The second quarter found the US economy grappling with unprecedented uncertainty, as investors attempted to weigh the carnage of a complete shutdown against an avalanche of economic stimulus programs from the US Government and Federal Reserve (Fed), which has boosted its balance sheet to record high levels. The economy and stock markets quickly decoupled, and the ferocity and breadth of the stimulus has encouraged increased risk taking which has translated into historically high-valued equities.
The shutdown has produced one historically bad statistic after another. Second quarter GDP will not be released for a couple weeks, but everybody knows it will be the single worst economic contraction in one quarter in US history. Real (inflation adjusted) Gross Domestic Product (GDP) fell by an annualized -5.0% in the first quarter versus 4Q19, according to the final estimate from the US Bureau of Economic Analysis. The Atlanta Fed GDPNow estimate is currently expecting a -40% drop for the second quarter, which is an improvement from the over -50% estimate as recently as early June.
Week after week, over a million people are still applying for first-time unemployment insurance, albeit at a decreasing rate from the record of near 7 million people at the beginning of the shutdown in March. Continuing claims have been falling as those in the decimated food service and tourism industries have started to return to work. Unemployment remains at historically high levels, especially relative to the 3.5% unemployment rate at the beginning of the year, an all-time low.
Hope for a so-called V-shaped economic recovery has waned since the early-June payroll report, as the sustained levels of new claims foreshadow a disturbing trend for a broader set of industries in the post-COVID19 economic environment. Many survey-based indicators have started to improve, even if contracting at a decreasing rate, with the manufacturing Purchasing Managers’ Index (PMI) rebounding and showing improvement in production, new orders, and employment. Service sector business activity and new orders had large rebounds in May, though the rebound in employment in this sector is subdued and indicates cause for concern in the broad classification comprising roughly 70% of American non-farm workers. Measures for inflation have dropped since the shutdown began, as plummeting demand led to the April seasonally adjusted annualized reading of -0.8% for the Consumer Price Index (CPI).
With the Fed effectively negating the potential for a liquidity crisis, the opening of fiscal spigots led to a jump in savings. This in turn reportedly put forth a flood of retail investors with excess cash and nowhere to spend it, including casinos, so they piled into equity markets. Growth and momentum names were in particularly high demand, with an improved tailwind of an expected acceleration in the remote work paradigm due to the COVID19 outbreak.
The beaten down financial sector rallied from mid-May until early June as part of a “value” push, finding upside on relative valuation and yield differential, as growth/momentum paused some after having run far. After the most recent stress tests, banks have been instructed by the Fed to not increase their dividends and suspend share buybacks (politically tricky) through the third quarter, in order to preserve capital. The S&P 500 is trading at just under 20x the 2021 Operating Earnings estimate of $161.28, which has been revised lower by over -15% from the January pre-pandemic estimate. This forecast represents an optimistic 50% increase on the 2020 shutdown-impaired estimate. If the 2021 estimate holds true, it would equate to a 2.7% growth rate from 2019’s Operating Earnings of $157.12.
Since May, European and Japanese markets have performed better on a relative basis compared to US markets. This is attributed to the expansion of stimulus measures and a relatively successful suppression of COVID19 infections, all leading to forecasts of an economic rebound. The Bank of Japan has continued to add to its portfolio of Japanese assets, which includes a large chunk of the country’s equity ETFs, while unleashing a mammoth $1 trillion of fiscal spending to support its economy, the world’s third largest. This brings Japan’s total spending during COVID19 close to the US’s response, but amounts to a whopping 40% of their annual GDP.
The broad, developed market-focused iShares MSCI EAFE ETF (EFA) is still -11.1% lower year-to-date, but earnings are expected to increase by roughly 14% in 2021 compared with 2019, according to consensus estimates on Bloomberg. Compared to large cap US stocks, they have a more reasonable PE ratio of 15 and offer a relatively higher dividend yield, providing more margin for error for earnings adjustments during the second half of this year.
Despite official reports of continued cooperation since the signing of the Phase 1 deal, relations between the US and China have deteriorated under the surface. US political rhetoric regarding the handling of COVID19, Hong Kong, the South China Sea, and now a territorial dispute with neighboring India has been just that, rhetoric, but threatens to derail the already tenuous relationship. Both sides are seemingly planning for a future with at-best less cooperation, and at-worst, conflict, as multi-national corporations continue to adjust supply chains accordingly.
Emerging markets have lagged US markets year-to-date but have outperformed in May and June thanks to COVID19 cases peaking, and economies re-opening, earlier than in the US. The iShares MSCI Emerging Market ETF (EEM) is down -10.4% year-to-date, even after a near 10% increase from the beginning of May. A PE ratio of 12.3 on 2021 earnings, that are expected to be nearly 17% higher than in 2019, reflects the increase in variability of those Bloomberg consensus expectations. Emerging markets at those earnings values look cheap, but those values can change quickly and unexpectedly.
In Fixed Income, the top performing asset class this year has been long-dated US Treasury securities. The US 30-Year Treasury Note yield dropped from 2.3% at the beginning of the year to a low near 1.0% in early March, and finished June just above 1.4%. The iShares 20+ Year US Treasury ETF (TLT) gained over 22% in the first quarter but has traded sideways in the second quarter as investors rushed towards riskier fixed income options, spurred by the Fed’s April 9th announcement it would buy corporate bonds and their ETFs, including high yield bonds.
Though technically illegal, the Fed is using a loophole that allows the US Treasury to first buy the bonds or broad ETFs, and then buy them from the Treasury. The result has led to the broad investment grade iShares iBoxx US Investment Grade Corp Bond ETF (LQD) to return nearly 6.5% total return year-to-date after a -21% peak-to-trough drawdown during the panic. High yield bonds have recently diverged from their investment grade counterparts, with the iShares iBoxx US High Yield Corp Bond ETF (HYG) being roughly flat since the Fed’s April 9th announcement and still -5.1% on the year.
It was an incredibly wild and historic first half for oil prices. After starting the year over $60 per barrel, the front month WTI Crude Oil futures contract hit nearly negative $40 per barrel on the last day of contract trading in April. Full domestic storage and complete disappearance of demand due to COVID19 led to speculators having to pay people to offload contracts for the right to buy oil. The US energy sector has been rocked by volatility and uncertainty, with many companies responsible for the US energy boom in recent years unlikely to make it through without substantial US assistance.
Markets are data-driven in the long-term yet can experience amazing volatility in the short-term, as we just witnessed. We will have more clarity in the coming months, but there are still numerous uncertainties surrounding how the global economy moves towards a full economic recovery. Markets are constantly searching for equilibrium. Many argue that the first quarter sell-off was an overreaction, and others say that markets have become overly reliant on government stimulus and central bank rescues. This dependence only exacerbates the potential volatility if future stimulus measures prove insufficient or ineffective. How much stimulus is enough, and can the long-term health of the US balance sheet handle it?
Our mission remains protecting our clients against such market turbulence, with a disciplined, emotionless investment approach guided by our principles of Passion, Integrity, Vision, and Care.
Thank you for the opportunity to be of service and we hope that everyone stays healthy and positive in these trying times. Keep in mind, this is not a destination, it’s a transition.
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