Bear Market Rally or New Bull Market?
US stocks have rebounded sharply from the June lows, with the S&P 500 Index soaring over 15% the past eight weeks, continuing the extreme volatility that has persisted throughout 2022. The key question for investors following the recent upturn is whether the strong positive returns are sustainable and mark the beginning of a bull market, or if relief is temporary and will ultimately end up as a “bear market rally.” Our view is that based on the path of inflation, incoming economic data, and equity valuations, there is no obvious answer as to which of these two scenarios is most probable.
The positive case anticipates a decline in inflation sufficient to satisfy the Federal Reserve and consequently prompt an end to the current rate hiking cycle. Critically, this decline in inflation must occur while the US economy remains resilient enough to support a healthy consumer and maintain corporate earnings growth. Optimists cheered the most recent CPI report, which showed inflation peaked in June and fell slightly month over month in July. The July jobs report boasted a 528,000 rise in nonfarm payrolls and an unemployment rate of 3.5%, matching a 50-year low. Second quarter corporate earnings have been better than expected; on June 30 the aggregate estimate was for 4.0% year-over-year profit growth but has since been revised higher to 6.7%.
The negative case is predicated on inflation staying persistently high and the Fed continuing to raise rates in response. Pessimists point to weak or weakening economic indicators to show the economy is already under duress: consumer confidence has plummeted to all-time lows, housing market data have cooled, and the latest PMI services reading showed a contraction. With a slumping economy, higher interest rates will result in individual buying power evaporating, liquidity drying up, and business profits turning negative. Already, corporate earnings excluding the energy sector fell in the second quarter. In addition, some members of the Fed have stated categorically that a deteriorating economy is a tolerable side effect in the battle against the major adversary: high inflation.
In our opinion, current US stock market valuations appropriately reflect the uncertainties regarding these opposing scenarios. Even the Fed is broadcasting confusion; in its July meeting minutes, members stated concern for both being too hesitant about raising future rates (thereby permitting inflation to continue at an unacceptably high level) as well as being too aggressive in interest rate hikes (thus damaging the economy too much). We think the Fed is being pragmatic in adopting a data-dependent strategy rather than committing to a predetermined course. Similarly, investors should resist the temptation to make major portfolio changes until the picture becomes clearer.
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.
The Risk of Recession is Rising
Yesterday, the US Department of Labor reported that inflation in April remained very high at 8.3%. While the headline measure of rising consumer prices pulled back from March’s peak of 8.5%, it was both higher than forecasted and at a level that is unsustainable for continued growth. The core measure, which is favored by the Federal Reserve to guide policy, came in at 0.6%, also higher than expected and double the rate in March. This all but guarantees another 50 basis point rate hike or greater next month and a faster tightening path at subsequent Fed meetings than they have previously indicated for 2022.
We wrote in April that we did not expect a recession in the US this year. The Federal Reserve planned to raise interest rates to cool off the heated economy but there was room for error to navigate a soft landing. However, the persistently high level of inflation will likely take a heavy toll. Economic conditions are already worse now than at the start of the quarter. The initial measure of the economy for the first quarter showed a declining GDP of –1.4%, the first contraction since the start of the pandemic. Still, the consensus expectation, which we agree with, is for a rebound in the second quarter to just under 3% growth. So while the risk of an imminent recession is rising, we think it is still more likely that the economy will be able to avoid recession this year.
The market will continue to respond to the path of inflation, which is very difficult for investors to predict. The positive case for the economy and the market is that inflation has peaked. That’s not impossible, especially considering developments already at work in the economy. The Fed’s 50 basis point hike, which occurred at the beginning of the month, coupled with the expectation of more hikes coming, could already be dampening upward price pressures. Certainly, the declines in the stock market will slow consumer demand to some degree. The alternative is continuing high inflation that further harms the economy. In this case, the Fed is behind the curve and will have to catch up with faster rate hikes that threaten a prolonged recession and bear market.
It will take time to see enough data to determine with confidence whether we have brought inflation under control and stabilized the economy. We are unlikely to see an end to the volatility for some months. However, volatility includes sharp moves upward as well. In a market like this, positive indications will have a large reaction in stock prices. We caution against making short-term decisions that will miss out on the eventual recovery rally. That said, we don’t expect the market to start a consistent rise until we can see inflation come down significantly and remain at lower levels.
In this market, investors should balance the current high levels of volatility and uncertainty against the opportunity brought by the recent market declines. The next few months will likely continue to see large swings in the market but, historically, following big declines stocks have generated better than average returns. Investors with a short-term investment horizon or who are more sensitive to high volatility should consider implementing a more defensive position. For a long-term horizon, equity investments appear attractive in this market and these investors should consider holding or even adding to equity positions.
Reflections on the Current US Stock Market Correction
Our January 13 Economic and Financial Market Outlook opened with the comment, “uncertainty and volatility dominate the 2022 outlook for global and US economic growth and financial markets.” Through the first two months, this has certainly been the case. Well before the Russian invasion of Ukraine, a barbaric and inhumane catastrophe that saddens us greatly, the S&P 500 Index had already approached a correction, which we define as a 10% or greater decline. By the 23rd of February, as Russian armies prepared to launch a full-scale invasion of Ukraine, the S&P 500 had retreated 11.2% and the technology-heavy NASDAQ had fallen 17.9%. Within the S&P 500, 40% of stocks had experienced a 20% or greater sell off. A discussion of the current correction, which places it in historical perspective, is useful to guide investors through the volatility. Though the stock market’s sudden retreat has been startling, it is worth keeping in mind that including this correction, the S&P 500 has provided strongly positive returns over the past 1-, 3-, and 5-year periods. We also think it is most probable that the current correction will resolve without a recession and corresponding bear market.
Corrections are not an uncommon occurrence, with 24 instances since 1974, or about one every two years. Only 5 of these 24 turned into a full-fledged bear market with at least a 20% decline. The remaining 19 recovered to reach new highs and continue a prior bull market. The average duration from peak to trough has been 177 days, with a median duration of 87 days. So far, the duration of this year’s peak on January 3 to trough on February 23 was 51 days. If this correction proves to be typical, we are already more than halfway through it and the worst may be behind us.
The consensus view is that there are two major developments behind the retreat in equities. One is the threat that rising inflation will prompt the Federal Reserve into excessive rate hikes, which has led to several recessions in the past. The optimistic view is that the Fed will be able to tame inflation, and restore its own credibility, without causing a recession. Many investors are skeptical. The recent surge in inflation increased fears that the Fed would need to adopt more restrictive policies more quickly than anticipated. There is a widespread view that the US economy is not strong enough to absorb higher interest rates. We do not think that the expected 4 or 5 rate increases in 2022 to 1-2% is high enough to meaningfully upset economic growth. The Fed is determined to avoid recession speculation and possible financial market dislocations and yet be strong enough to have a propitious impact on inflation. We also expect a gradual improvement in supply chain disruptions and reduced labor shortages to slow the rate of inflation. Our conclusion is that inflation will peak in the first half of 2022 and trend lower by year-end, so that a corresponding Fed-induced recession will be avoided.
The second threat is that the Russian invasion of Ukraine will create significant global economic upheaval with highly uncertain negative consequences. It has already caused a further jump in the cost of most commodities, which makes the Fed’s task of subduing inflation even more problematic. An area of special concern is Russia’s substantial oil and gas exports, which could result in significant shortages and price shocks if these exports are shut down. Currently, Europe relies on Russia for nearly 40% of its natural gas and 25% of its oil. However, apart from energy the Russian economy is too small, about 2% of global GDP, to have serious impact. Similarly, the ongoing plunges in the ruble and Russian banking system, while shocking, is of minimal influence outside Russia. We do not know Putin’s ultimate objectives, but we do not think he is willing to risk an expansion of warfare by attacking NATO member countries. Although the Russian invasion of Ukraine will have huge humanitarian and geopolitical consequences, we do not think that it will derail the global economic expansion.
The two threats to the US economy and stock market come at time when the economy is exhibiting impressive strength; this provides a major argument against the likelihood of US recession and bear market this year. Economic indicators remain very strong despite the lingering effects of the COVID-19 Omicron variant. The unemployment rate remains low at 4.0% and labor markets should be able to withstand rate increases of 1-2%. Real GDP expanded a massive 6.9% in the 4th quarter, and manufacturing and services purchasing manager reports indicate huge demand for and production of goods and services. US consumers are as healthy as they have been in decades. Consumer confidence has dropped below the all-time highs reached in 2019 but is still above the 10-year average. Corporate profits in the 4th quarter experienced their 4th consecutive rise of at least 30%. With mask mandates ending and local economies fully reopened from COVID restrictions, a 2022 recession seems extraordinarily unlikely.
It is never comfortable when stocks fall to this degree, but our advice in the January Outlook remains appropriate. Although we did not foresee the crisis in Ukraine, we expected heightened volatility this year. Despite the seriousness of world events, our long-term view of the global economic expansion is unchanged. As we wrote in January, we continue to recommend that “investors focus on their long-term strategy, exercise patience and discipline … and avoid chasing short-term trends.”
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.
The Economy is not the Stock Market
Stock markets have rallied sharply from the bear market lows reached in late March. Astoundingly, the fastest 30% sell-off ever for the S&P 500 Index was followed by the strongest monthly return in over 33 years, soaring 12.7% in April. This incredible performance occurred while market participants have absorbed a deluge of grim economic data, including the highest unemployment rate since the Great Depression, the highest 8 weekly jobless claims ever recorded, and a wave of companies reporting depressingly low earnings and eliminating future guidance, with a significant uptick in companies filing for chapter 11 bankruptcy. GDP growth rates in the first quarter were sharply negative and estimates for the second quarter are expected to slide even further. It is shocking to many that global stock markets have rebounded so swiftly even as many economies have plunged into recession.
How can a stock market legitimately rise even as an economy falls? To answer this, it is informative to recall the situation at market lows and what has occurred in the seven weeks since.
In March, it was not known if COVID-19 was containable, if millions of patients would overwhelm the health care system, or if the Federal government would be able to respond, given intense partisan bickering and mixed messaging on the severity of the threat posed by the virus. It was unclear if shelter-in-place orders would be effective or how long they would last. Also unclear was the potential impact on the labor market, consumption, and production. The uncertainty was rampant and was reflected in depressed stock markets, as investors sold indiscriminately amid the confusion on how to appropriately value future company earnings.
As the past seven weeks unfolded, significant developments indicated that the worst-case scenarios feared in March had become increasingly unlikely, which supported a meaningful stock market rally. We learned that the social distancing shutdown would be temporary, and that activity would increase as economies slowly reopened. Markets are forward-looking and the prospects for business is considerably better than two months ago. We note:
- Shelter-in-place emergency measures slowed the virus’ spread and many countries are past peak outbreak.
- Countries and regions are reopening. Strategies differ by geography; ultimately some will be seen as successful and others as a failure, but experimentation is necessary as policymakers balance the speed of reopening with public health.
- The employment situation is much worse than feared in March, but there is hope that it is temporary. According to the Bureau of Labor Statistics April jobs report, of the 23.1 million unemployed persons in April, 18.1 million believed they were only temporarily laid off, while the number of permanent jobs lost increased by 544,000 to 2.0 million.
- The US Federal Government came together to pass bipartisan, greatly needed stimulus programs, boosting unemployment benefits, extending lifelines to businesses, and injecting money directly into the bank accounts. However, the aid will not last forever and likely more will be needed soon to continue to prop up household and business balance sheets.
- The US Federal Reserve slashed interest rates to zero, launched the largest monetary stimulus initiative in history, and took the unprecedented step of buying corporate bonds, including junk bonds. This injected much needed liquidity into the financial system and allowed companies with access to financial markets the ability to “weather the storm” by borrowing money at relatively low interest rates.
- The EU and other major international economies launched monetary and fiscal stimulus packages as well, but none came close the size and scope of the US. This could explain why international stock markets have not rebounded as strongly as the US.
Despite the hope-inspiring developments cited above, we still live amidst a public health threat and a deep recession. Huge questions remain, including whether a second wave of the virus will occur, what shape the recovery will take, and if stimulus measures will be effective. However, those who wait for certainty on these issues before investing likely will be forced to buy assets at much higher valuations. Investors are best served by adhering to their long-term objectives and remaining committed to appropriate asset allocations. Within the stock market, we recommend that investors focus on quality and those companies that are best able to recover their earnings. We reiterate our view from the beginning of the COVID-19 scare, written in our February 11 blog:
“We expect there will be winning and losing sectors and companies, which could provide an opportunity for active portfolio management to help mitigate portfolio risk and increase returns. The longer the pandemic takes to resolve, the greater the negative impact will be to industries such as travel, autos, oil, some luxury goods, and commodities. Companies with supply chain disruptions should be monitored closely for downward earnings revisions. We recommend caution in “buying the dip” in these industries until the magnitude of the global economic impact is better understood.”
Thus far, this approach has been successful, and we think this trend will continue until the end of the pandemic is in sight. Until then, stay disciplined, vigilant, and most importantly, safe.