Economic Flash: After the Market Melt-Up, Risks Remain


September 2020

US Economy: Reasons for optimism.

Data continues to suggest that the big drop in Q2 US GDP marked the bottom of the COVID-driven recession, even though unemployment is likely to remain close to 10%. Broad improvement in business and consumer activity, including acceleration in manufacturing and the residential mortgage market further support analyst expectations the economy rebounded over the summer.

US Stocks: August sizzle.

US large-cap stocks took another leap forward after posting an uncommonly robust historical return for August. With persistent headwinds from COVID likely to continue, companies that have thrived during the pandemic continued to lead the market, with IT (+12.0%), Consumer Discretionary (+9.5%) and Communications Services (+9.1%) the top-performing sectors.

Foreign Stocks: Asian outperformance.

Non-US stocks advanced in August but less so than their US counterparts. Asian stocks drove performance in both developed and emerging markets on strong results in Japan and China respectively. Both countries were relatively successful in containing the COVID outbreak and are well-positioned for a more rapid recovery with the support of government stimulus.

Fixed Income: Fed OK with inflation.

As investor appetite for risk increased, so did expectations that government stimulus and easy monetary policy would lead to an increase in inflation. The Fed announced a historic change in policy to allow inflation to rise above the historical goal of 2%, with the last decade suggesting low probability of a surge. High-yield bonds and TIPS were the strongest performers while regular US Treasuries fell 1.2%.

Real Assets: Industrial commodities in demand.

While the price of gold drifting down from recent highs, many other commodities surged forward led by the energy (+13.0%) and industrial metals (+6.9%) sub-sectors. Signs of a resumption in economic activity has meant a modest increase in demand in both areas, while softening in the US dollar was another contributing factor.

Alternatives: Holding their own.

The overall hedge fund market posted returns competitive with fixed income, with the best returns coming from equity-oriented strategies. With forward looking return expectations muted in many traditional asset classes, hedge funds as well as less liquid investments, such as private equity, are increasingly looked to by investors to augment portfolio returns.

Equities Total Return

U.S. Large Cap 7.2% 9.7% 21.9%
U.S. Small Cap 5.6% (5.5%) 6.0%
U.S. Growth 10.1% 28.9% 42.6%
U.S. Value 4.2% (9.9%) 0.4%
Int’l Developed 5.1% (4.6%) 6.1%
Emerging Markets 2.2% 0.4% 14.5%

Fixed Income Total Return

U.S. Agg. Bond (0.8%) 6.9% 6.5%
TIPS 1.1% 9.6% 9.0%
U.S. High Yield 1.0% 0.8% 3.7%
Int’l Developed (0.2%) 5.5% 3.2%
Emerging Markets 0.3% 1.6% 5.6%
Intermediate Munis (0.1%) 3.2% 3.4%
Munis Broad Mkt (0.3%) 3.2% 3.1%

Non-Traditional Assets Total Return

Commodities 6.8% (9.0%) (3.9%)
REITs 0.1% (9.9%) (8.1%)
Infrastructure 1.7% (15.5%) (9.3%)
Hedge Funds
Absolute Return 0.4% 0.1% 2.1%
Overall HF Market 1.4% 1.7% 4.8%
Managed Futures (1.6%) (1.7%) (6.9%)

Economic Indicators

AUG-20 FEB-20 AUG-19
Equity Volatility 26.4 40.1 19.0
Implied Inflation 1.8% 1.4% 1.5%
Gold Spot $/OZ $1968 $1586 $1520
Oil ($/BBL) $45 $51 $60
U.S. Dollar Index 118.5 116.8 116.3

Glossary of Indices

Our Take

Looking forward, a lot depends on the progress toward new COVID-19 treatments and vaccines. However, based on declining equity market volatility, it appears that investors are struggling with a case of virus fatigue: The markets have learned to quit worrying about virus headlines and focus on the Federal Reserve. The Fed’s extraordinary support of the financial markets has been critical for restoring investor confidence, and with that support ongoing, a risk-taking sentiment has returned, even if it is most concentrated in the areas directly benefiting from that support or on companies uniquely positioned for today’s environment. If not the virus, trade and the upcoming presidential election appear the most likely candidates to upset investor complacency.

There are fundamental reasons for investor optimism. In our last few reports, we envisioned a recovery in the US economy as we moved into 2nd half of 2020, and that is still our outlook. The data through this summer has highlighted the resilience of the US consumer and US businesses: in July, mortgage applications rose by more than a third from last year and there was an 11% spike in durable goods orders, driven by demand for cars and trucks. Meanwhile, additional US government stimulus is likely, even if it remains in the political wrangling stage for now. With that kind of backdrop, maybe it should not be a surprise that we’ve seen a dramatic recovery in equity markets.

Looking Abroad

Apple, Amazon, Netflix and Google are thriving in the new COVID normal, and may continue to dominate their respective spheres as we learn to live alongside the virus. But their valuations have reached peak levels historically. In our view, international equities, both developed and in emerging markets, offer a better risk/return outlook, given superior virus containment, supportive monetary policies, and lower valuations. Accordingly, we have increased our international equity positions in the past month.