“Keep calm and carry on” appeared to be the mantra of the global economy in the third quarter of 2020 as the recovery continued, notwithstanding a shift in new COVID-19 hotspots, including a recent surge in cases in Europe. Equity markets continued to rise, led by the U.S. technology sector, and U.S. equities remarkably made new all-time highs in early September. Meanwhile, interest rates have failed to budge from historic lows as the Federal Reserve instructed that it will not raise interest rates until after 2023, and that it will allow inflation to temporarily run above its long-standing 2 percent target. Corporations and homebuyers alike have taken advantage of such ultra-low interest rates to lock in very favorable financing terms. The U.S. political landscape remains extremely polarized, making it no surprise that lawmakers have failed to deliver a second COVID-19 stimulus package. With the upcoming U.S. presidential election, investors are undoubtedly bracing for more volatility and an unpredictable finale to 2020.
Recovery continues as the global economy adjusts to living with COVID-19
The U.S. economy shrank an unprecedented 31 percent in the second quarter as the world came to a standstill in an effort to “flatten the curve.” Consensus expects growth to rebound to 25 percent and 5 percent in the third quarter and fourth quarter, respectively, bringing full year 2020 U.S. GDP growth to -4.4 percent. Similarly, the global economy is expected to shrink 3.9 percent this year. The only exception to a shrinking economy in 2020 is China, where many economic measures have incredibly returned to pre-COVID-19 levels and a “V-shaped” recovery appears to be a reasonable possibility.
Source: Bloomberg as of Sept. 30, 2020.
While service-oriented sectors remain constrained by the risks of COVID-19, manufacturing and housing have been strong pillars of the economic rebound. Consumer spending has shifted disproportionately to tangible goods versus intangible experiences. As inventories for many items dropped during the second quarter due to halted production and supply chain disruptions, this has led to a surge in prices for everything from lumber to used cars to used boats. The change in consumer spending habits due to COVID-19, de-urbanization, and the income boost from enhanced unemployment benefits and stimulus payments have helped to drive U.S. spending for durable goods more than 10 percent above pre-pandemic levels.
Source: Bloomberg as of Sept. 30, 2020.
The economic outlook has become incrementally more positive with businesses and consumers learning to live with COVID-19 and a vaccine expected to become available sometime in 2021. Though the recovery remains on track and thus far has exceeded the expectations of many, we do not expect the current rapid pace of growth to persist and the U.S. economy to experience a perfect “V-shaped” recovery. The economy has recovered approximately half of the jobs and GDP lost due to COVID-19. However, we are already seeing a moderating pace of job growth and slower consumer spending. The next half of the recovery is likely to be longer and slower especially if Washington fails to deliver additional stimulus in the near term.
Growth over value, U.S. over rest of world continues in equity markets
It was not all smooth sailing in the third quarter, but U.S. equity markets maintained their post-lockdown uptrend. The rally in equities continues to be driven by growth stocks (ex. technology companies or companies with above-average growth rates), which have surged past pre-COVID-19 levels. On the other hand, value stocks (ex. banks or companies that typically pay dividends but tend to trade at below-average valuations) remain well below pre-COVID-19 levels.
This trend has persisted for the past several years and was intensified by the pandemic, which turned out to be a windfall for companies like Amazon and Netflix. Although the valuation of the overall U.S. equity market appears elevated relative to history, there is stark difference between growth and value. The Russell 1000 value index trades at approximately 18.8x forward 12-month earnings, while the Russell 1000 growth Index trades at approximately 31.5x forward 12-month earnings. The technology sector was a significant source of equity volatility in the third quarter as concerns over valuations and concentration came to the forefront.
Source: Bloomberg as of Sept. 30, 2020; indexed to 100 as of Dec. 31, 2014.
Moreover, during the third quarter, we observed that U.S. equities continued to outperform the rest-of-world, which is attributed to a higher weight toward technology and growth companies. Treasurys, U.S. large cap equities, and investment grade bonds remain the top performing asset classes year-to-date, and they all have common performance drivers – low interest rates and central-bank liquidity. The S&P 500’s dividend yield continued to fall in the third quarter from 1.9 percent to 1.8 percent, but it remains attractive relative to 0.7 percent on the U.S. ten-year Treasury bond or 1.5 percent on the thirty-year Treasury bond. Not to mention, three-month Treasurys yield a whopping nine basis points.
Still, some might find it hard to reconcile elevated equity market valuations with negative corporate earnings growth. S&P 500 earnings per share fell 32 percent year-over-year in the second quarter and are expected to be down 22 percent year-over-year in the third quarter. However, for 2021, earnings per share are expected to grow 28 percent from 2020. Relatively high equity market valuations reflect the forward-looking nature of the stock market, and once again, we come back to low interest rates, which we believe are driving high price-to-earnings and valuation metrics higher.
Source: Bloomberg as of Sept. 30, 2020. Note: U.S. Large Cap Equities=S&P 500 Index, High Yield Bonds=Barclays Capital High Yield Index, U.S. Small Cap Equities=Russell 2000 Index, Investment Grade Bonds=Barclays Capital Investment Grade Corporate Index, International Equities=MSCI EAFE Index, EM Government Bonds=JP Morgan GBI-EM, Emerging Markets Equities=MSCI EM Index, US Treasurys=Barclays Capital Gov’t & Treasury Index.
Fed’s adoption of average inflation targeting expected to keep short term rates at zero
At the end of August, the Fed announced a long-awaited change to its policy framework by adopting average inflation targeting. Previously the Fed had a 2 percent inflation target, meaning the Fed would adjust policy in order to keep inflation around 2 percent. Now the Fed has communicated it is comfortable allowing inflation to temporarily run above 2 percent without raising interest rates so as not to restrain economic growth and the job market. With inflation running below 2 percent over certain periods and above 2 percent over certain periods, this would theoretically achieve an average inflation rate of 2 percent over time.
The most immediate implication of the Fed’s policy change is for short-term interest rates. The Fed’s preferred inflation measure, core PCE, is nowhere near 2 percent, and the Fed has signaled that its policy rate will likely remain at zero at least through 2023. Nevertheless, as we look out over the next few years, the Fed’s new policy raises several questions, especially if inflation does eventually exceed 2 percent. There is no explicit formula and limited detail around how far above 2 percent and for how long the Fed is comfortable with inflation running above this threshold.
Source: Bloomberg as of Sept. 30, 2020
Historically low interest rates drive corporate debt binge and extend company lifelines
As individuals took advantage of low interest rates to finance home purchases and refinance existing mortgages, companies have issued records amount of debt in 2020. There was a surge in new issuance in the third quarter, and investment grade companies have already issued more debt in 2020 than in any other year with year-to-date new issuance totaling over $1.8 trillion and expectations for full year issuance to approach $2 trillion. The U.S. government also continues to borrow with the federal debt now approaching $27 trillion or almost 138 percent of GDP.
Record low borrowing costs have allowed many companies who otherwise would not be able to stay in business to continue to do so. Such companies have been called “zombies” as they are halfway between alive and deceased. A zombie is generally defined as a company whose earnings do not exceed its interest costs. Zombies are unprofitable and do not generate enough cash flow to pay off debt or invest in their businesses. However, because of record low rates and ample liquidity, they can continue to borrow, refinance debt, and stay (somewhat) alive. Continued lending to these zombies is an example of wasted capital if these businesses are unprofitable and do not spur further growth. If they were simply allowed to fail, capital could be reallocated to new, potentially more profitable businesses. The COVID-19 crisis combined with actions from the Federal Reserve has caused the number of zombies to increase to record levels.
Outlook: U.S. election—the best outcome is a clear and expedient one
We would be remiss if we did not mention the upcoming U.S. presidential election. We believe the risk related to markets and the upcoming election is less about who wins and more about the possibility of a contested election that ends up being decided in a courtroom. The market is bracing for a drawn-out election, which is evident in the elevated pricing of options expiring around and after the election. Investors prefer certainty about the future, and the uncertainty that a contested election presents may lead to some volatility. For example, during the 2000 presidential election when Florida was still in contention for weeks after election day, the S&P 500 fell around 12 percent peak-to-trough.
Eventually, however, the 2020 election will be sorted out (hopefully sooner rather than later), and investors can focus on the policy implications of the outcome and the ongoing economic recovery. The good news is that the chance of another COVID-19 related lockdown remains incredibly low, and many countries have turned to targeted approaches that allow their economies to operate at some capacity, but with precautions in place to limit the spread and protect the vulnerable. Medical professionals are also getting better at treating COVID-19, resulting in fewer deaths. Unfortunately, COVID-19 remains a risk that will continue to weigh on our economy even after a vaccine is available. With the overhang of a pandemic, a growing number of “zombies,” significant dispersion in equity markets, unprecedentedly low interest rates, and central bank-driven markets, it has never been more important to work with a financial professional. We wish you a happy rest of 2020 and look forward to reviewing the market landscape with you in early 2021.
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