Altair Insight: Catch-Up Mode (2Q20) – Quarterly Market Review
Historic, unprecedented, extraordinary – all have been used to describe the mercurial movements of the economy and financial markets this year. Yet none quite does justice to the dizzying juxtaposition of extremes that have taken place during the coronavirus pandemic. Occurring virtually simultaneously, they include:
- The U.S. economy’s worst quarter since at least the end of World War II
- The biggest global recession since the 1930s (estimated)
- Stocks’ best quarter in decades (following their worst quarter since 2008)
- A soaring COVID-19 death toll: Over 600,000 worldwide with close to a fourth in the U.S.
Many anticipated that “Fastest economic recovery in history” would soon be added to the list. That hope is threatened by a summer surge in virus infections in multiple U.S. hotspots. We may now be in for a longer slog than expected before returning to pre-pandemic activity levels.
While it may not be the rapid recovery that was foreseen months ago, it is a recovery nevertheless. We believe it will continue to strengthen, even if by fits and starts. Ultimately, however, the pace and success of the recovery will be determined by the staying power of COVID-19.
Keeping Things Afloat
Noah Kroese Illustration for Altair Advisers
Zoom is not just the preferred new way to meet up but also an apt description of the stock market’s behavior in the second quarter. The Standard & Poor’s 500 Index saw the fastest-ever melt-up in the postwar era: 44% in 53 days. A handful of growth companies that are thriving in the pandemic accounted for most of the gains, with most stock indexes still negative for the year because they lack exposure to the small group of large tech-oriented stocks that are outperforming.
That record runup, along with the uncertainty surrounding COVID-19, is why we unwound our recommended overweight to equities in June – after initiating the overweight position in March. In the average recession over the last 70 years, the S&P 500 gained back 42% after two years; this time, it surpassed that in about two months.
Still, we believe stocks are unlikely to return to their March lows and see several factors that can keep a floor under prices and potentially drive them higher even in the short term. Perhaps none is more important than the ongoing multitrillion-dollar monetary support of the Federal Reserve and other central banks coupled with the greatest global fiscal easing of the post-World War II era. And while the speed of the recovery hinges on areas’ reopenings that have so far had mixed results, an eventual second wave should not be as economically devastating as the first.
While the recovery is likely to be long and the short-term outlook is particularly uncertain with elections upcoming and geopolitical risks rising, we are fully confident in prospects for both the economy and the markets over the longer term and recommend clients remain invested at their target allocations.
Most important, we wish our clients and friends continued good health as we await vaccines and an end to the COVID-19 era.
Please read on as we explore and share our views on five key topics:
1. Economic fallout from the pandemic will continue beyond what we see as a deep, short recession, but the recovery is firmly under way.
Progress on the long road back to normalcy has proven frustratingly fragile this summer. Initial hopes for a V-shaped recovery – a quick and sustained snapback – have been dashed by the virus’ revived potency and resulting reopening delays. Economists and market analysts now are rushing to recalculate the shape they think the recovery will take: U, W, L – or perhaps a checkmark, square root sign or even reverse square root sign.
Instead of applying a letter or a label, we will just say that we expect the recovery that began in May to continue experiencing fits and starts as we climb out of the hole created by the voluntary lockdowns. Ultimately, the coronavirus will decide the letter and the outcome, and no one can accurately predict its course.
The presumed path of the global recovery also has sagged since spring, with the International Monetary Fund projecting a 4.9% contraction for 2020 in June after pegging it at 3% in April. The IMF still foresees a robust rebound of 5.4% next year but cautions that its forecast faces high uncertainty concerning the spread of the virus.
Arguably the best barometer of the state of the U.S. recovery is the jobs market, where a speedy initial improvement has slackened. After a period of ultra-low unemployment, the jobless rate soared to 14.7% in April and remained stubbornly high at 11.1% in June despite gains. A record 22 million jobs were lost in the first two months of the crisis and the economy will not return anywhere near normal again until most are regained, which may be challenging given the permanent job losses of many. Jobless claims are declining, but less rapidly than before.
The report card is better in some other key areas, albeit with a recent loss of some momentum.
Consumer confidence and retail sales both rose sharply in June as stores reopened, although the surge in infections is certain to have eroded the July numbers. The housing market has firmed up as stay-at-home orders eased and consumers resumed house-hunting, with sales of both existing and new homes showing gains amid historically low interest rates. Manufacturing also has picked up strongly. Sentiment, hiring and restaurant bookings all have slipped in July, meanwhile, due to the paused reopenings in hotspot states.
The recession that began in February may already have officially ended as one of the shortest ever – we will not know for certain until the National Bureau of Economic Research weighs in. That designation, though, would hardly diminish the ongoing damage from a second quarter with a horrific pullback in growth, a drop currently estimated at 25% based on a blend of estimates by the New York and Atlanta Federal Reserve Banks.
If states experiencing recent case increases manage to reign in those surges, the lost momentum could soon return. Confirmation comes from formerly struggling Europe, where the recovery from the worst of the virus has been so noticeable that it prompted European Central Bank President Christine Lagarde to say “We’re in a good place” in mid-July.
For the United States, this saga and its repercussions will not be over any time soon. But we believe the worst is past. The second wave will not cause more damage than the first, and the inevitable development of therapeutics and vaccines, a quest being pursued aggressively on six continents, will eventually speed the economy back toward full strength.
This “new abnormal” economy will continue to produce both winners and losers (and some new, compelling investment opportunities – discussed further in our #5 discussion point below). We remain confident in the long-term outlook but feel it is appropriate to remain neutral in our positioning given the near-term economic uncertainty.
The recovery may have slowed somewhat but it has not been derailed.
2. The Fed, soon to be joined by Congress again, continues to underpin the recovery and that is unlikely to change before vaccines are developed.
Now that the economy has emerged from its spring nosedive into recovery mode and the stock market has bungeed back from the depths, questions have arisen in some quarters about the government’s colossal monetary and fiscal intervention. Critics say the Fed, primarily, is inflating stock prices, expanding wealth inequality, enriching companies that need no help and postponing an inevitable cascade of defaults for those that do.
It may be fair to challenge the central bank for determining winners and losers or certainly for amassing trillions of dollars in new debt, with potentially worrisome long-term consequences. But the bottom line for us is that its policies are working, and at a time when they are critically needed. The Fed’s open-wallet approach, bolstered by Congress and a similar response abroad, has breathed life into a formerly moribund economy and financial markets and is playing a vital role in bridging the gap between periods of normal commerce and activity.
Since its March flurry of rate-slashing and stimulus actions, the Fed has raised its balance sheet from roughly $4 trillion to $7 trillion and activated other tools in its crisis tool kit. It recently started buying the debt of creditworthy companies on the open market while investing indirectly in non-investment grade bonds. It has pledged to buy the bonds of about 800 companies, holding $9.4 billion in corporate bonds and exchange-traded funds as of June 30th.
The mild-mannered Powell has even inspired investors with his words. After his energizing spring declaration that “We’re not going to run out of ammunition,” he rallied the markets more recently with “We are not even thinking about thinking about raising rates” before 2023.
Other global central banks have stepped up too. Japan’s central bank says it will keep its monetary policy accommodative at least through 2022. The European Central Bank has approved $3 trillion in stimulus measures in recent months along with buying roughly 150 billion euros ($171 billion) of debt since initiating a new bond-buying program in March.
The likely majority of monetary stimulus being applied worldwide during the pandemic already has been implemented. So what else can the Fed provide in its role as lifeline for the economy if the recovery takes longer than originally expected?
The bank still has multiple monetary tools at its disposal, having only minimally used special facilities designed to provide liquidity to capital markets while mostly purchasing Treasury bonds and mortgage-backed securities. The full arsenal also includes unconventional policy tools that Powell has so far been loath to deploy, such as yield curve control – setting caps on long-term interest rates to keep them from rising – or negative rates.
Equally as important as monetary support for the recovery’s continued momentum, especially in the face of this summer’s COVID-19 case surge, will be more fiscal stimulus from Congress. We view an additional stimulus package as likely by early August – though it will no doubt be a contentious journey for both sides of the aisle to come to an agreement. It will likely be needed to avoid more long-term damage to the economy.
3. Control of both Congress and the presidency is increasingly up for grabs in November, but stock returns historically do not differ that much based on the balance of power in Washington.
Investors understandably want to know what changes could occur under a President Joe Biden, perhaps governing in tandem with a Democratic-led Congress, and how the election will affect the markets. Polls after all show Biden with a substantial lead among registered voters and Democrats with a chance to gain control of the Senate while retaining a comfortable majority in the House.
The range of possibilities for a prospective Biden administration and the impact on markets is broad given all the unknowns: the makeup of Congress, whether voters send a strong mandate for change, and how aggressive a new government wants to be on economic policy with a challenging recovery under way. We share a few observations below.
First, some thoughts on what still could happen and the hazards of handicapping a horse race with the “horses” still in the backstretch.
While President Trump’s deficit is unusually large for an incumbent, a sitting president has come from behind to win reelection three times (1948, 2004 and 2012) in the postwar era after trailing in August or later.
Thomas Dewey (1948), Michael Dukakis (1988), Al Gore (2000), Mitt Romney (2012) and Hillary Clinton (2016) all led in August and lost. And John F. Kennedy (1960) and Ronald Reagan (1980) lagged their opponents in August and won. In fact, the winners of 10 of the 18 presidential races since World War II trailed during the final three months, our review of election-year Gallup polls found. So, basing portfolio moves on the polls this far out from November is a big gamble.
Besides a resurgent economy, a further rise in the stock market could augur well for the president’s reelection chances. The pre-election movement of the S&P 500 has foretold the outcome of every presidential race since 1984 and all but three of the 23 elections dating to 1928. If the index increases over the three-month period leading up to the election, the incumbent party’s candidate generally wins.
Would the stock market fare better or worse under new leadership in Washington? History provides little guidance. Regardless of the partisan makeup of power – one party controlling the presidency and both houses of Congress or a split of some kind – the market’s performance has not been drastically different in the two calendar years following the election.
In four of the six possible combinations, the S&P 500’s returns during the two following years have been within a percentage point of each other (12.9% to 13.6%). The weakest two scenarios were still positive but significantly lower: 9.3% for a Democratic president with a Democratic Congress and 4.9% for a Republican president with a Democratic Congress – either outcome of which is possible in this election.
Higher taxes on corporations, estates and the wealthy are a distinct possibility if the Democrats take power and implement their agenda. But it is no foregone conclusion how the market would respond, as it often responds quite differently to events than investors originally expected. Case in point: Stock-market futures dove overnight immediately following Trump’s victory in November 2016. Investors then realized that lower taxes and deregulation would be good for stocks, and the market took off.
The current theory is that a Biden presidency would be bad for stocks because of his and the Democrats’ agenda. This could turn out to be true. On the flip side, the market might respond positively if trade tensions lessen with China and Europe and higher taxes fund even more government spending. This could also be true.
A change of control may not be universally good or bad for markets, although it would certainly mix up the winners and losers.
4. The pandemic and upcoming U.S. elections have reshaped geopolitical risks.
President Trump’s potential lame-duck status and most of all COVID-19 have heightened global uncertainty. Longstanding concerns about the U.S.-China trade war have been joined if not superseded by other worries abroad because of economic and political vulnerabilities created by the virus.
One major new concern, as voiced by the World Economic Forum, is that the pandemic will fuel a dangerous and volatile global upheaval – politically, socially and geopolitically – because of the monumental economic disruption it has wrought. The fear is that populist leaders and aggressive countries are moving to exploit the crisis for geopolitical advantage.
A solid recovery – the base case of most economic forecasts – could go a long way toward alleviating those concerns. In the meantime, we see numerous evolving areas of contention besides U.S.-China tensions that have the potential to hinder the recovery. How they play out will influence not just the world economy but also financial markets, especially international stocks.
Decline in global trade – Global trade is forecast to drop anywhere from 13% to 32% in 2020, with any shifts toward domestic production and regional supply chains likely to have major consequences for the world economy. A related issue – further restrictions on the cross-border movement of people and goods – was the No. 1 geopolitical risk cited in a July survey by the World Economic Forum of hundreds of analysts.
Fraying U.S.-European relations – Other trade relations around the world besides the U.S. and China are deteriorating. President Trump has threatened to impose tariffs on goods from Europe such as chocolate, butter and beer made with malt. U.S. moves to cut back on visas for skilled immigrant workers also have raised hackles. Some European countries have banned American visitors because of high numbers of U.S. COVID-19 cases.
China’s growing assertiveness – Since subduing its huge early coronavirus outbreak, Beijing has been active on multiple fronts involving territorial control. China has clashed with Indian troops in the western Himalayas, tightened its grip on Hong Kong, expanded sovereignty claims over most of the South China Sea and raised tensions with Japan and other Asian neighbors with its increasing military presence.
Middle East – The dual blow of the pandemic and low oil prices will stoke social unrest in an already turbulent region by worsening poverty and unemployment, according to the International Monetary Fund in a July report. The IMF projected its weakest economic outlook for the Middle East and North Africa in 50 years: a contraction of 5.7% this year and more than double that for countries torn by conflict. Both China and Russia seek to fill the void left by the lessened U.S. presence.
North Korea’s bellicosity – North Korea has become more militant, blowing up an inter-Korean liaison office in an explosive rebuke to Seoul and vowing to deploy more troops along the border with South Korea.
We noted in this quarterly commentary in January that the world had lived with growing levels of geopolitical risk for nearly a decade without a true crisis. That global crisis has since arrived in the form of COVID-19. While we expect an economic recovery that will improve the outlook by 2021, the pandemic will have a major impact on investment decisions for the foreseeable future.
We expect there to be more clarity on some of these issues by year-end, based on the course of the pandemic and the prospect for any U.S. policy changes following the elections. For now, these geopolitical risks cast a shadow on the near-term investment outlook.
5. The COVID-19 recession has created opportunities for investors who are willing to provide a lifeline to distressed companies.
Despite the U.S. government’s best efforts to resuscitate the economy through monetary and fiscal stimulus programs, companies large and small are faltering because of the coronavirus situation. The countrywide lockdowns have led to a collapse in revenues and profits, resulting in a wave of corporate downgrades, defaults and bankruptcies – all expected to accelerate in coming months as reopenings are scaled back and the government’s Paycheck Protection Program runs out. Indeed, Standard & Poor’s estimates the trailing 12-month default rate for junk bonds will rise to 12.5% in the U.S. and 8.5% in Europe by next March. Both were at or just below 3% before the pandemic.
Many industries such as restaurants, hotels, retailers and airlines have been decimated by COVID-19, with some unable to meet mounting debt obligations. Those without strong balance sheets and sufficient collateral to borrow money to get them through this uncertain period will be forced to declare bankruptcy and potentially reorganize. The most troubled companies, however, will have to liquidate their assets and close for good.
A number of household names already have declared bankruptcy, including Hertz, J.C. Penney, J. Crew, Neiman Marcus and Chuck E. Cheese. But the vast majority of companies that have filed or will file for Chapter 11 protection are small and medium-sized businesses. The magnitude of bankruptcies as measured by total assets involved already has surpassed the amount created by the global financial crisis in 2008-09, with hundreds of companies having filed in the U.S. because of the pandemic this year.
Bankruptcies and companies going through restructurings can be advantageous investment opportunities – known as distressed investing – to buy from noneconomic sellers or forced sellers at deep discounts. The distressed opportunity is estimated to reach between $500 billion and $1 trillion globally over the next 18 months as an increasing number of companies succumb to the fallout from COVID-19.
Distressed investors’ aim is to buy the senior bonds and loans of companies that already have filed for bankruptcy or are likely to do so, with the goal of helping guide the reorganization. This position in the capital structure provides creditors with significant influence or control during a company’s reorganization or liquidation. The expectation is that the company can restructure and emerge as a going concern, leading to significant gains for investors. If the company continues to struggle and is forced to liquidate, distressed debt investors can still generate a profit from the sale of assets.
The current environment is shaping up to be the most attractive entry point since the global financial crisis, and distressed debt investors have the ability to create equity-like returns even through senior-secured positions in the capital structure. Due to COVID-19, “You’ve got a lot of companies that are in trouble. … It’s a once-in-a-lifetime opportunity,” said veteran distressed debt investor Marc Lasry.
- The global economy will continue to climb its way back from a severe contraction as lockdowns end, with sharp improvement likely throughout the second half of 2020. We are again back at target (neutral) allocations in all three risk categories, given the unusual amount of uncertainty surrounding the pandemic.
- We believe the worst of the U.S. recession is over. While the recovery will be challenged by resurgent COVID-19 hotspots, a second wave is unlikely to result in another total shutdown or to be as economically devastating as the first.
- Returning to full employment in the United States will take years – an ongoing drag on the economy. Even though employers are bringing back millions of workers, many job losses will be permanent.
- Government stimulus continues to be the economy’s linchpin until more normal levels of activity return. The Federal Reserve remains ultra-accommodative with its monetary policy and will continue to act as a backstop; additional fiscal support from Congress is likely.
- Markets may be choppy in the runup to November elections as investors ponder the possibility of a change of control in the White House, the Senate or both. Historically, election outcomes have not made a significant difference in the stock market’s performance.
Quotes of the Quarter
“There’s probably never been more uncertainty about the economic outlook.” – Randal Quarles, Federal Reserve vice chair for supervision
“We are not thinking about raising rates. We are not even thinking about thinking about raising rates.” – Jay Powell, Federal Reserve chair
“The sudden stop of activity that has slowed down the pace of life, the pace of growth, the creation of value … will have lasting effects despite all the measures we are taking.” – Christine Lagarde, European Central Bank president
Stocks ascended even as the pandemic spread and the economy shut down in the second quarter, propelled by an outpouring of stimulus money and investors’ confidence in an economic recovery. The market rebound mitigated but did not fully erase the impact of the historic COVID-19 sell-off.
After having plunged 34% from February 19th to March 23rd, the Standard & Poor’s 500 Index entered the quarter in high gear thanks to multitrillion-dollar commitments from the Federal Reserve and Congress that sent the index up as much as 44.5% in 2½ months. Ultimately the iShares S&P 500 ETF investable proxy gained 20.3% from April through June for its biggest quarterly return since the final three months of 1998 and the index’s best second quarter ever, cutting its 2020 loss to 3.2% by the year’s halfway point.
Technology was a key driver of the rally, with giants Microsoft, Apple, Amazon, Facebook and Netflix all rising to all-time highs in June and Google parent Alphabet not far off. The tech-heavy Nasdaq Stock Market raced to a 31% gain for the quarter to go up over 12% for the year, the lone major stock index to be positive. The only positive S&P sectors year-to-date were technology (14.9%) and consumer discretionary (2.6%).
Another consequence of investors’ propensity for greater risk-taking was an unusually heavy preference for growth over value. Growth stocks walloped value stocks at every market-capitalization level during the second quarter, including an advantage of 27.7% to 14.2% for the iShares Russell 1000 Growth Index over its value counterpart.
Small caps, battered during the coronavirus drawdown, pogoed back with a 25.5% rebound in the second quarter to top all major asset classes. The iShares Russell 2000 ETF remained down 13.0% for 2020.
Global stocks joined the largely U.S.-led rally as central banks overseas provided massive stimulus and most nations reopened their economies in May and June. While continuing to trail their U.S. peers, stocks abroad narrowed the gap in the final weeks of the quarter as foreign currencies gained against the dollar and the pandemic ebbed in previously hard-hit countries.
The iShares MSCI EAFE ETF, which tracks stocks in Europe, Australia and the Far East, added 15.5% in the quarter and was down 11.1% year-to-date at midyear. The dollar, whose steady ascendance in recent years has chipped away at the value of overseas stocks held in U.S. accounts, provided a slight tailwind for a change. The greenback tumbled 5.3% from its March 20th peak and overall dipped 1.6% during the quarter against a basket of other major currencies – reducing its 2020 advance to 1%. That translated to the dollar-denominated index outperforming the same stocks measured in local currencies by nearly 3 percentage points in the quarter.
Emerging-markets stocks came on strong late in the quarter as China in particular put much of the virus’ economic impact behind it. The iShares MSCI Emerging Markets ETF gained 17.8% in the quarter to climb back up to negative 10.4% for 2020.
The pan-European Stoxx 600 index added 12.5% for its best quarter in five years while Japan’s Nikkei 225 was up 17.8% and China’s mainland markets also rebounded – the Shenzhen Composite vaulted 20.4% and the Shanghai Composite gained 8.5%. Virtually all countries’ stock exchanges remained underwater year-to-date, with Brazil trailing the pace with a loss of nearly 40%.
Optimism about the employment rebound and the economic recovery fueled a comeback in real-estate stocks in the quarter after they were devastated in the first quarter when businesses switched to remote operations and the travel, hospitality and retail sectors all hit pause. The Vanguard REIT Index Fund rose 13.5% to reach midyear with a 13.9% loss for 2020.
Internationally, the Vanguard Global ex-US Real Estate ETF added 10.2% but remained 20.4% in the hole for the year.
Hedged and opportunistic strategies posted more modest gains than stocks in the quarter but had smaller first-half losses in many cases, somewhat muting the impact of the blow dealt by the coronavirus downturn.
The HFRX Global Index, a proxy for all hedge-fund strategies, added 6.2% from April through June and was down just 1.1% for the year. Altair’s blended benchmark for closed-end funds rebounded 16.3% in the quarter to reduce its year-to-date loss to 12.4%.
Taxable and tax-exempt bonds demonstrated their value in portfolios in a most turbulent year, reaching the middle of 2020 with gains while stock indexes remained negative.
The Vanguard Total Bond Market ETF rose 4.1% in the quarter and was up 6.4% through half the year. With the Federal Reserve having moved rates to zero and pledging to keep them there, the 10-year U.S. Treasury yield began the quarter at a near-historical low of 0.7%, down from 1.9% at the beginning of the year. Yet it managed to edge still lower at 0.65%. Bond prices rise when yields fall.
Altair’s municipal bond benchmark, a blend of the Market Vectors short and intermediate ETFs, overturned its first-quarter decline with a 4.2% rise, leaving it up 2.4% for the first half. New issue volume spiked in June as borrowers sought cash, but the elevated supply was balanced by strong demand – investors’ confidence in munis boosted by the outpouring of financial assistance from the federal government and the sense that more is coming. Most importantly for investors, there was no hint of any liquidity issues like the ones that hamstrung the market and sent prices briefly plummeting in March.
The material shown is for informational purposes only. Past performance is not indicative of future performance, and all investments are subject to the risk of loss. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, and actual results may differ materially from those anticipated in forward-looking statements. As a practical matter, no entity is able to accurately and consistently predict future market activities. Information presented herein may incorporate Altair Advisers’ opinions as of the date of this publication, is subject to change without notice and should not be considered as a solicitation to buy or sell any security. While efforts are made to ensure information contained herein is accurate, Altair Advisers cannot guarantee the accuracy of all such information presented. Material contained in this publication should not be construed as accounting, legal, or tax advice.