. Mexico will likely experience above trend growth as well given its close relationship to the US.
There are always threats to an optimistic outlook and we closely monitor risks that could disrupt economic growth. Again, first and foremost, is the continued presence of COVID-19 which has begun to rise again in Europe, South America, and India. We are also cognizant of global supply chain shortages, particularly in semiconductors. Further, we think rising nationalism is a significant risk as people in various countries push for less globalization and it could negatively affect international trade. Lastly, as always, we want to keep watch on geopolitical tensions, especially with respect to China.
Across the world, but especially in the U.S., interest rates have turned higher in anticipation of stimulus-fueled spending and economic growth. While the move has been sudden, the 10-Year US Treasury yield jumped from 0.92% to 1.74% during the last quarter, rates are still exceedingly low. The 10-year rate is still lower than 2019 levels and near the lows for the entire 2009-2020 expansion. Rates will likely move higher as this expansion matures but bond investors should not expect a return to a pre-financial crisis yields. This may provide an opportunity to select some bonds at better prices for fixed-income portfolios but we still recommend underweighting this asset class.
One year ago, we wrote at the outset of the pandemic that one key question was “When will there be a return to near-normal activity, and will the mass amounts of unemployed workers be able to resume their jobs?” One year later we can finally see the light at the end of the tunnel as the reopening gets underway. Economic indicators are turning decidedly positive and global stock markets have advanced in anticipation. This process will take place over the next few quarters and it will not be a steady journey, but there are better days ahead.
As always, stay safe and healthy and be optimistic for the future.
The Marietta Investment Team
Economic and Financial Market Outlook 2021 Q1
The tumultuous 2020 calendar year has finally ended. Despite enduring a global recession, most of the world’s stock markets recovered to finish the year with solid gains: the US benchmark S&P 500 Index returned 18.4% while the MSCI All-Country World ex-US Index rose 10.3%. When we issued our last Outlook on October 13, we noted that a heavy fog had obscured financial market forecasting. At that time, major questions regarding the future course of COVID-19, the response of policymakers, and the impact of US politics, were impossible to predict with conviction. We also anticipated this uncertainty to lift by year-end and improve visibility into 2021. This has happened and, on balance, the developments have been positive for financial markets. The consequence has been surging global equities propelled higher by a growing consensus view, which we share: a synchronized global economic expansion will gain steam in the second half of 2021, resulting in another year of rising stock markets.
The greatest factor affecting economic progress remains the battle against the coronavirus. The consensus forecast expects COVID-19 to become more severe in the US and Europe in the first few months of 2021, which has already led to increased restrictions in some countries. However, if vaccine distribution estimates are correct, by the end of the first quarter a hundred million or more people should be inoculated globally and the virus will commence a steady retreat. This positive outcome would lead to the beginning of a “return to normal” by the end of summer. In the US, the current record-high household savings rate indicates pent-up demand and should boost consumer spending in the medium-term. Corporate profits are poised to rebound faster than the economy, surging over 20% in 2021. All eleven S&P 500 sectors are projected to report year-over-year earnings growth. Huge corporate cash positions could spur a new wave of stock buybacks, dividend increases, and mergers and acquisitions activity. In short, the end of the COVID-19 pandemic would likely be accompanied by flourishing economies and stock markets.
The role of the world’s central banks in supporting economies and lifting equity markets should not be underestimated. For example, the Fed has promised to maintain historically low interest rates relative to other recoveries. In 2003, interest rates were between 4.0-5.0%. Following the Great Recession, the yield on 10-year Treasuries vacillated between 3.0-4.0%, whereas currently the yield is about 0.9%. The resulting boost to stocks is twofold: near-zero interest rates support economic growth, but also reduce bond yields to such a low level that the asset class ceases to be a substantial investment alternative for investors seeking capital appreciation. Sovereign wealth funds, pension plans, and retirement plans with balanced investment portfolios are already experiencing pressure to increase equity ratios as their only hope of achieving total return objectives. The power of the Fed is on full display. Generations of investors have learned wisdom in the phrase, “don’t fight the Fed.”
Despite strong tailwinds, our near-term enthusiasm is tempered because the strong equity gains in 2020 occurred in the absence of corporate profit growth, resulting in high valuations. While we think the overwhelmingly positive economic fundamentals will prevail, the road ahead is likely to sustain setbacks and challenges; expensive stock markets pricing in considerable optimism frequently lay the groundwork for corrections. Our view would be any pullback would likely be short and provide a buying opportunity. Our forecast for the year is that 20%+ growth in corporate profits will reduce current sky-high multiples, and US equities will provide a solid 8-10% annual return.
A key strategic question for both US and international investors is where to invest? Should investors favor the growth stocks that performed so well in the second and third quarter of 2020, led by technology and companies benefiting from the “stay at home” economy? Or should investors take the leap of faith that the positive forecast is correct and invest in downtrodden industries such as travel, transportation, banks, and commodity producers? We recommend a broadly diversified blend of the two strategies with a strong emphasis on high-quality, well-established companies which will almost certainly survive, if not thrive, if the bright outlook dims.
We emphasize that our positive case and strategy recommendation applies to both the US and international stock markets. In the fourth quarter, the 12.2% return of the S&P 500 Index was overshadowed by the 18.4% surge of the iShares Emerging Market ETF (EEM). This is not surprising, since emerging markets and highly volatile commodity stocks have been market leaders in the early stages of recovery following each of the last two recessions. Emerging markets are also benefiting from weakness in the US dollar, which is partially a consequence of Federal Reserve policy. Euro Area GDP is expected to grow at 5.2% with a hefty 30%+ increase in corporate profits, both at a faster pace than the US. With European stocks trading at lower valuations than their US counterparts, value-oriented investors may look to the region for opportunities.
The 2020 bear market and its ultimate resolution has reaffirmed our view that keeping a long-term perspective is highly beneficial to improving investment results. We find it especially gratifying to guide our clients through turbulent markets such as last year.
We wish our clients and readers a healthy and happy 2021.
The Marietta Investment Team
Economic and Financial Market Outlook 2020 Q4
Global financial markets are focused on developments within the US relating to COVID-19, the economy, and government stimulus. While forecasting during this extraordinary period continues to be abnormally difficult, we expect the US economy will continue its asymmetrical recovery. This supports a modestly positive outlook for equities. The fourth quarter will also bring considerable clarity to the political landscape and we will be three months closer to a coronavirus vaccine with further improvements to testing and treatments. As the fog of uncertainty lifts, the path to corporate profit growth will become apparent. The major risk to our forecast is a double-dip recession, which could be caused by widespread shutdowns following a surge in virus cases or failure of the US government to adopt additional stimulus.
We continue to deal with the economic effects of the global pandemic. Our modestly positive outlook is dependent on the path of COVID-19. There remains considerable uncertainty surrounding the future course of the virus, with health experts allowing for a wide range of possibilities. Our short-term forecast is that the next three months will look much like it does now: a steady rate of new cases, or hopefully a slight decrease, with scattered hotspots. There still exists the potential for severe devastation from a surge in cases – but, in our view, this would likely force congress to provide a swift and substantial relief package to keep households and businesses solvent, which would support the economy and be positive for the stock market. We do not in any way want to minimize the physical, social, and financial suffering this pandemic has already caused nor the further damage that will occur. Our goal here is to consider the financial market impact and our major point is that the downside to investments is limited so long as the government stands ready to provide economic support.
We are closely watching the negotiations in Washington to provide further financial relief. This is the area where political developments will have the most effect on the markets. With election day less than four weeks away, we note that the stock market has been resilient and even slightly positive as political polling remains steadily in favor of Vice President Biden. While Democratic gains in the upcoming election would increase the possibility of higher taxes and business regulation, it also would likely drive up the size of the eventual stimulus bill. According to Goldman Sachs in their October 5, 2020 research note, Democratic control of the Presidency and both Houses of Congress would lead to a surge in economic growth. Alternatively, continuation of a Republican led government will further a business-friendly deregulatory agenda and possibly more tax cuts. Ultimately, we caution investors not to overemphasize the market impact of this or any presidential election as, historically, markets have advanced under both parties.
Source: Dimensional Fund Advisors
The election will undoubtedly dominate the news for the next month but, in the context of financial market outcomes, it will not likely play a large role.
Of great consequence to global stock markets is the health of the US economy. The recovery thus far has been mainly due to unprecedented government stimulus and reopening from historic shutdowns, rather than a healthy expansion. Some industries have snapped back quickly, while others have only returned to a fraction of their pre-COVID levels. The travel industry will remain depressed for the indefinite future: the TSA measures air passenger traffic –67% from this time last year and Smith Travel Research shows the hotel occupancy rate –31% year over year. On the other hand, online shopping was up 44% in the second quarter and will flourish for years to come. While we think the worst of the recession is behind us, future gains will likely be more gradual and remain uneven. The labor market illustrates the challenges of the current situation: while unemployment is improving, permanent job losses are rising at an alarming rate.
The Federal Reserve has expressed its clear determination to support the economy; it has launched the most expansive bond buying program in history and lowered the fed funds rate to zero. Despite these immense efforts, Chair Jay Powell has stated emphatically that additional government stimulus is necessary to bring much needed relief to millions of Americans. At greatest risk is consumption, which makes up two thirds of US GDP. Without new fiscal support, the economy will be at risk for giving back its realized progress.
Aside from a new federal stimulus bill, the key issue driving the US stock market is expectations for next year’s corporate profits. The virus situation, action from policymakers, and economic realities will all influence earnings sentiment and determine which industries and investment styles outperform. While aggregate S&P 500 earnings are expected to rise, the disparity between industries is widening. The current business environment is one of “haves vs have-nots.” Companies that benefit from a socially distant world have returned to earnings growth, while others remain heavily damaged. As a complete eradication of COVID-19 becomes increasingly unlikely in the short- to medium-term, we prefer companies in industries able to quickly return to earnings growth. This includes technology, home entertainment and improvement, housing, and health care. Volatility is often the companion of uncertainty, so until the major issues become more definite, we expect financial markets to remain choppy. Our cautiously optimistic view of the US stock market is further supported by extremely accommodative Federal Reserve policy.
International economies are also experiencing economic strain due to the pandemic. As with the US, global GDP projections are very uncertain. On October 6, the Managing Director of the IMF, Kristalina Georgieva, succinctly captured the situation: “The global economy is coming back from the depths of the crisis. But this calamity is far from over. All countries are now facing what I would call ‘the long ascent’ – a difficult climb that will be long, uneven, and uncertain. And prone to setbacks. “
Amid rapidly changing conditions from country to country and potential new waves of the virus, we think the most effective strategy is to focus on companies able to thrive in the current environment. Many international companies are benefiting from similar trends rewarding US equities. High on the list is the work-from-home trend which favors numerous global technology companies and online retailers. Yet another interesting opportunity is provided by companies with products designed for building improvements and HVAC systems. Finally, we think the China pledge to be net carbon neutral by 2060, along with strong global commitments toward reducing carbon emissions, is a major trend to consider.
The Eurozone is determined to recharge its economies. The region has adequately managed the virus thus far, although new hot spots have emerged. The unprecedented stimulus passed in 2020, including $857B in grants and loans from the EU and almost $3T in additional monetary stimulus from the European Central Bank, will prevent worries of the collapse of weaker economies and strengthen the economic union. This response is much more effective than the actions taken during the Financial Crisis of 2008-09 and gives us confidence in a sustained recovery, which should support higher stock markets.
A special comment needs to be made about China, which is the only major country expected to achieve GDP growth for the 2020 year. A strong Chinese economy is essential for a global economic recovery. Recent trends provide some optimism: public transit ridership in China is back to 100% of pre-COVID levels, domestic travel is up to 80%, and schools are open. However, there are still signs of lingering weakness. Consumer spending during Golden Week, the national holiday period from October 1 – October 8, was depressed from 2019 levels, although improving from the lockdown periods of the 1H2020. Further, the ongoing trade war between the US and China and rising clashes targeting individual companies remains a potential headwind. Despite this political risk, many Chinese companies are incredibly profitable and should be considered for opportunistic investors.
The US bond market was stable throughout the third quarter and yields are expected to trade in relatively narrow ranges for the remainder of the year. The benchmark 10-year US Treasury Note, for example, fluctuated between 0.51% and 0.81% over the past three months. The Federal Reserve, in a determined commitment to support the economy, has promised to keep yields low for the foreseeable future. There is animated discussion among economists as to whether the massive fiscal and monetary stimulus will prove to be inflationary, but we do not anticipate a meaningful increase as long as the economy is being adversely impacted by COVID-19. Longer bond maturities offer higher yields, but the risk to principal resulting from an economic updraft far outweighs the benefits of a further decline from the current low yields. Although bonds remain a bulwark against potential recession, current yields are relatively unattractive to income-oriented investors.
We hope all our readers stay safe and healthy.
The Marietta Investment Team
Economic and Financial Market Outlook 2020 Q3
We continue our odyssey through 2020 amidst a severely challenged global economy and extremely volatile equity markets. After suffering its worst performance in history in the first quarter, the S&P 500 Index partially recovered in the second quarter. International stock markets have paralleled the ups and downs of their US counterparts, with tracking extending to the relative performance of industry sectors and investment styles and themes. The path to greater stock market gains relies on continued progress towards containing COVID-19 and the successful adaptation of businesses and consumers in a post-virus world. Therefore, in developing an outlook, our focus is on the coronavirus and its economic impact.
We begin with the condition of the US where there is considerable uncertainty and heated debate, which shape the positive and negative investment cases. To place our outlook in perspective, it is useful to summarize the major assertions of the opposed forecasts.
The bullish case for stock markets has been in the ascendancy since March 23:
- The economy will bounce back quickly to pre-virus levels.
- Corporate profits will not fall as far as feared and second half earnings estimates will rise.
- The federal government passed the largest stimulus package in history, which limited the negative economic impact of the shutdowns and boosted household savings and consumer confidence. Additional stimulus is forthcoming and will aid a swift economic recovery.
- The Federal Reserve has pumped liquidity into the financial system, has lowered interest rates to zero, and has promised to remain extremely accommodative for the foreseeable future. Don’t fight the Fed.
- Globally, new cases are under control and most countries are rapidly opening. This will restore supply chains and boost overseas revenues and profits.
- Trillions of dollars are sitting in cash on the sidelines, ready to be invested.
- Bonds and money markets provide unattractive returns compared to stocks.
The bearish case is also persuasive:
- COVID-19 cases in the US have reached new highs and regions are shutting down again.
- The economy has barely recovered from a historic plunge and the US is in the early stages of a long recession.
- Corporate profit estimates have yet to accurately depict the magnitude of the decline and management will lower further earnings forecasts.
- Households and small business bankruptcies will accelerate, starting a default cycle.
- State and local governments will cut spending due to huge budget gaps.
- Fiscal stimulus measures passed only temporarily helped households and are set to expire very soon, with little political appetite for additional deficit spending.
- Stock market valuations have soared to extreme levels.
- A deteriorating US-China relationship will unravel the “Phase 1” trade deal and new tariffs have been levied on the European Union. Global trade tensions are on the rise.
Both the positive and negative cases rely on significant assumptions regarding the spread of COVID-19, the subsequent response of policy makers, and the resulting impact on the economy, so that it is impossible for us to have a high degree of confidence in either outlook. We share the IMF Outlook statement that “there is a higher than usual degree of uncertainty around this forecast.”
With visibility impaired, we nevertheless offer our insights regarding an appropriate investment strategy. We note that underlying factors in both the bullish and bearish cases can be true at the same time, and as a consequence, are likely to offset each other. Therefore, the most likely outcome will be somewhere in the middle of these two extremes. We think the economic recession is bottoming and the most probable future scenario is a “U-shaped” recovery (slow and gradual as contrasted with a “V-shaped” immediate strong surge, and the “L-shaped” stagnation or continued recession). With double-digit unemployment and the imminent threat of a severe recession, policy makers in the US and abroad will continue to maintain outsized fiscal and monetary stimulus policies. This enormous effort, coupled with a modest pick-up in economic growth and corporate earnings from second quarter lows, should provide adequate optimism and confidence to move markets modestly higher by year-end. Currently, we advise investors to maintain their normal, long-term exposure to equities.
Our expectation for a slow growth, U-shaped recovery has a major impact concerning individual equity selection. The economy will improve sufficiently to benefit growth stocks but will not have the surge necessary to sustain outperformance from value stocks. We continue to favor high-quality companies with strong balance sheets, experienced management, leadership positions in their industry, and long-term earnings growth potential. From a sector perspective, we recommend overweighting technology, health care, communication services, and select consumer discretion stocks. Companies which benefit from the “stay at home” trend, such as e-commerce retailers, should do well, whereas we would avoid cruise, airline, casino, hotel, and other coronavirus ravaged businesses, despite their heavily damaged stock prices. For diversification reasons, we would hold, but underweight, some value stocks in the financial and industrial sectors. Oil companies are undesirable, with anticipated negative demand/supply conditions for the commodity. Utilities and consumer staples stocks will remain an attractive group to income oriented, preservation of capital sensitive investors, but as a group we expect them to underperform.
As global economies reopen, international economies and stocks are positioned to outperform the US. Countries that adopted a disciplined approach in isolating and treating COVID-19 patients have seen dramatic and sustained declines in new cases. These economies are already showing signs of improvement as reopening turns into recovery. While additional lockdowns are a potential risk, we think they will be targeted to specific regions rather than nationwide and businesses have done well to adapt to social distancing restrictions. Further supporting international equities is substantial global stimulus, with programs surpassing 2009 levels in the Eurozone, Japan, UK, and China. A faster economic snap-back, massive stimulus measures, and attractive valuations should result in international equities leading global markets higher. Finally, the Chinese government is encouraging their citizens to buy stocks. Similar initiatives have been very effective in the past and have led to strong near-term rallies in Chinese equities.
Investors should seek out companies that benefit from the post-COVID economy. For example, the urge of city dwellers to purchase single-family homes and escape the virus will increase the demand for housing that is already in short supply. Another theme is the meteoric growth of the video game industry as consumers look for home entertainment. There are also some past themes which should remain productive. For example, global demographics support huge demand for medical devices and pharmaceuticals and retailers will continue to rapidly improve their e-commerce capabilities.
On the other hand, investing in fixed income in this market does not offer clearly desirable options. While we have long recommended that investors keep bond holdings in a low-yield environment to short maturities of high-quality issuers, the latest moves by the Federal Reserve and other major central banks have driven yields to even further historic lows. This makes it nearly impossible for bond investors to generate a sufficient income stream. This reality is another reason why equity markets have ballooned so rapidly, as bond investors have turned to stocks when they see there is no attractive alternative. Additionally, while we have not yet seen many ratings downgrades, municipal issuers are going to get squeezed in the coming months, absent any federal relief, as tax revenues dwindle due to lower hospitality, retail and tourism receipts. Corporations are slightly better positioned if they can continue operate after adjusting to COVID-19 but with low rates, we expect their balance sheets to grow even larger with new debt. We expect the bond market to remain challenging and welcome the chance to review asset allocations to see if historical fixed income targets can still meet objectives and guidelines.
We emphasize that the current conditions are without precedent; history offers very limited and potentially misplaced guidance. Conditions can change rapidly, and investors will need to exercise active and flexible portfolio management.
We wish our readers a safe, healthy, and happy summer.
Economic and Financial Market Outlook 2020 Q2
Remarkable developments occurred in the first quarter of 2020: the worst pandemic in over a century spread around the globe at alarming speed, policymakers responded with unprecedented monetary and fiscal stimulus, and national, state, and local governments effectively shut down the global economy in the interest of public health. Equity and credit markets responded with incredible volatility. While the selloff in the S&P 500 Index reached a low on March 23, dropping 35.4% intraday below the February 19 high, the US benchmark index also made historically fast gains, including the strongest one-week advance since March 2009. Of the 22 trading days in March, 21 saw stock market moves of at least 1.0%. When all was said and done, the S&P 500 and Dow Jones Industrial Average each incurred their worst first quarter ever. The bond market also saw unprecedented volatility, with 10-year US Treasury bond yields plummeting from 1.92% to a low of 0.50%, while high yield bonds, measured by the iShares High Yield Corporate Bond ETF (HYG), plunged over 30%. Looking ahead, our outlook is essentially unchanged from the March 20 update: “Stopping the Coronavirus: Putting the Brakes on the Economy.” We maintain that for stability to return to markets, investors need greater visibility regarding COVID-19 and its impact on the economy. At this stage, we can provide some updates to the key questions, but a lack of definitive answers continues to cloud the investment landscape:
- How much of the country will be affected by the virus, and how long before we start to see a decline in active cases and fatalities?
COVID-19 has already impacted every US state and over 180 countries with varying ferocity. Globally, new cases are still growing and the timing and severity of peak intensity in the US and abroad remains uncertain. It is somewhat encouraging, however, that a few countries have reported infection rate declines and several more have reported a deceleration in the number of daily new cases.
- How restrictive will the national, state, and local policymakers be in shutting down the economy in the interests of public health? How successful will the restrictions be in containing the virus?
The White House has recommended all Americans to stay home and 41 states have issued orders to shelter in place except for essential activities. Although these steps thankfully appear to be reducing the spread, in our view, the widespread “stay at home” orders have caused the US to enter recession of unknown duration and turmoil. In the week ending March 28, 5.8 million people applied for unemployment insurance following 2.9 million the week before (the previous highest single-week totaled 695,000 in 1982).
- When will there be a return to near-normal activity, and will the mass amounts of unemployed workers be able to resume their jobs?
We don’t know how long it will take until the number of active cases is low enough to resume normal activity, or frankly, at what that level is. What we do know is that the longer we remain in some form of lockdown, the more severe the disruption will be to economic activity and the rehiring process.
- How successful will the healthcare industry be in developing a vaccine or other remedies and how long before distribution is permitted? Will hospitals be properly equipped to treat the virus? Will the testing process be adequately advanced?
There is still a long way to go, but progress has been made in addressing shortages of necessary supplies and protective equipment. There have been promising headlines about potential therapeutic advances, but experts warn that an available vaccine will require months more of development. Based on the experience of other countries, the stay at home orders will lift long before we see a vaccine or cure.
- How quickly and how successful will the national government be in countering the economic impact of their public health measures on citizens, small businesses, and corporations?
Congress and the White House have taken a bipartisan, “whatever it takes” approach to stabilizing the economy, already passing $2 trillion in relief measures, the largest stimulus package in history. Even so, it is not clear whether the initiatives will be effective or if another rescue package will be needed to further protect against economic malaise.
- Will policymakers be able to effectively deal with liquidity problems in financial markets?
The Federal Reserve has acted stronger and quicker than in 2008, dropping the Federal Funds rate to zero and offering up to $4 trillion in asset purchases to keep financial markets functioning. The usefulness of this massive undertaking is unknown as there has never been such a crisis nor such a response. Through these actions, however, the key policymakers have demonstrated that they are 100% committed to combating a credit crunch.
- What will be the impact on corporate profits and stock buybacks, which totaled $700 billion last year? How will investors react to the threat of dividend cuts, bailouts, and bankruptcies?
The exact effect on corporate profits is yet unknown, though we know for certain that the impact will be strongly negative. Factset consensus estimates expect a decline of -4.5% in S&P 500 earnings for 2020, though this number includes outdated forecasts as many research houses have yet to update their projections to reflect current conditions. Goldman Sachs has attempted to produce relevant estimates, and now expect 2020 full-year S&P 500 profits to fall 33%. Companies especially hurt by the virus are expected to cut their dividends in the second quarter, including 21 in the S&P 500, and many more share repurchase plans have been suspended.
We normally view bonds as a stable, income-generating asset. US Treasuries remain very safe, though their yields dropped to record lows in the first quarter. Corporate and municipal bonds have not been a good income source due to low yields and now we see increased credit risk during these trying economic times. We recommend holding to maturity high-quality bonds, which should still provide portfolio stability, whereas lower-quality bonds have been severely punished during the crisis. In addition, we recommend staying short-term in duration, as reaching for yield by going further out in duration will lock in yields for years near record lows.
The situation remains in flux and new information emerges hourly. We are encouraged by some recent developments but clearly do not have the answers to know when the crisis will pass. Investors must accept that there is an abnormally large range of possible short-term outcomes and they should monitor closely developments and the changing probability of various scenarios.
We will get through this eventually. May all our readers stay healthy, safe, and in good spirits!