2020 3rd Quarter Update
Top Headline for Q3: “Winners” and “Losers” Continue to Separate
Unfortunately, the COVID-19 pandemic remains with us and continues to affect nearly every aspect of our lives. This includes the financial markets where the most obvious impact is the dispersion of results in the US equity market. There have been clear “winners” with over 25 companies now up more than 400% for the year – a cluster of success that we haven’t seen in twenty years. This group includes Zoom, the most obvious pandemic success story, that has become a household name. On the flip side the pandemic has had a massive adverse impact on certain industries. The most obvious of these is the energy sector where the economic lock-down and reduction in travel has crushed the global demand for oil. To highlight the overall separation, the technology sector (ticker: XLK) is up 28.6% on the year while the energy sector (ticker: XLE) is down 47.5% through Q3. We can’t recall ever seeing such a pronounced gap in sector performance. The market dynamics are contributing to social unrest related to economic inequality as we are seeing a surge in new tech-entrepreneur billionaires at the same time that unemployment is spiking in traditional industries.
General Market Update
US Equities: The S&P 500 Index finished up 8.5% for the quarter while the technology-heavy Nasdaq Composite continues its year-to-date outperformance by rising 11%. The Russell 2000 Index finished up 4.6% and continues to substantially lag the larger-capitalization indices. As mentioned above, there were substantial differences in equity sector performance during the quarter. As we recently highlighted in a blog post from early August (Midsummer…..), the S&P 500 and Nasdaq Composite are up for the year but there has been very little “breadth” in this market surge. A lack of market breadth means that the stock market is being carried higher by a minority of high-performing companies. It is generally not a sign of market strength. As mentioned above, the year-to-date rally has happened mainly on the back of one sector (i.e., Technology) and more specifically on the back of “Megacaps” like the “FANGMAN” group (i.e., Facebook, Amazon, Netflix, Google, Microsoft, Apple and Nvidia) – now collectively worth more than $7 trillion dollars. To further highlight how much these mega cap companies are driving market performance you can compare performance of the S&P 500 Index, which is “market cap weighted” to its “equal weighted” counterpart (ticker: RSP). The S&P 500 Index gives greater influence to larger companies mentioned above while the equal weighted holding RSP gives every company in the index the same weighting. Through Q3 the S&P Index is up 4.1% YTD while RSP is -5.3%.
International and Emerging Market Equities: The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 5.5% in Q2 and the Schwab Emerging Markets ETF was up 9.9%. The developed international market continues to lag the US mainly on account of the industry composition of the European market (i.e., it has a lower percentage of technology companies). This allocation also helps to explain why these markets trade at much lower earnings multiples relative to the US at the moment. Emerging markets are starting to see a surge as economies continue to re-open, leading to a sharp rebound in manufacturing and trade.
Fixed Income and Credit: The bond market has entered a new dimension of unprecedented price stability. The “MOVE Index,” which measures volatility in Treasury Bonds, is sitting at all-time low levels as bond prices trend sideways. The Federal Reserve entered these markets by buying corporate bonds and ETFs during the year to encourage price stability, and it worked. Corporate bonds would normally be selling off in a recessionary time but we’re seeing very little downside price movement as investors perceive the Federal Reserve as a “backstop” against price declines. Moreover, the Federal Reserve is driving the market in treasury securities where it has become, by far, the largest purchaser. This market is largely in the hands of the Federal Reserve at this point. If one believes they will continue to support it, price stability will likely remain. Without government intervention, we’d likely see a pull-back in prices as rising bankruptcies and the threat of inflation, combined with no room for further interest rate decreases, creates downside risk.
A Look Ahead
The US stock market performance continues to surprise to the upside. There are some reasons for concern including (1) valuations are high, (2) the market is riding to new highs with very low market breadth, (3) technology is leading the market high and can be highly volatile, (4) the adverse economic impact from COVID continues with no clear end date and (5) we will enter 2021 with high economic-policy uncertainty given the ongoing social unrest. On the positive side, we are likely to continue to see a massive amount of ongoing government support in the way of direct subsidies to individuals and a continued zero interest rate policy (“ZIRP”). We continue to believe that the biggest winners of ZIRP and the Federal Reserve’s intervention are public corporations. With interest rates near zero, combined with the Federal Reserve’s direct purchases of corporate bonds, the cost-of-capital is at record lows. Not surprisingly, corporations are making 2020 a record year for bond issuance and are locking in rates for the long-term. The large-cap group looks to be the best positioned as companies like Amazon, Microsoft and Apple are able to issue bonds at rates that are barely above US Treasuries. They’re likely to resume share buy-backs with this money as soon as economic stability appears – a huge driver of shareholder return in recent years. It’s also noteworthy that the stimulus checks and PPP actually increased personal income during Q2 and would do so again when/if further rounds are approved. This likely helps corporations in the short run but may lead to inflation over time. To say the least, it’s a tricky time for projections – especially when the government has taken such an active role in affecting outcomes.
With the upcoming Presidential election and headlines regarding ongoing additional stimulus negotiations, the stock market will likely see increased volatility. Historically speaking, the market hasn’t liked uncertainty. Not knowing who the next President will be will likely influence short-term market moves more than who actually wins the election.
On the bond side, it would seem that we’re in a position where all the risk is to the downside (i.e., rates are not likely to go any lower and inflation is only likely to go higher – neither of which would be good for bonds). So, why are prices not trending lower? For one, the Federal Reserve has indicated that ZIRP is here to stay for a while so investors are not perceiving much interest-rate risk. Moreover, the Federal Reserve is in full price-manipulation mode in this market. As the primary buyer of US Treasuries, they can likely control price. This has been done in other countries (e.g., Japan) as a form of stimulus and is known as “yield curve control.” And, the direct purchase of corporate bonds has curbed any selling. Giving the Federal Reserve’s willingness to provide a virtual “blank check” to create stability in these markets, near-term stability is probably a good bet. Still, bonds are not likely to provide substantial overall yield going forward. Rather, a small dividend with stable price is likely where we’ll stay for the foreseeable future. Of course, any stock market panic could drive treasuries higher as we’ve seen in the past.
One interesting dynamic at work right now in the marketplace is the tension between inflationary and deflationary pressures. Recessions are inherently deflationary as are productivity enhancements driven by technology. Moreover, demographics (i.e., the aging “baby boomer” population) is driving less economic demand in the US as we’ve seen play out in “aging” countries like Japan. Deflation is generally considered bad for an economy because it discourages investment and spending (i.e., participants prefer to wait until prices are lower). Given this dynamic, the Federal Reserve, like most central banks, has a target inflation goal of 2%. Moreover, they’ve recently stated that the goal is to “average” 2% and intend to let inflation run above 2% to achieve that goal. The effective “money printing” by the government by issuing Treasury bonds that are then bought by the Federal Reserve can contribute to inflation as economic activity picks up. And, it can happen quickly. We’ve seen this occur historically in the US around World War II and also during the 1970s to the early 1980s. Given the threat of inflation, real-assets (e.g., land, real-estate, commodities and precious metals) become a more interesting investment. We plan to continue to monitor the inflation dynamic and will consider additional allocations to these types of investments.
Stay safe and, as always, feel free to reach out if you have any questions or if we can help with anything.
