“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of light, it was the season of darkness, it was the spring of hope, it was the winter of despair.” ― Charles Dickens, A Tale of Two Cities
We hope that this letter finds you safe and healthy during these unprecedented times.
The second quarter of 2020 turned the tables on Charles Dickens’ quote from his novel, A Tale of Two Cities. While the quarter began with “the winter of despair,” it ended with the “spring of hope” as angst over the impact of COVID-19 on economies around the world gave way to a sense of optimism about global recovery.
Markets staged a historic rebound in the second quarter driven by an initial peak in the growth of coronavirus infections in April, economic re-openings across the United States and the rest of the world, hopes for a COVID-19 vaccine, and continued stimulus from global central banks, including the Federal Reserve. Combined with the fiscal stimulus found in the CARES Act passed by Congress, the Fed’s unprecedented support for the U.S. bond markets led to greater confidence in the financial system and provided the needed “insurance policy” to support the U.S. economy through the crisis.
As we encourage investors to “look to the horizon” of an economic recovery and a period where the pandemic has run its course, we remind clients of our opportunistic comments from the April 2020 edition of Huddle:
“While no one knows the extent and duration of the pandemic or the current bear market (a market value loss of 20% or more from the previous highs) in which we find ourselves, we feel that becoming overly negative on the long-term U.S economy and the equity markets is an inappropriate strategy at this time. With the stock market having experienced a 35% drop in value at the March 23rd lows, with interest rates at historic lows, and with unprecedented monetary and fiscal stimulus in the pipeline, we believe that we will look back on this period as a unique opportunity to invest in America at very reasonable prices. Once a therapeutic treatment (or a vaccine) for COVID-19 is discovered or the rate of transmission begins to decelerate, markets will likely begin to discount a future economic recovery and respond in a very positive manner as upwardly revised earnings forecasts for 2021 drive stock valuations. Historically, market lows have tended to lead an economic recovery by several months and were rarely perceived to have been a buying opportunity until well into the recovery period.”
Indeed, the markets did begin to discount a future economic recovery after we wrote the previous article on April 6 with the S&P 500 rising 26%, the NASDAQ composite index increasing 38%, and the MSCI All-Country World Index ex-U.S. gaining 24%. The recently improving data regarding U.S. unemployment, retail sales, and manufacturing reflect an economy on the mend. While many challenges remain on the journey to recovery, we still believe that the economic healing that the rebounding stock market has foreshadowed is firmly in place. As markets have historically recovered from periodic stumbling blocks such as recessions, pandemics, and global conflict, taking advantage of opportunities and taking the long view has benefited investors over time as the chart below demonstrates (the red dots reflect the intra-year drops in the market from their highs).
Third Quarter Outlook
The pandemic and containment measures brought activity to a virtual standstill, delivering a historic shock to the economy. This is not a business cycle slowdown and recovery. That is why markets could see beyond the unprecedented contraction and started to recover well before any signs of a rebound in activity. The near-term contraction is the worst since the Great Depression and far deeper than the global financial crisis of 2008, according to the Organization for Economic Co-operation and Development (OECD) forecasts. But the cumulative shortfall in GDP should only be a fraction of that in the wake of the global financial crisis. The reason is the overwhelming policy response to cushion the pandemic’s impact. We don’t see the shock morphing into another financial crisis as long as these policies stay in place.
Like markets, society also made a substantial rebound in the second quarter, as economies have at least partially reopened in all 50 states, people are starting to return to the office, families are taking summer vacations, and there’s even the hope for a return of sports and other cultural staples in the coming weeks and months. Indeed, we have come a long way from those panicked days of late March.
Looking forward, as we begin a new quarter and the second half of 2020, the macroeconomic outlook has improved substantially since March, and stocks have responded accordingly with a very strong rally off the March lows. But the last two weeks of June were a stern reminder that much uncertainty remains; and during the next several months, we will learn whether the coronavirus outbreak will peak, and if the economic recovery we’ve seen since April can continue. Those factors, along with the increasing influence of politics given the November election, will impact markets in the months ahead.
As Wall Street wrapped up its best quarter in decades, history shows that gains of that magnitude usually signal momentum into the next quarter. The S&P 500 rallied nearly 20% in the second quarter, notching its biggest quarterly gain since the fourth quarter of 1998, when it surged 20.9%. It was also the S&P 500′s fourth-biggest quarterly gain since 1950. Data compiled by SunTrust/Truist Advisory Services found the S&P 500 usually follows strong quarterly performances with even more gains.
The data showed the S&P 500 gained an average of 8% after posting one of its 10-best quarterly returns dating back to 1950. The broader market index also averages a return of 15% in the one-year following such a quarterly performance.
Three Keys to the Market
With the dramatic increase in stock prices in the second quarter, we believe the keys to second half stock market performance center around the concept of “better-than-expected.” As valuations based on 2021 earnings estimates are no longer inexpensive (the S&P 500 is now at a 20 PE on 2021 earnings projections), incrementally better news needs to be seen on three fronts in order to move markets higher:
- COVID-19 transmission data, therapeutics, and vaccine updates – For the moment, U.S. COVID-19 data are negative with daily cases hitting record highs in late June as the country reopened. With positive test rates increasing, the outlook for the spread of the coronavirus is still very unclear, providing a somber signal that the virus will be with us, in one form or another, for some time to come. So far, while cases are surging, they are hitting a younger cohort, and hospitalizations and deaths are thankfully not accelerating like they were in March and April. Work on a viable vaccine continues with renewed hope for a year-end solution and doctors are now armed with better treatment protocols and therapeutics that have contributed to death rates on closed cases (recovered patients plus those who died) falling in the U.S. and globally.
- The economy – Recent data are improving as a result of re-openings but don’t reflect the current “pause” due to a spike in positive coronavirus tests. While progress has been better-than-expected, it is important to remember that the current level of economic activity remains far below the levels of a year ago. Despite the gains seen in the second quarter, there remains a long road ahead for the U.S. economy to return to pre-pandemic levels.
The latest Employment Report showed 4.8 million jobs gained vs. 3.0 million jobs expected. That comes on the heels of the previous jobs report which showed 2.7 million jobs gained vs. expectations for -7.7 million jobs lost. The unemployment rate also fell to 11.1% from 13.3% last month. Workers on temporary layoff fell to 10.6 million, down 4.8 million, on top of a decline of 2.7 million in May.
The stronger than expected economic recovery is also being underscored by the latest Retail Sales Report, which jumped 17.7% for the biggest monthly gain ever, and the Housing Market Index that surged 56.8%, also the biggest monthly gain ever.
Additionally, mortgage demand has climbed to an 11-year high; Weekly Jobless Claims have fallen again for the 13th week in a row; Factory Orders are up 8%; and the ISM Manufacturing and PMI Manufacturing numbers are up even more, increasing by 22.0% and 25.1% respectively.
While second quarter GDP may well fall 25-30%, third quarter GDP is expected to rise by a record 20%, with another double-digit gain in the fourth quarter. GDP for all of 2021 is expected to grow by 5% (the largest annual GDP growth rate in 38 years).
The Fed and Congress to the Rescue
Unprecedented monetary and fiscal stimulus provided by the Fed and Congress has served to blunt the economic impact of the forced shutdown of the economy and has created a liquidity “bridge” to the restart of the U.S. economic engine that was functioning quite efficiently before the impact of COVID-19. Prior to the outbreak, the U.S. economy was considered to be the strongest of our lifetime with 50-year low unemployment, 20-year high in household income, near record high consumer confidence, and record high corporate profits.
So far, nearly $10 trillion in fiscal and monetary stimulus has been pumped into the economy. Aggressive stimulus measures have not been confined to the U.S. as similar actions were undertaken across the globe.
Talk of bipartisan support for another $1.5 trillion stimulus bill could get done sometime this month, before Congress leaves for its August recess. That could include checks to individuals, more small business loans, aid to states and municipalities, infrastructure, and more. However, Treasury Secretary Steven Mnuchin made it clear that this package would be "jobs-focused," with a priority on "bringing back" positions.
- 2021 earnings estimates – Continuing to improve, especially in Developed Markets (EAFE) and Emerging Markets (EM).
The fate of the historic stimulus enacted back in March remains uncertain as of this writing. Paycheck Protection Program loans, which provided critical assistance to small businesses over the past three months, will only be available until August 8th while it remains unclear what will become of the federal unemployment benefits included in the CARES Act, as they are set to expire at the end of July. That federal stimulus played a critical role in the bigger-than-expected economic rebound witnessed in the second quarter, and without it, the economic outlook will become increasingly uncertain.
Politically, markets have largely ignored the looming presidential election so far this year, but that’s likely to change in the coming months; and it’s reasonable to assume the outlook for the election will begin to influence not just specific sectors, but also the broad markets during the third quarter.
Despite the lofty valuations in the stock market today, stock prices are supported by historically low interest rates that serve to incent new investment dollars into equities rather than bonds, especially low-yielding Treasury bonds. While bonds certainly have a place in diversified strategies as a source of portfolio stability, we believe the current environment still favors an overweighting in stocks if one has a one-year or greater time horizon. Also, unprecedented levels of near-zero yielding money markets held by nervous investors serve as future “fuel” for stock purchases given any additional positive economic surprises.
Within equity asset classes, we continue to believe that international equities, both in developed markets and emerging markets, represent good value vs. U.S. stocks as international economies have emerged from COVID-19 lockdowns with fewer spikes in new cases and higher projected earnings recoveries in 2021 than large cap U.S. stocks. Valuations are compelling for international stocks as they trade at a 23% discount to their U.S. counterparts and, as in the U.S., are benefitting from massive economic stimulus programs. European and Japanese equities offer attractive cyclical exposure due to their public health measures and ramped-up policy response as well as the recent weakness in the dollar vs. the Euro and the Yen.
Second Quarter Market Performance Review – A Historic Rebound
The end of the first quarter marked what we believe will be the lows for markets in 2020 as new coronavirus cases in the U.S. began to peak in mid-April thanks to the historic economic shutdown. That peak and initial decline in new COVID-19 cases throughout April gave investors and markets hope that the economic shutdown would not last into the summer and the S&P 500 rallied materially as a result, gaining over 12% in April.
The rebound continued in May, as the spread of the coronavirus continued to slow, paving the way for economic re-openings in the U.S and abroad. Meanwhile, markets were supported by continued economic stimulus from both the Federal government, via unemployment checks and “PPP loans” to businesses, and the Federal Reserve via bond purchases. The S&P 500 rallied more than 4% in May, while the Nasdaq Composite turned positive for 2020 — a development that seemed almost impossible during the depths of the March declines.
But the two-plus-month rally was interrupted in mid-June, thanks to a sudden resurgence in coronavirus cases. Numerous states, including Florida, Texas, Arizona, and California saw coronavirus cases begin to increase mid-month, and by the last week of June, new daily COVID-19 cases in the U.S. hit an all-time high. As a result, volatility edged higher into the end of June, although the market reaction was muted compared to the volatility in February and March, as the increased case count had not put extreme stress on various state healthcare systems.
The major U.S. stock indices all enjoyed a strong rebound and substantial gains in the second quarter, and just like in the first quarter, the tech-heavy Nasdaq notably outperformed the other three major indices. In the most recent quarter, that outperformance was due to large-cap tech companies being viewed as the longer-term beneficiaries from changing work and shopping trends in response to the pandemic, specifically “work from home,” cloud computing, and online shopping.
By market capitalization, small caps outperformed large caps in the second quarter, and that is what we’d expect given that the market rally of the past three months was partially driven by a sooner-than-expected economic rebound, as small caps are historically more sensitive to changes in economic growth compared to large caps. From an investment style standpoint, growth substantially outperformed value, yet again, because of strength in large-cap tech.
On a sector level, performance was the opposite of the first quarter, as all 11 S&P 500 sectors finished the second quarter with positive returns. Traditionally defensive sectors, those that are less sensitive to changes in economic activity such as utilities, consumer staples, and healthcare, relatively underperformed after outperforming in the first quarter; and again, that’s historically typical when stock market gains are driven by expectations for improving economic growth.
Cyclical sectors, those that are more sensitive to changes in economic activity such as energy, consumer discretionary, and materials, outperformed in the second quarter along with the technology sector. Energy, the worst performing sector in the first quarter, was the best performing sector in the second quarter, thanks to a significant rebound in oil prices and growing expectations for a global economic recovery.
International markets also rallied in the second quarter as European and Asian economies re-opened, and those regions saw a consistent decline in new COVID-19 cases throughout the quarter. Emerging markets, whose economies are typically more sensitive to changes in expected global growth, modestly outperformed foreign developed markets and the S&P 500 thanks to a declining U.S. dollar paired with rising hope for a global economic rebound, following successful reopenings in Asia and parts of Europe.
Commodities also staged a large rebound in the second quarter as prices were driven higher by firming global growth expectations. Oil was historically volatile in the second quarter, with prices briefly turning negative in late April due to a short-term supply glut. But an extension to the unparalleled OPEC+ agreement to slash oil production, paired with evidence of returning consumer demand for refined products, sent oil sharply higher into the end of the second quarter. Gold, meanwhile, added to the gains of the first quarter thanks to a declining U.S. dollar, recovering inflation expectations and steady bond yields amid the historic global central bank stimulus.
Switching to fixed income markets, the total return for most bond classes was again positive in the second quarter, as bonds joined gold in registering back-to-back positive quarterly returns so far in 2020. The leading benchmark for bonds, the Bloomberg Barclays US Aggregate Bond Index, saw positive returns for the seventh straight quarter.
Longer-duration bonds outperformed those with shorter durations in the second quarter as global central bank commentary stated that rates would stay low for years to come, which anchored shorter duration bonds and in turn, increased the appeal of higher yielding, longer-maturity bonds.
Corporate bonds, in a sharp reversal from the first quarter, saw solidly positive returns in the second quarter thanks to optimism surrounding the economic reopening process combined with the Federal Reserve actively buying corporate bonds in an effort to ensure adequate liquidity. High yield bonds outperformed investment-grade corporate bonds as investors rushed to take advantage of the more beaten-down prices of lower quality credits.
Once the Fed announced its support for the corporate bond market in late March, the premium yield required (spread) for investors to find corporate bonds more attractive than Treasuries shrank precipitously as confidence in the fixed income market’s stability was restored.
While essential to the economic recovery so far in 2020, the historic government stimulus unleashed on the U.S. economy has also resulted in an explosion of debt and surging deficits, a trajectory we believe is not sustainable and is something we are mindful of as we craft long-term investment plans.
So, as we start the second half of the year, there has been a lot of progress on the economic and biological fronts, but a lot of uncertainty remains. However, we can take comfort in the fact that there are still many tailwinds on these markets, including historic support and stimulus not only from the Federal Reserve, but also from every major global central bank. Additionally, global governments are stimulating their economies in ways that haven’t been seen since the end of World War II, and the global medical community is united in a historic effort to produce a vaccine for COVID-19.
Bottom line, investors are currently facing a lot of unknowns as we begin the second half of 2020, but there are also powerfully positive forces supporting markets.
We all know that past performance is not indicative of future results, but history has shown that a long-term approach combined with a well-designed and well-executed investment strategy can overcome periods of heightened volatility, market corrections, and even bear markets. We’ve seen that again so far in 2020.
At McKinley Carter, we understand the risks facing both the markets and the economy, and we are committed to helping you effectively navigate this challenging investment environment. Successful investing is a marathon, not a sprint — and even intense volatility like we experienced in the first half of this year is unlikely to alter a diversified approach set up to meet your long-term investment goals.
Therefore, it’s critical for you to stay invested, remain patient, and stick to the plan, as we’ve worked with you to establish a unique, personal allocation target based on your financial position, risk tolerance, and investment timeline.
Finally, we thank you for your ongoing confidence and trust, and please rest assured that we remain dedicated to helping you successfully navigate this market environment.