2020 2nd Quarter Update

Top Headline for Q2: Stimulus Wins Round 1

Unfortunately, Q2 ended much as it began with the COVID-19 pandemic disrupting our lives in unprecedented ways.  Our thoughts continue to go out to all those families directly affected and the many healthcare professionals who are risking their lives each day to support them.    

As we reflect on the market performance for the quarter, it’s hard not to be somewhat in awe of the resiliency of the market, given the economic backdrop.  The equity market “bounced” off the lows and saw one of its best quarters ever.  While the S&P 500 Index did not quite fully recover its drawdown, the Nasdaq Composite now sits at an all-time high.  The surge was led primarily by its largest constituents (Amazon, Apple, Microsoft) each regaining an all-time high during the quarter and each finishing with a market capitalization near $1.5 trillion. There were clear sector winners and losers with certain technology sectors booming amid the “stay at home” requirements while others like energy and real-estate struggled to gain footing.  What is most shocking about the overall rebound is that there has been very little good news.  For example, during Q2 companies adjusted earnings down 37% (the highest drop ever recorded by Factset), some jobs returned but the news is still bad as Refinitiv reports that we’ve recovered less than ¼ of the lost jobs and July 1 marked the largest number of new COVID-19 cases (over 50,000) since the crisis began.  So, why does the US equity market not seem to care about the negative news?  The two most common explanations are (1) that the market is reacting favorably to the stimulus and looking at earnings 2-3 years out, and (2) that some of the excess capital from the stimulus is finding its way into the equity market. 

General Market Update

US Equities:  The S&P 500 Index finished up 20% for the quarter while the technology-heavy Nasdaq Composite surged 30.6%.  The Russell 2000 Index finished up 25%, but, after falling more than 30% in Q1, it continues to substantially lag the larger-capitalization indices.  There were substantial differences in equity sector performance during the quarter as the market attempted to assess “winners” and “losers” from the crisis.  The tech sector (measured by the ETF XLK) surged during the quarter and finished up about 15% year-to-date whereas a few of the big losers included energy (XLE) which is now down over 35% year-to-date and financials (XLF) which is down nearly 24%.  Certain sectors of the REIT market continue to struggle, including retail and hospitality, with over 50 companies already slashing dividends to improve cash flows.  The equity market is a bit of a paradox right now as it has been awhile since we’ve seen such a disconnect between market valuations and the present economic realities.

International and Emerging Market Equities:  International equity markets continue to lag US markets.  Not only did they fall further during Q1 but they recovered less in Q2.  The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 16.0% in Q2 and the Schwab Emerging Markets ETF was up 18.2%.  International markets continue to trade at much lower earnings multiples relative to the US. 

Fixed Income and Credit: The economic fear hitting the equity markets also appeared in bonds where rampant selling led to substantial drawdowns in corporate bonds.  However, the “bounce” in this segment was even more dramatic.  As the government stepped in to buy corporate bonds, money flooded back into the market where suddenly yields seemed high and risk low.  The long-term corporate bond market crashed about 30% but has nearly fully recovered.  This market also leaves one perplexed as the economics are not good for many highly-leveraged corporations.  Bankruptcies are rising along with bond downgrades but both are being overshadowed by the perception that the government with continue to support corporates.  Treasury bonds have also performed well with the massive tailwinds of falling interest rates, economic uncertainty and government buying.

A Look Ahead

In our opinion, it has never been harder to assess the near term direction of the equity market.  There are many factors that point to “bubble-like” conditions (e.g., the US market is at an extreme valuation relative to foreign markets, the US market is squarely in the “high” range of almost any valuation metric and economic conditions are horrendous).  However, we’re dealing with a level of stimulus that is truly unprecedented.  No one benefits more than large corporations from a zero interest rate policy and we’ve seen a surge in bond issuance as corporations have taken the opportunity to lock in low rates and extend due dates.  This refinancing will improve margins for the survivors coming out of the downturn and the large-cap group looks to be the best positioned.  It’s also noteworthy that the stimulus checks actually increased personal income during Q2, despite the record unemployment, so we don’t have a clear picture of the impacts.  Moreover, we don’t know what additional stimulus may be coming and how long it will last.  It’s hard to imagine a time when our economy and equity markets were not more closely linked to the actions of our federal government. 

To compound the forecasting problem, we are dealing with a number of large unknowns.  The biggest, of course, is the ongoing pandemic.  Cases are still rising but we’re getting better at mitigation techniques and treatment methods.  Moreover, many companies are at work on vaccines.  Still, the near-term direction of the crisis in the US couldn’t be more unclear.  The second massive unknown is the upcoming November presidential election.  Aside from not knowing the winner, we can only guess about the policies that will take priority as the election approaches.  Will social issues be the focus or, for example, will tax reform move to the forefront?  The recent tax cuts have benefitted corporations, and any reversal will certainly have an adverse impact.  Lastly, the massive stimulus has led to an enormous growth in our money supply.  This is an experiment without precedent, and economists can’t seem to agree on the inflation impacts or when they’re likely to hit.     

In closing, it’s hard to not comment on the “moral hazard” aspect of the stimulus and its unknown impact on our capital markets.  In 2008, there was, appropriately, significant debate about having the government step in to “rescue” companies deemed “too big to fail.”  During this crisis, there was little debate or delay before supporting a wide swath of corporations through bond buying.  Some of these companies are “zombies” (i.e., negative cash flow companies) that perhaps shouldn’t survive and, in fact, should be absorbed by companies that are more productive with capital.  The current talk is now around the possible direct purchase of equities.  The general perception right now seems to be that the US government is protecting corporations and it’s driving up equity and bond prices.  In other words, it’s at least partially artificial which will likely lead to further volatility in the future when perception changes.  While we’re supportive of intervening to a certain extent during a crisis, one is left to wonder how to get this genie back in the bottle without a massive market disruption.