With the presidential election just under a month away, prospects for another round of fiscal stimulus seem to be dwindling. The recent death of Justice Ginsburg, the diagnosis of President Trump and the First lady contracting COVID-19, and the rapidly approaching election have shifted the Senate’s gaze.
Conventional wisdom is worried that a lack of additional stimulus, and the potential for a drawn out and contested election, could impede the economic recovery. And some of those fears seem to be reflected in the stock market recently, with the S&P 500 having fallen 7.9% from its high of 3588 on September 2, as of September 25.
The key at the current juncture is to recognize that volatility is normal but markets are resilient; investors should ensure that their portfolios are structured in such a way that they will be able to remain invested during this period of elevated volatility, and subsequently participate in the upside that capital markets have to offer over the longer-term.
While we need to wait for August data on incomes, through July, the Commerce Department’s measure of personal income was 4.9% higher than in February, as government transfer payments – which the U.S. borrowed from future taxes – more than fully offset declines in wages and salaries.
Think about that for a moment.
Even with the end of special unemployment bonus payments, there is likely more money in people’s pockets today than there would have been had the pandemic never happened!
Right now, any weakness in the economy is coming from the fact that many sectors (especially service-type activities) remain shut down or lightly used.
Spending on goods in July was up 6.1% from February, while spending on the more pandemic-restricted service sector was down 9.3% over the same period. Overall spending (goods plus services) remains down 4.6%. We doubt a full recovery can happen without a rebound in services. Additional checks can’t change Americans’ wants and desires. Instead, continued recovery is going to require states to push ahead with reopening in a responsible manner.
Take New York and California. Daily new cases are down roughly 92% and 66%, respectively, from the peak in these states. Deaths are down, 99% and 40%, respectively as well. Yet both still have some of the nation’s strictest pandemic-related restrictions in place. This, in turn, has held back their economic recoveries.
According to August data from the Bureau of Labor Statistics, New York and California had unemployment rates of 12.5% and 11.4%, respectively, while the unemployment rate for the U.S. excluding these two states was only 7.7%. If New York and California mirrored the nation’s unemployment rate, the result would be an additional 1.2 million Americans employed. New York and California combined have 18% of the U.S. population, but 32% of all people receiving continuing unemployment benefits.
Just this past month, Florida (7.4% unemployment) and Indiana (6.4%) have fully opened their economies. These states, among many others, had lower unemployment than the national average, mainly because their shutdowns were less draconianrestrictive.
The competition between states that open and those that don’t – at the political, business, sports, school, and even family level – will lead to even more opening of the economy in the months ahead.
The economic recovery is gaining pace as macro data improves and business and consumer confidence strengthens. An unprecedented level of monetary and fiscal stimulus will continue to fuel a powerful pickup in growth.
The combined effect of improving macro-economic data, a better than expected earnings season, and a decline in virus cases in Europe and the U.S. buoyed equity and credit markets for much of the third quarter. But as we approach the fourth quarter, it appears the event risks we face in the coming months are back on investors’ minds, just as virus stats in Europe appear to be worsening.
In our view, the economic recovery is gaining pace and we expect a robust expansion into 2021, but the tail risks—in both directions—are palpable. Our constructive central case leads us to maintain a risk-on tilt in our portfolios. At the same time, the fatter and flatter distribution of tail risks, together with extremely low bond yields, calls for thoughtful portfolio construction.
Our optimism on the underlying economic trajectory may seem at odds with the recent news flow, but away from the hyperbolic headline’s macro data continue to improve.
New orders data imply further strength in purchasing manager surveys, Asian export data point to a robust goods market, high savings rates suggest reasonable resilience in the household sector, and confidence is improving among businesses and consumers alike.
The surge in the housing market reflects pandemic-induced demographic trends. As virus cases continue to rise and millions are finding it difficult to leave their homes, many people are increasingly looking for new housing in suburbs and rural areas.
Further, the level of monetary and fiscal stimulus is unprecedented. We have remarked previously that the alignment of monetary and fiscal stimulus will distinguish this cycle from the last one. While we acknowledge that there is uncertainty about the extensions of fiscal packages in some regions, the combined effect of zero rates and the 13.1% of GDP committed by G20 nations to fiscal stimulus this year continues to fuel a powerful economic recovery.
Nevertheless, we see looming event risks in the fourth quarter. Uncertainty about President Trump’s health, the U.S. election, and the shape of any Brexit deal between the UK and the European Union is acute. Confusion is running high over how voting will actually work, whether we will have a clear winner and whether either side will concede defeat. This uncertainty could persist for days or weeks after the election, and financial markets notoriously loathe political uncertainty.
While we expect fiscal packages to be extended and monetary policy to remain extremely accommodative, hawkish voices are becoming louder and fears about debt sustainability—muttered only in hushed tones during the height of the coronavirus crisis—are increasingly vocalized.
The path of the virus is central to the uncertainty many feel, and the recent uptick in caseloads in Europe is of concern. While we don’t anticipate a repeat of the large-scale lockdown that occurred in the second quarter, some disruption is inevitable.
The apparently growing level of risks in the fourth quarter might suggest it is time to reduce portfolio risk levels. However, while some prudence may be justified, there are tail risks in both directions. Certainly, we should not ignore the upside opportunities around a vaccine, further monetary accommodation, and renewed fiscal support. We also note that corporate earnings are starting to rebound and there are powerful base effects as we enter 2021; moreover, signs of a pickup in capital expenditure and a rebuilding of inventories present further upside opportunities.
We look to spread our risk between stocks and credit. Within equities we favor a broad regional diversification and are overweight European and emerging market (EM) equities, as well as U.S. equities, with a tilt toward small caps.
Prospects for (eventually) rising inflation are causing many to wonder if any areas of the market could benefit from such a trend. We would point to the traditional historical winners: small caps, financials, energy, industrials, gold, and convertible bonds.
The dilemma for portfolio construction is that low yields also reduce the degree of protection bonds offer. Indeed, a large notional bond exposure would be necessary for duration to function as an effective hedge, which would in turn hit portfolio returns if the low growth expectations priced into yields start to rebound. Central bank backstops in credit markets allow us to use high quality corporate credit as a proxy for duration in some cases; but, above all, diversifying exposure across assets remains a focus.
Our portfolios reflect our optimism that the recovery which began in the second quarter will extend over the next 12 months. Nevertheless, we anticipate some volatility over the autumn and expect to remain well diversified and nimble, in equal measure, as we navigate the final months of 2020.
Despite these potential risks, massive monetary support will continue to support stock prices and we could still see some fiscal stimulus. These tailwinds should create buying opportunities during times of weakness until we see a vaccine, which should cause an economic resurgence.
We know clients continue to have challenges navigating the more frequent, ongoing spikes in volatility that have returned to the market. We believe this is part of our “new new normal,” and that clients should remain patient and focused on achieving their long-term investment goals.
Staying invested for the long-term without panicking and being tempted to time the market, as well as keeping perspective on the long-lasting attractiveness of equities are vital to successfully maneuvering through choppy markets.
We remain optimistic. Despite the lingering uncertainties out there, we have history on our side. And we remain bullish on equities. Companies, like the rest of us, are acclimating. They are figuring out how to limit losses, budget accordingly, grow, and become more responsible during this ambiguous period.
In the end, all of us will emerge stronger when the clouds part.