When the World Health Organization reported in December of last year that a mysterious pneumonia was sickening dozens of people in China, it was hard to imagine that a few months later, we would be in the midst of a global pandemic that would result in a tragic loss of life and the worst recession since the Great Depression. Congress and the Federal Reserve enacted unprecedented levels of stimulus to soften the economic blow and ensure healthy functioning of financial markets. According to Bank of America Global Research, the Fed was buying more than one million dollars in assets per second during the peak panic phase of the crisis. “Stay at home” companies thrived as efforts to “flatten the curve” kept most of us within the confines of our homes. Millennials and Gen Z turned to the Robinhood app to trade stocks and options as professional sports seasons were cancelled. After modern life was turned upside down, we are now on a journey to return to normal, albeit with adequate “social distancing” and many precautionary measures in place to slow the spread.

Equity markets are in a tug of war with the positive forces of improving economic data, extremely low interest rates, and unprecedented stimulus on one end. The undoubtedly most powerful “positive” is record low interest rates, which have continued to help drive up the value of financial assets. On the opposing end are rising COVID-19 cases, an economy that cannot operate at its full potential due to social distancing, a loss of nearly $10 trillion in global GDP, and a double-digit unemployment rate. As far as equity markets were concerned in the second quarter, the “positives” dominated with the S&P 500 having its best quarter since 1998 and returning over 20 percent. Nevertheless, an improving COVID-19 picture in former hotspots such as New York City has been tempered by rising case counts in other parts of the country, leaving plenty of uncertainty regarding the path of the economic recovery and direction of equity markets in the second half of the year.

Road to economic recovery begins as the world reopens

Most of the world has emerged from national lockdowns and embarked on a journey toward economic recovery, but in a “socially-distanced” society where COVID-19 remains a grave threat influencing our decisions about how we work, eat, travel, spend leisure time, and everything in between. U.S. GDP and the U.S. labor market are dominated by services-oriented businesses, which have been impacted most severely by the pandemic. Restaurants and airlines, for example, cannot come close to maximizing profitability in a “socially-distanced” world. The Economist has dubbed this constraint the “90 percent Economy,” meaning that the economy can only operate at 90 percent of its potential due to efforts to contain the virus. Consumption makes up roughly 70 percent of U.S. GDP, and though the U.S. consumer has proved a resilient force throughout history, an 11 percent unemployment rate and the continued risk of a potentially deadly virus are extraordinary obstacles.

chart 1

Source: Bloomberg as of June 30, 2020. Note that unlike the unemployment rate, the employment population ratio includes unemployed people not looking for jobs.

On the positive side, U.S. economic activity probably bottomed in the second quarter with economists, on average, expecting a steep 35 percent quarter-over-quarter contraction in GDP. The current recession has seen a much sharper decline in economic activity as compared to the Global Financial Crisis (GFC), but will likely be shorter in duration with sequential growth expected to turn positive in the third quarter. Compared to the GFC, financial institutions are in much better shape, and access to capital is not an issue for many businesses, particularly larger ones, thanks to unprecedented policy intervention. Still, after such a precipitous drop in activity and given the unfortunate demise of many businesses and jobs due to prolonged shutdowns, returning to pre-COVID-19 levels of employment and spending will take some time. To put the magnitude of the current crisis in perspective, the U.S. economy shed 22 million jobs in April and May, nearly wiping out all of the job gains made since 2010. However, looking on the bright side, early economic trends post-re-openings are encouraging with data showing a strong rebound in retail sales and new home sales, not to mention job growth of 7.5 million in May and June. We are hopeful that the economy can return to pre-COVID-19 levels in two to three years if a vaccine is made available in the next year.

chart 2 Source: Bloomberg as of June 30, 2020

Savings rate soars amid economic turmoil and massive fiscal stimulus package

As the COVID-19 pandemic brought commerce to a standstill in the second quarter, the U.S. government swooped in with trillions of dollars of stimulus to alleviate economic pain felt by individuals and businesses. In fact, income support from unemployment insurance, Economic Impact Payments, and the Paycheck Protection Program were around three times the drop in income in April. As a result, the U.S. savings rate catapulted to 32 percent, the highest on record since the Bureau of Economic Analysis started tracking the series in 1960. This stimulus likely helped to drive an 18 percent month-over-month increase in retail sales in May and stabilized the labor market. The savings glut has also led to a massive spike in money market fund assets, which according to the Investment Company Institute, stand at approximately $4.7 trillion, well above the GFC peak of $3.9 trillion. We expect an elevated savings rate going forward, which is typically the case after economic shocks and crises.

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Source: Bloomberg as of June 30, 2020

Continued economic growth momentum will be somewhat dependent on the continuation of fiscal support. Will there be another round of stimulus? Total U.S. government stimulus to date of approximately $2.7 trillion is roughly 13 percent of GDP, but there could be more on the way. The Trump administration has proposed up to another $2 trillion of stimulus including $1 trillion in infrastructure spending. If enacted, this would bring total fiscal spending to approximately $4.7 trillion or 22 percent of U.S. GDP.

Stay-at-home beneficiaries: Retail trading and digital giants

What have many people done, particularly millennials, with their excess savings amid stay-at-home orders and lack of the thrill from watching or betting on professional sports? They have utilized retail-friendly, commission-free trading platforms like Robinhood. 2020 has seen a surge in online brokerage account openings, retail options trading, trading of fractional shares, and retail investors bidding up beaten down, sometimes bankrupt stocks of companies such as Hertz. In an interesting turn of events, stocks favored by retail investors have outperformed many hedge-fund picks since the March low, according to Goldman Sachs.¹

Despite short-term success in 2020 for some retail investors, supported by the snapback in U.S. equity markets in the second quarter, we caution against high turnover trading and concentrated positions in individual stocks. Several studies show that most who day trade end up losing money. A 2019 study found that about twice as many day traders lose money as make money, and only about one trader in five made more than $5,000 in a twenty-month period.² Especially for millennials and Gen Z, we stress that there is a clear distinction between trading and investing. The former has a much higher risk profile and lower likelihood of a favorable outcome while the latter, if exercised under the principles of diversification and a long-term perspective, has a greater potential for financial success and long-term wealth.

chart 4 Source: Robintrack.net and Arbor Investment Research

Unsurprisingly, the market leaders during the COVID-19 storm were companies which capitalized on the “stay at home” consumer (and employee) like Facebook, Amazon, Apple, Netflix, Microsoft, and Alphabet (Google). An equal weighted basket of the aforementioned six stocks returned 26.8 percent in the first half of 2020 compared to the S&P 500’s return of -3.1 percent, and this year the NASDAQ has outperformed the S&P 500 in the first half of the year by the most since 1983. We have written about the dominance of these technology behemoths in the past; before COVID-19, they already accounted for a tremendous share of the U.S. equity market. Now as of the end of the second quarter, they represent a whopping 19 percent of U.S. equity market capitalization compared to 15 percent at the end of 2019 and only 5 percent at the beginning of the last decade, an important consideration for investors who invest in index-type vehicles that tend to be market-weighted, and may also have individual positions in these companies.

U.S. equity optimism and interest rates lower for much, much longer

The U.S. equity market roared back in the second quarter seemingly disconnected from a dire economic backdrop and a surge in COVID-19 cases in many areas of the country. We attribute the V-shaped stock market recovery to a few factors. The first is the enormous amount of liquidity support from the Federal Reserve. At the end of 2008 and during the peak of the Financial Crisis, the Fed’s balance sheet expanded from about $900 billion to $2.3 trillion. During the COVID-19 crisis, the balance sheet has ballooned from $4.2 trillion to $7.1 trillion, an increase of more than double compared to that during the GFC. Since 2008, the Fed’s balance sheet has grown by an astonishing multiple of more than 7x. We should also note that U.S. government debt has grown from $10 trillion to over $26 trillion over the same period. As we observed throughout the past several years, monetary easing and low interest rates have boosted asset prices and financial returns despite markets being viewed by many as “overvalued.” Faced with a choice between a 0.7 percent yield on the U.S. ten-year Treasury bond or 1.9 percent dividend yield on the S&P 500, the decision is not difficult for many investors.

Another often-forgotten point is the forward-looking nature of equity prices and that typically the stock market bottoms before the economy does. During the second quarter, the S&P 500 had its best quarter since 1998, yet GDP growth likely contracted by the most on record during the same three months.

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Source: Bloomberg as of June 30, 2020

Although Bloomberg consensus estimates are for S&P 500 earnings per share to contract over 20 percent in 2020, they are expecting 30 percent year-over-year growth in 2021. We believe returns will continue to be driven by a combination of central bank policy, interest rates, and corporate earnings. The unevenness in returns over the past four years reinforces the importance of a long-term investment horizon and that repeated buying and selling could do more detriment than value creation.

Interest rates: Lower for how much longer?

Interest rates globally remain near historic lows due to very accommodative monetary policy. The Fed has also gone beyond what many investors thought possible by directly purchasing debt issued by corporations. What more can and will the Fed do? Fed Chair Powell has dismissed the use of negative interest rates as an inappropriate tool for the U.S. and questioned its efficacy, encouraging words for savers and financial institutions alike.

chart 6 Source: Bloomberg as of June 30, 2020

One policy tool the Fed has discussed is yield curve control or yield cap targets. The June Fed meeting minutes suggest adoption of such policy is probably not imminent, but we would not count anything out down the road when it comes to central bank policy! Yield curve control can be thought of as a ceiling on interest rates. Under this policy, the Fed would commit to purchasing enough bonds to keep interest rates at a specific target. The Bank of Japan has used this tool to peg its ten-year government bond yield at 0 percent. The end goal of yield curve control is the same as other easing measures: to encourage spending by businesses and consumers. Such a policy would put the Fed’s credibility at risk should it fail to meet its objective of keeping interest rates at their target but could result in a smaller balance sheet for the central bank if investors believed the Fed were committed to its peg.

Outlook: Election 2020 and the 90 percent economy

As if 2020 was short of volatility catalysts, it will conclude with the 2020 U.S. presidential election. The current polls show Vice President Biden is leading by a wide margin, but we know from history (the 2016 presidential election and the Brexit referendum) that polls are no guarantee. While there are many differences between the proposed policies of Vice President Biden and the current administration, the most directly impactful one for the economy and stock markets is tax policy. Vice President Biden has proposed raising the corporate tax rate from 21 percent currently to 28 percent, reversing most of the corporate tax changes enacted in 2017, in addition to raising taxes on high income individuals. Surprisingly there is one issue that most Republicans and Democrats can agree on in principle: a tough stance toward China on trade and other economic policies. While a Biden presidency may bring a different tactical approach and negotiating style to talks with China, we would not expect a complete policy reversal.

Many of us can now eat in a restaurant or shop in a store, but the fight against COVID-19 is by no means over. Emerging data on new cases, hospitalizations, and regrettably, deaths, will continue to move markets, and until there is a vaccine, the “90 percent economy” will be the new norm. Although another nationwide lockdown is unlikely in our view, we are concerned about the risks of a “second wave” and increased transmission rates. Fed Chair Powell put it best when he said, “a full economic recovery is unlikely until people feel safe.”

Turning to the second half of the year, we are focused on Congress’ efforts to reach a deal on another round of stimulus this summer as this will be critical for avoiding a large drop in consumer spending at such elevated levels of unemployment. Second quarter earnings will be very important in providing color on current trends and guidance for 2021. The power of ultra-low interest rates will continue to be a dominant force and supportive for equity markets. However, the economy certainly matters, and we are paying close attention to indicators including the savings rate, consumer confidence, and jobless claims. Many are optimistically expecting a “V-shaped” economic recovery. We believe the economy will continue to improve but in a more “zig-zag” fashion or “three steps forward, two steps back.” We encourage investors to work with their financial professional to address any changing needs.