Altair Insight: Riding Out 2020 (3Q20) – Quarterly Market Review
When video footage went viral this fall showing a Brazilian surfer navigating one of the tallest waves on earth, it seemed somehow emblematic of what markets and the world’s economy have experienced in this year of COVID-19.
Maya Gabeira was relieved just to have survived the 73½-foot wave. “I had never been so close to such a powerful explosion,” she said of her world record-setting ride. “I had never felt that energy and that noise. I got really close to disaster.”
Investors doubtless had similar feelings as the world was engulfed by the tsunami of a pandemic, stock market crash, recession and civil unrest. Like Gabeira, we have all endured it.
While we do not view a large or lasting setback as likely for markets in the two months remaining in 2020, a short-term pickup in volatility is very possible amid all the uncertainty surrounding the upcoming elections, not to mention the growing coronavirus toll and uncertain timing for a second round of fiscal stimulus.
A Spooky Stretch
Noah Kroese Illustration for Altair Advisers
Despite all of this year’s tumult, much progress has been made in recent months and both the economy and the markets are faring better than expected at the three-quarters mark as people continue to learn to live with the virus. The last six months have shown that – with a boost from government stimulus – consumers and businesses are resilient and can adapt quickly.
Even if the coronavirus’ impact worsens, full lockdowns like the ones we underwent six months ago are unlikely, as is another complete shutdown of the economy.
The government’s economic “bridge” – support from both the Federal Reserve and Congress – is still under construction and may not yet be long enough. But we are confident it will be sufficient to connect to a better outlook in 2021 once we are past some potential near-term volatility. We recommend no allocation changes for our clients’ portfolios in the interim.
We next explore five topics still shaping 2020’s legacy as our quarterly commentary continues:
1. The U.S. economy is strengthening in fits and starts and should continue trending upward.
While the recovery has been choppy, we do not believe there will be a double-dip recession. This assumes that government policy remains supportive, as we anticipate, and the economy is not jolted by another unexpected shock in the months ahead. It is on the right path.
Third-quarter economic growth, estimated at a 25% annual rate based on a blend of the Atlanta and New York Federal Reserve Banks’ forecasts, was nearly as impressive as the second-quarter decline (-31.7%) was abysmal. The underlying data shows how far the economy still has to go.
Yet even with a recent fading of momentum, overall progress has been better than expected. The International Monetary Fund estimated in mid-October that U.S. real GDP will contract 4.3% in 2020, an improvement from the June forecast of an 8% drop. The nation’s biggest banks reported less in loan losses than anticipated and signaled their confidence that the pandemic will not send the economy skidding into a dangerous spiral.
We are tracking the state of the recovery by watching changes in the following five key categories. While the data is mixed, it tilts positive overall:
Unemployment – The No. 1 symbol of losses from the recession has improved but remains historically high. Slightly more than half of the 22 million jobs wiped out by the coronavirus have been regained and the jobless rate has fallen to 7.9% from a peak of 14.7% in April. But the decline in first-time claims for unemployment benefits has tapered off and a wave of corporate layoffs complicates the labor market outlook. The labor force participation rate has dropped from 63% to 61% and the number of permanent job losses has climbed from 1.8 million just before the pandemic to 3.8 million – people first sidelined by temporary shutdowns and now out of work for more than six months because their employers never reopened for business.
Consumers – Consumer behavior has shifted dramatically to more online shopping and overall sentiment is improving, although still far below pre-pandemic levels. Optimism rose toward the end of the third quarter after a summer lull, with both the University of Michigan and Conference Board gauges showing the highest confidence readings of the pandemic. Retail sales, which represent two-thirds of the economy, have rebounded to set records every month since June. Continued government stimulus will be key to maintaining the momentum.
Government support – The Fed signaled in mid-September that it expects to keep interest rates anchored near zero through at least 2023. The central bank also continues to buy $120 billion of bonds a month and says it will allow periods of higher inflation (above its 2% target) as it attempts to help revitalize the economy. Pressure is on Congress to provide another fiscal stimulus package, and despite the lengthy delay we remain confident it will be forthcoming. The Federal Reserve’s expanded balance sheet and untapped emergency lines of credit it extended in March make credit conditions easy for larger businesses; however, it remains up to Congress and the Treasury Department to deliver additional stimulus to individuals and businesses.
Business strength – Quarterly earnings season remains in progress, but signs point to better-than-anticipated results in a year when the bar remains low because of the pandemic. Small business confidence rose in September to its highest level since February, reflecting improved sales. Manufacturing, still a bellwether of the economy even though considerably smaller than in past decades, climbed for a fifth straight month in September.
Housing market – The housing industry has boomed since being effectively shut down last spring by the pandemic. The work-from-home culture, record-low mortgage rates and rise in household formation by millennials all are positive trends for the housing market. Pending home sales hit a record high in August and new home sales rose to their highest monthly level in 14 years. Overall housing starts declined recently but strong demand and ultra-low rates have spurred construction of single-family homes, which comprise the bulk of the housing market. Much of this demand has come at the expense of densely populated urban dwellings, as individuals and families alike seek more room and more physical distancing due to the coronavirus.
The bottom line for the economy: Momentum is slowing as the recovery inevitably moderates from its initial snapback, but jobs are still being added and continued growth is promising barring an unlikely drying up of fiscal and monetary aid.
2. Like the U.S., the global economy faces near-term challenges but is performing better than expected.
A “long, uneven and uncertain” ascent lies ahead for the world economy, according to the IMF’s sobering assessment, following the biggest economic plunge since the Great Depression. So far, at least, the push to regain higher ground is concerted and beginning to pay off.
While Washington remains deadlocked on the issue of fiscal stimulus, the global effort is proceeding. Close to $20 trillion of stimulus from governments and central banks has pulled the world’s economies much of the way back toward pre-pandemic levels. The United States has delivered the equivalent of 15% of its gross domestic product to stimulus but that has been significantly exceeded by Germany (41%), Italy (37%), Japan (35%), the United Kingdom (23%) and France (19%).
In the meantime, China, the world’s largest economy after the United States, has seen its economy snap back faster than any other following its successful containment of the original COVID-19 outbreak born there last December. It will be the only major economy to grow this year, according to the IMF.
These trends affirm our confidence in not only the international economic outlook but also in non-U.S. stocks, though they have continued to lag their domestic counterparts during the pandemic. A weakening dollar and a resurgence in global trade already have benefited emerging markets in particular, making them the top-performing asset class in the third quarter. Based on our expectation for overseas stocks to join the U.S. in performing well as the global recovery advances, we are maintaining our exposure to both developed- and developing-world stocks at current levels.
In the short term, we are closely watching as some of these countries face threatening new obstacles. Rising infection rates have put a dent in Europe’s recovery this fall, reducing travel and consumption as new restrictions are imposed or considered and compounding the challenge for the European Union as it seeks to provide relief aid to the hardest-hit countries. In the United Kingdom, where the economy already is deteriorating rapidly, the worst-case scenario is approaching for the issue that has hung over the nation’s economy since 2016: a job-killing hard Brexit, with a crash out of the European Union looming at year-end absent an 11th-hour trade deal.
China’s unexpectedly swift revival, bolstered by a rebound in global demand as well as its government’s supportive measures, offsets some of the weakness elsewhere. The International Monetary Fund pegs China’s real GDP growth at 1.9% even as the global economy shrinks by 4.9%.
As with the U.S. economy, the pace of global growth will be dictated by the wide availability and usage of vaccines.
3. Growth stocks have powered the market to its second-best six-month rally ever; for value and cyclical stocks, better times are coming.
The short version of the stock market’s resurgence from the depths in 2020 is that the gains have come almost exclusively from the technology leaders and other giant growth-oriented companies.
This trend could continue as long as economic activity remains unusually tilted toward the trends of working from and staying at home. Yet we believe patience with the value style of investing is merited because the economy’s next phase has the potential to reset the growth-value pendulum.
How have tech and growth stocks been so dominant to this point? One key reason is the fact that these businesses generally have experienced the least interruption. They continue to increase earnings, and some have benefited greatly from the move to physical distancing and living remotely. Growth’s outperformance vs. value predates this year, but this year’s forced lifestyle and cultural changes have exacerbated the divergence – a level of disparity that we believe is unsustainable.
The FAANG stocks driving this rally bear no resemblance to the money-losing tech companies of the dot-com era that grew into speculative bubbles and popped. Their earnings have grown greatly in excess of the S&P 500’s average and their business models are proven and work well in the pandemic. Even after a sell-off in September, these mega-caps were up nearly 44% year-to-date through three quarters: Facebook 28%, Amazon 70%, Apple 59%, Netflix 51% and Google parent Alphabet 10%.
Without these stocks, which have among the highest weightings in the index, the S&P 500 would be well into negative territory for 2020. Instead, the index was up 9% through the middle of October. They have enabled growth to keep adding to its huge lead over value: 37 percentage points for the Russell 1000 Growth Index over its value counterpart, the largest gap in decades and potentially the largest on record for a full calendar year.
Value stocks have unquestionably been disappointing by comparison, yet their outlook historically brightens in a resurgent economy. The Russell 1000 Value Index had shed half of its first-half loss of 16.3% as of mid-October. An end to election uncertainty, an easing of the virus outbreak and improvement in corporate profits, all of which we see ahead next year, can help value stocks catch up to growth stocks over time. Our value-oriented managers see brightening prospects for select stocks in an evolving economy.
While the timing of a medical breakthrough in the fight against the coronavirus will heavily influence their performance, we see solid prospects for both growth and value stocks as the economy ramps back up toward a normal pace.
4. Pandemic progress? The tantalizing prospect of medical solutions underpins markets as the one-year mark of COVID-19 nears.
Rarely has hope and optimism lifted markets to the extent it has done for this year’s rally – ignited by the economy’s gradual reopening but extended by faith in the pharmaceutical industry’s ability to deliver timely coronavirus relief.
Is the confidence misplaced, the rally overdone? We do not think so. The timing for development of an effective vaccine remains a big unknown for markets, and a lengthy delay would crimp the economic recovery. The apparent momentum toward medical remedies, however, lends a certain inevitability to the quest’s ultimate success.
The race for vaccines is in overdrive this fall, creating the possibility that we are within months of widespread distribution. The World Health Organization says about 170 vaccine candidates are in development, with 26 being tested on humans and eight of those near completion of the final test phase. Mitigation measures and therapeutics also appear close.
Certainly the pandemic will not vanish once a vaccine hits the market. Problems with access, efficacy and acceptance could perpetuate the disease and prolong the global recovery. And researchers with the Center for Global Development suggest that the challenges of manufacturing mass dosages make it unlikely that enough doses to cover the world’s population will be available before 2023.
In terms of the economy and markets, however, even the prospect that a vaccine will soon become available is likely to provide another jolt of confidence for businesses and consumers as travel, office work and other economic activity begin to look more plausible.
Even more encouraging is that death rates from COVID-19 have fallen and younger people continue to prove to be less vulnerable to the disease, even with a resurgence this fall. The return of cold weather poses additional challenges. Still, the widespread panic appears to have subsided as we have found a way to live with the pandemic. We look forward to encouraging developments in 2021.
5. Doubts about the election outcome could persist for weeks after the vote, but ultimately there will be a clear resolution.
“Strange times are those in which we live, forsooth.” – George Francis Train, U.S. presidential candidate (1872)
The confluence of events that has occurred in 2020 is so unusual that we are sure even Mr. Train would be struck by it, 37 presidential election years after his still-quoted comment as an independent long shot on the campaign trail.
Things would get even stranger in that turbulent political year: 1872 is the only U.S. presidential election in which a major party nominee (Horace Greeley) died during the election process, handing a unanimous Electoral College victory to the incumbent, Ulysses S. Grant.
This tumultuous year hurtles into November with the prospect of yet another set of abnormal circumstances looming. Not just the outcome is in doubt; so too are questions about the vote-counting process itself, the chances either party will dispute the result and President Trump’s threat to declare the vote fraudulent if he loses – not to mention control of Congress and what a Democratic sweep would portend.
Significant potential for market volatility exists, intensified in the event of a contested result and drawn-out ballot-counting or litigation. Numerous scenarios are possible, even – despite all the nerve-jangling headlines – a straightforward verdict known the night of November 3rd.
We believe any such election-related volatility would be short-term, with the outcome becoming clear fairly quickly – if not in November, by year-end. The heightened uncertainty that can roil markets will soon ease with a definitive result. While the makeup of power in Washington will differ greatly depending on the outcome, the longer-term impact on the economy and markets should not.
The economy has had a largely nonpartisan performance over the decades, as witnessed most recently by the fact that real GDP was almost identical in the first three years of the Trump administration to the last three years of the Obama administration despite drastic policy differences. Whoever wins this year will preside over what we believe will be an improving economy, boosted by the likelihood of effective COVID-19 treatments and vaccines becoming widely available sometime in 2021.
It is impossible to know whether the stock market would perform better during a Biden administration or a second Trump term. As we said in our last quarterly commentary, the market’s performance regardless of the partisan makeup of power has not been drastically different in the two calendar years following the election, aside from under a Republican president and Democratic Congress when returns are markedly lower – an outcome we believe to be highly unlikely.
A second term for Trump would likely mean status quo for U.S. economic and trade policies, although he has not outlined a planned agenda for the next four years and surprises are possible if not likely.
Biden has pledged to raise the corporate tax rate, among other changes. Still, the increasing expectation that a Democratic administration would spend more on stimulus and other projects (at the expense of the government deficit) could potentially more than offset that concern for investors in the near to intermediate term.
No bold tax reform or other sweeping financial measures likely are imminent under a Biden administration unless the Democrats gain an overwhelming majority in Congress. COVID-19 mitigation will presumably be the first priority for either side.
- The recession that began last February likely is over and we do not expect the economy to fall back into negative growth again given the unlikelihood of another full lockdown. While the recovery should proceed without reversal, the 11 million lost jobs that have yet to be restored will keep the economy and employment from returning to pre-pandemic levels before 2022.
- While the timing and size are in doubt, a substantial fiscal stimulus package undoubtedly will be forthcoming from Congress. Coupled with ongoing support from the Federal Reserve, this should help provide momentum – or at minimum a backstop – for the economy and markets into 2021.
- We are overweight large-cap U.S. stocks because we expect this current secular growth trend to continue and overweight U.S. small caps because they should accelerate along with the recovery. International stocks too should benefit from a return toward full global growth once a vaccine is out. We are still at long-term targets for all three risk categories: higher, medium and lower risk.
- A delay in tallying and confirming election results is a near-term risk for markets, with the potential for days or weeks of political turmoil. We expect any election-related volatility to ease by year’s end.
- Efforts to quell COVID-19 will continue to dictate the pace of the global economy until an effective vaccine is widely distributed. Based on reported progress from the many drugs in development, we view the likeliest scenario as mass distribution of a vaccine occurring by next summer.
- We expect value stocks to narrow their large gap with growth stocks. Value typically outperforms once recessions end and should benefit from a strengthening recovery.
Quotes of the Quarter
“The global economy is coming back from the depths of the crisis. But this calamity is far from over.” – Kristalina Georgieva, International Monetary Fund managing director
“The US federal budget is on an unsustainable path, has been for some time. (But) this is not the time to give priority to those concerns.” – Jerome Powell, Federal Reserve chair
An improving economy and investors’ continuing embrace of technology titans helped drive impressive gains for U.S. stocks throughout the summer and into the fall, resulting in the best back-to-back quarters of performance since 2000. The Federal Reserve contributed, too, pledging years of no interest-rate hikes until the economy is fully revved up again after the coronavirus pandemic.
The iShares S&P 500 ETF, an investable gauge of large caps and the broad U.S. market, advanced 9.0% for the quarter and was back in positive territory for 2020 with a 5.5% return through nine months. Even with a September pullback – driven by pre-election tension, a delay in fiscal stimulus in Congress and profit-taking after five months of a steep climb – it was up more than 30% in the previous two quarters and 50% since the March 23rd market bottom.
Tech high-flyers led the way. Through three quarters, the FAANG stocks were collectively up 43.6% year to date: Facebook 27.6%, Amazon 70.4%, Apple 58.8%, Netflix 51.4% and Google parent Alphabet 9.9%. While technology is by far the year’s top S&P 500 performer with a 28.6% return, four other sectors joined it in double digits for the third quarter, led by consumer discretionary stocks gaining 15.3%. Energy was the big loser, shedding 19.5% in the quarter and down 47.4% “year-to-date” on a plunge in demand.
Technology also was a big factor in growth’s continuing outsized domination of value as an investing style. The iShares Russell 1000 Growth Index added 13.2% in the third quarter to 5.5% for its value index counterpart and extended its lead over value in 2020 to 36 percentage points (+24.1% for growth to -11.7% for value), the largest gap in records going back to 1979.
Small-cap stocks, which had led all major asset classes during the economy’s snapback in the second quarter, lagged large caps this time amid the strength in large-cap technology and other stay-at-home stocks. But the iShares Russell 2000 ETF still added 5.0% to trim its 2020 decline to -8.6%.
The global recovery and more stimulus from central banks boosted foreign stocks. International developed stocks trailed their U.S. counterparts, due in part to fewer giant technology companies to produce outsized gains. But emerging markets produced double-digit gains as the world economic recovery broadened.
The iShares MSCI EAFE ETF, measuring large- and mid-sized stocks in Europe, Australia, Asia and the Far East, rose 4.6% to reach the year’s three-quarter mark with a negative 7.1% return. The continuing decline of the U.S. dollar, which fell nearly 4% in the quarter against a basket of other major currencies, was a boost to overseas returns measured in dollars. In local currency without translating to the weaker dollar, the gain over the three months was only 1.3%.
Strong growth in Asian markets, especially China, propelled emerging-markets stocks to their second straight quarter of outperformance over international developed stocks. The iShares MSCI Emerging Markets ETF was within 1.2% of breaking even for the year after a 10.3% quarter.
Among overseas markets as measured by country ETFs, India was the big third-quarter winner with a 16.9% return, with Germany and Japan in the 7% to 8% range. Brazil, Spain and the United Kingdom all were slightly negative.
Real estate investment trusts stabilized in the third quarter after having plunged in the early months of the pandemic but still underperformed stocks. The Vanguard Real Estate Index Fund managed a 1.3% gain but remained down 12.7% for the year to date.
Timber REITs and self-storage shares were the notable real estate gainers, with the timber sector benefiting from record-low mortgage rates and a strong housing market, resulting in more building and renovation projects. Companies that invest in shopping centers, office space and apartments all continued to post losses, a reflection of the challenging economic environment.
Global trends were similar. The Vanguard Global ex-U.S. Real Estate Index Fund, which has broad exposure to both real estate stocks and REITs overseas, rose 3.8% but was still 17.3% in the red for 2020 entering the fourth quarter.
Hedged and opportunistic strategies moved positive for the year following gains that were more modest than those of the previous quarter, mirroring the status of the going-but-slowing economic recovery.
The HFRX Global Index, a measure of average hedge-fund performance, increased by 2.7% for a year-to-date return of 1.6%. Altair’s blended benchmark for closed-end funds added 4% in the quarter to narrow its 2020 loss to 8.8% through nine months. Our distressed debt benchmark, a blend of 65% mortgage-backed bonds and 35% high-yield bonds, advanced 1.6% from July through September and was up 2.3% for the year.
Bonds traded in a narrow range, reflecting a steadying economy, lack of movement in the 10-year Treasury note yield and the Federal Reserve’s hold on near-zero interest rates. The 10-year yield ended September at 0.7%, virtually unchanged over the past two quarters after plunging from 1.9% to start the year.
Higher coupons and improving bond prices in corporate sectors drove performance for taxable bonds. The Vanguard Total Bond Market Index Fund, measuring the performance of government, corporate and other investment-grade bonds, edged up 0.4% for a nine-month return of 6.9%.
Tax-exempt municipal bonds outperformed their taxable peers, in part because markets anticipated that a new fiscal stimulus bill will contain funding for state and local governments. Altair’s municipal bond benchmark, a blend of the Market Vectors short and intermediate ETFs, rose 0.8% for a year-to-date advance of 3.3% through the end of September.
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.