Economic Flash: A Recovery of Sorts, Although Not V-Shaped


August 2020

US Economy: Record plunge in US growth.

For 2nd quarter 2020, US GDP fell 9.5%, the largest drop in history, underscoring the severity of the Covid-19 driven recession. With close to 30 million Americans unemployed and the virus spread accelerating, consumer confidence fell in July; new jobless claims, which have been more than 1 million a week, ticked up as CA, TX, FL and many other states are pausing or rolling back re-opening.

US Stocks: The worst-is-over mentality.

Led by big tech, whose 2nd quarter profits soared, the S&P 500 has erased all 2020 losses. Overall, S&P 500 earnings are expected to be down an abysmal 36% for the 2nd quarter but investors chose to focus the development of Covid-19 vaccines/treatments, growth in retail sales (+7.5% in July) and the prospect of more US government aid for workers and companies.

Foreign Stocks: EM surge driven by China.

Non-US stocks also gained in July, with emerging markets (EM) again outpacing their developed peers. Two key factors: Strong gains in Chinese equity markets, and more tech companies in EM stock indexes. Cheaper valuations relative to US stocks, low global interest rates, and a weaker US dollar are attracting investor interest and capital to emerging markets.

Fixed Income: Stampede for yield.

With interest rates near zero or negative in many countries, central bank support and investor demand for higher yields drove strong gains in the riskier corners of the market. Both investment-grade and high-yield corporate bonds saw credit spreads tighten dramatically. This is despite the trailing default rate reaching a 10-year high of nearly 5.5% and record new bond issuance year-to-date.

Real Assets: No inflation necessary.

Forecasts for near-term inflation remain well below 2%, based on stalled wage increases and labor market softness. Still, inflation-insulated real assets, including gold, notched positive returns. After lagging the broader market rally, infrastructure stocks offer both compelling relative value and defensive characteristics, even if an inflationary environment doesn’t materialize.

Alternatives: Treading water.

Hedge funds again posted modest returns with most broad-based approaches in positive territory. An increase in volatility has been a tailwind for an asset class that benefits from a high level of differentiation between securities. Relative value (+1.9%) and event-driven (+1.9%) strategies have been the greatest beneficiaries. With many parts of financial markets already recovered, the timing may be right to make an increased allocation to the space.

Equities Total Return

U.S. Large Cap 5.6% 2.4% 11.9%
U.S. Small Cap 2.8% (10.6%) (4.6%)
U.S. Growth 7.4% 17.1% 28.2%
U.S. Value 3.8% (13.5%) (6.7%)
Int’l Developed 2.3% (9.3%) (1.7%)
Emerging Markets 8.9% (1.7%) 6.5%

Fixed Income Total Return

U.S. Agg. Bond 1.5% 7.7% 10.1%
TIPS 2.3% 8.4% 10.4%
U.S. High Yield 4.8% (0.2%) 3.1%
Int’l Developed 4.6% 5.8% 6.1%
Emerging Markets 2.0% 1.3% 3.0%
Intermediate Munis 1.1% 3.3% 4.0%
Munis Broad Mkt 1.6% 3.6% 5.1%

Non-Traditional Assets Total Return

Commodities 5.7% (14.8%) (12.1%)
REITs 3.8% (10.0%) (4.4%)
Infrastructure 3.0% (16.9%) (10.4%)
Hedge Funds
Absolute Return 1.0% (0.2%) 2.1%
Overall HF Market 1.3% 0.2% 3.6%
Managed Futures 2.6% (0.2%) (2.3%)

Economic Indicators

JUL-20 JAN-19 JUL-19
Equity Volatility 24.5 18.8 16.1
Implied Inflation 1.6% 1.6% 1.8%
Gold Spot $/OZ $1976 $1589 $1414
Oil ($/BBL) $43 $58 $65
U.S. Dollar Index 118.5 115.8 115.0

Glossary of Indices

Our Take

It is our base case that the global economy will continue to recover, although unevenly and subject to volatility from headlines on the spread of Covid-19 and (hopefully) promising news on a vaccine. Taking the equity market recovery at face value, prices appear to be baking in earnings results that are fairly rosy; at this point that isn’t unreasonable.

Unfortunately, the $600 weekly relief payments tacked on to unemployment benefits have expired, and Congress has not yet agreed on replacement. There are two competing CARES Act successors, both of which would renew benefits although at different levels. We think there will soon be a compromise and new government support since rising unemployment claims make failure to do something politically untenable.

Taking Stock

With half of S&P 500 companies reporting so far, more than 80% of 2Q earnings reports have been better than forecast. However, analyst projections were set quite low, given the unprecedented uncertainty. While the resumption in business activity has coincided with an increase in the spread of the virus both in the US and abroad, we do not think the lockdowns of March 2020 are likely. So, earnings guidance here out should be more helpful, now that we have better context for the COVID economy and key market drivers.

In our Q3 2020 Economic Outlook: Seeing Past Terra Incognita, we pointed out that the rebound in the S&P 500 is being driven by a handful of the largest index positions, mostly in big tech (Amazon, Apple, Facebook, Google, etc.), while most major US stocks are still showing negative year-to-date returns. Top tech names driving results in the US can be looked at a few ways: 1) There’s more room for upside when other index companies rebound as the economy improves; or 2) the 2020 rebound in equity markets is narrower and arguably more fragile beneath the surface.

While we are maintaining the generally defensive posture we established earlier in the year, we are finding a few opportunities to take increased risk. In addition to the emerging markets, we are now taking a closer look at European equities for the following reasons: the new ability of the Eurozone to issue debt to support member countries which suggests greater stability; lower equity valuations vs. the US, and the likelihood of a strengthening euro.