July 29, 2020
It’s hard to believe but it’s been six months since the COVID-19 pandemic took America by storm and completely disrupted most aspects of daily life for over 328 million citizens. If this unprecedented period in our nation’s history were captured in a Broadway play, a fitting title would be, “It’s All About the Virus.” Think of this play as consisting of three acts (thus far) with the third one still in process.
Act I: The Great Lockdown
The COVID-19 virus ended the longest expansion in U.S. history. Data suggests that the recession commenced at the end of February but lasted only through April. However, during these few short months, the U.S. economy experienced the most significant decline ever recorded, -32.9% on an annualized basis, a contraction worse than experienced during the Great Depression.
The collapse in economic activity was due to the unprecedented shutdown of commerce that economists say has never occurred on such a wide scale. Forty-one states ordered several businesses to close in hopes it would reduce the spread of the virus. Restaurants, universities, gyms, movie theaters and public parks closed were ordered to close. Millions of “nonessential” businesses shut off the lights, some permanently. Over 30 million Americans filed for unemployment, or 1 in 6 workers, a staggering number, as the unemployment rate jumped from 3.5%, a 50-year low, to 16% in a matter of weeks. Retail sales declined by over 8% in March and 16% in April, the biggest monthly declines ever, as people stopped dining out and buying vehicles, clothing, furniture. The fall-off reflected the pandemic’s effect on consumers, who drive 70% of the economy but were forced to stay home. Industrial production also collapsed; if consumers were no longer buying manufactured goods such as automobiles, there was no need to make them.
Global financial markets collapsed as the virus spread across China, to Europe, Asia, the Middle East and, finally, the United States, stoking fears that the global pandemic would result in a global recession.
Act II: The Great Response
The unprecedented government-mandated shutdown of the economy was met with equally unprecedented fiscal and monetary policy responses.
The Federal Reserve cut short-term interest rates to zero and pumped trillions of dollars of liquidity into the capital markets. The Fed resumed its purchases of Treasury bonds and resorted to measures never taken before by the U.S. central bank, including buying corporate bonds and ETFs. Importantly, the Fed signaled it was ready to do everything in its power to mitigate the economic fallout from the pandemic.
Congress responded with over $3 trillion in fiscal stimulus, including the CARES Act and the Payroll Protection Program. Importantly, the government also signaled they were prepared and willing to do whatever was required to bridge the gap so that when the virus permits resumption of activity, we could see a sharp rebound in the economy.
Financial markets rallied in response to the Fed’s actions, the CARES Act, and a sense that policymakers were prepared to provide support until the economy could be restarted. Markets also rallied on signs that quarantine measures bent the curve of the virus’ progression, allowing all 50 states to start to reopen in phases.
After bottoming out in April, economic activity rebounded, and optimism of a “V” shaped recovery emerged in May. The strongest evidence came from consumer spending. In a sign of pent-up demand caused by the lockdown, May retail sales jumped 17.7%, the highest monthly sales increase on record.
Act III – Resurgence
So far, the economy has been recovering quickly from the output trough as most states reopened, but the recent resurgence of the virus in some areas will likely cause the economic momentum to stall; in fact, some of the high frequency economic data points to a slowdown. According to Yelp, which skews heavily towards the restaurant and hospitality sectors, roughly 41% of enterprises that were forced to close on a temporary basis are now permanently out of business, likely making re-employment more difficult. Moreover, the pace of the rebound has slowed in recent weeks as a resurgence of infections has led to rollbacks and delays in the economy re-opening. The labor market has been lagging the recovery. Over 30 million workers are still on some form of employment benefits and the weekly unemployment claims have stubbornly stayed above one million for 18 weeks.
The equity markets as measured by the S&P 500 Index, have continued their rally off the March 23rd lows, and as of June 30, have recorded one of the best quarterly return performances in history. The index recently closed in positive territory for the year, within 4% from an all-time high.
So why the mismatch between the economy and the market? Underneath the surface, the index’s advance is somewhat misleading. The big five tech stocks (Amazon, Apple, Facebook, Google and Microsoft) are up on average over 30% YTD, while the remaining 495 stocks in the index are down almost 8% for the year; small caps as measured by the Russell 2000 Index are down over 10%. This disparity is possible because the big five now account for almost one quarter of the S&P 500’s market capitalization, a concentration greater than what existed in the tech boom in 2000. (An important difference between now and 2000 is that unlike 2000, the valuations of the big tech stocks can best be described as full - an average forward PE in the low 30’s- as opposed to crazy). Further, the pandemic has accelerated many disruptive trends that played into the business models of large technology companies. It appears to me that big cap tech can only carry the market so far without other groups participating. Those sectors will need the tailwind of an uninterrupted economic recovery to provide sustained advances, which will depend on the virus and the potential for vaccines and/or treatments. I would be remiss not to mention the unprecedented levels of accommodation being provided by the Fed and the stimulus measures passed by Congress. That wall of liquidity must find a home somewhere, and stocks look attractive relative to bonds that currently provide almost no nominal return (10-year rates are near a record low 0.57%) and potentially negative returns after inflation.
The easy money backdrop raises the potential for the misallocation of capital and bubble-type conditions in some asset classes. Yet despite pockets of retail enthusiasm in the day trading community and put-call ratios skewing to levels that display complacency, overall sentiment toward equities remains tepid. Flows since the March 23rd bottom have gone to fixed income over 3-to-1 versus stocks, perpetuating a trend that began after the financial crisis in 2009. Fund managers continue to hold cash at levels well above the long-term average and speculators have been leaning to the short side. With the Fed apparently on hold with respect to interest rates, investors are likely to remain willing to pay a premium for secular growth stories, meaning multiples may have even more room to expand for some companies.
But uncertainties remain until the virus issue is resolved. Even then we likely have a contentious election ahead. The democrats and republicans have diametrically opposing views on how to proceed with respect to policy – many of which have direct effects on investors (corporate and capital gains tax rates to name two). In the long term, rising PE multiples well above historical averages will likely reduce returns from equites as an asset class. But if the central banks pump liquidity, the tide may keep rising. Overall, this is a difficult landscape for the disciplined investor.
The resurgence of Covid-19 infections across the country has led to rollbacks and delays in the re-opening of the economy. The right side of the V is leveling off – meaning the pace of the economic recovery is slowing. The economic recovery is contingent on how soon we have effective treatment or a vaccine for the virus. There are reasons to be optimistic. Many therapeutics with “make-or-break” data should be coming in the next few months. In addition, several companies have announced progress towards developing a vaccine. Phase 3 trials will shortly answer questions on their safety and efficacy. Until then, it’s likely that the shape of the recovery will look like the Nike swoosh or a series of W’s.
Remember the title of our play, “It’s All About the Virus.”
All opinions and data included in this market commentary are as of 7/29/2020 and are subject to change. The opinions and views expressed herein are not intended to be relied upon as a factual prediction or forecast of actual future events or performance or a guarantee of future results or investment advice.
All investments are subject to risk, including loss of principal. Past performance is no guarantee of future results. Investors cannot invest directly in an index.
The information contained should not be used as the sole basis to make any investment decisions.
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