Summer 2020 Market & Economic Commentary
The recent recovery in the capital markets has been nothing short of miraculous. Yes, the economy has bounced from the worst levels of April, but not that much. Certainly, unemployment has rebounded from over 14% to perhaps as much as only 10%-11%. But that remains worse than the worst levels of the 2008-2009 financial crisis. The travel industry is still decimated. The restaurant industry–what’s left of it–is limping along at diminished capacity and even more diminished demand. Commercial real estate is in triage mode, fighting local rent relief laws on one side, tenant failures and workouts on another, and all while mortgages need to be paid. Meanwhile, the Fed has stepped in with atomic firepower and Congress has thrown a kitchen sink full of $3 trillion at the economy, while preparing to toss in a couple of gold-plated bathroom sinks and a diamond wet bar to boot.
And speaking of wet bars, investors have certainly been bellying up to theirs as they’ve piled back into a raging party in growth stocks, especially tech, select healthcare, and, interestingly, outdoor consumer companies. The irrational inebriation carried on as stocks recovered from their March lows, with the S&P Large Cap Growth Index exceeding 30 times earnings, over a 50% premium to longer-term norms. Mid Cap Growth stocks are trading at double their historical averages, nearly 40 times earnings. And the small cap space? Forget about it, they don’t even have earnings to strike a P/E off of (though the broader Russell Small Cap Index does – it’s at 55 times earnings… nearly triple its long-term norms).
But who cares, we cured the virus, right? Umm… nope. In fact, it’s spread reaccelerated through June and July, doubling the number of daily new cases. Many domestic economies that had begun to reopen re-tightened restrictions on restaurant patronage, gym facilities, bars, and many other social meeting places. Where’s all of this optimism coming from? Could it be FOMO? With gains of double and triple in names like Tesla and Zoom, who wants to miss this party? As Prince said, “We’re gonna party like it’s 1999.” We all know how that song ended.
How the Markets Fared
With the economy’s fate uncertain and a resurgence of new COVID-19 cases weighing on investors’ minds, interest rates for high quality paper stayed relatively unchanged during Q2. The yield on the 10-Year Treasury finished fractionally higher at 0.68%. However, credit spreads tightened dramatically after they blew out in March, thanks to the Fed pledging to backstop the fixed income markets by purchasing an “unlimited” amount of bonds, from high quality corporates to mortgages and all the way down to junk bonds. So, although the flight to quality did not reverse, the appetite for risk assets returned with a fever, supported by the belief that any meaningful downside would be covered by the Federal Reserve. With cash paying near zero again, as it did for much of the decade following the financial crisis, why not jump back in? This buying erased most of Q1’s losses in risk assets, led by high yield paper that returned over 10% for the quarter.
But the real buying occurred in equities of every size and shape: big and small, near and far. Just as in Q1’s selloff, growth stocks led the way over more cyclical value industries. Value stocks fortunately recovered nearly half of their losses from Q1, led by a bounce from cratering oil stocks. Large cap value was up 14% and small cap value was up almost 19%. However, both paled in comparison to the growth end of the spectrum. Large cap growth stocks, dominated by soaring technology companies, were up almost 28% during the quarter, and small cap growth indices were up over 30%! With Q2’s results, the Russell 1000 Growth Index finished the quarter up almost 10% for the year. Not bad in an economy that was without over a tenth of its workers.
Even international stocks jumped in on the festivities. Most international market indexes advanced from returns in the mid-teens to nearly 20%. This was true of developed markets as well as those of emerging market economies. Perhaps the only disappointment came from the meager 5% bounce in commodity prices during the quarter, leaving them down nearly 20% YTD (which is unsurprising given the vacuum of demand for raw materials). However, since the end of Q2, Gold has rallied nearly 15% and oil continues to climb back into normal ranges, which would suggest that commodities will post much better results for Q3 as global manufacturing and local travel comes back online.
As we posted repeatedly in our COVID updates during Q2, we feel that most economic data is presently too volatile or too stale to build confidence-inspiring (or eroding) models. Though unemployment appears to have clawed back to near 11%, the effects of PPP are rolling off for many companies, eliminating the incentive to maintain payrolls. Average Hourly Earnings climbing 5% year-over-year would normally be applauded, but when most of the jobs lost in March and April were lower-paying service-sector, even this datapoint is distorted to the point of invalidity. Purchasing manager surveys (like the ISM’s Report on Business) have rebounded dramatically but remain of little value, as the recovery is from catastrophic lows. (As an example, if you fall into the Grand Canyon, and you climb your first mile out, the view might seem pretty good). Retail sales have followed a similar pattern. After little buying for months, can we trust that the surge in spending will persist, or is it just a catching-up of demand that was pushed forward?
The Real Real
Perhaps the only sector data that we can rely on is the housing market. Remarkably, home purchases stayed somewhat steady after the initial month or two of the COVID crisis. However, pricing remained firm throughout. Now that sales are exploding back to life, those firm prices are holding up, suggesting that buyer appetite will support these near all-time-high levels. With 30-year mortgages costing borrowers less than 3% annually and only a 4-month of supply of home inventories available (6 is equilibrium), prices are likely to stay firm for some time. With consumers deriving a meaningful contribution of their sentiment from the values of their homes, this may be an important anchor if the economic storm turns nasty again.
As we’ve maintained from the onset of this crisis, until the proliferation of the virus is curtailed, economic measurements and predictions are futile. If the path of the spread of the virus finally mimics the pattern seen in much of Europe, then we may see case numbers decline enough to further restore normalcy to our economy. However, with cooler weather approaching in a couple short months and no vaccine imminent for the masses, the chance of a resurgence could send us hurtling in the other direction, necessitating tighter restrictions on in-person commerce.
As such, we feel and have always felt that mapping the data surrounding Covid is of far more value than measuring sentiment, which could shift on a dime. For the moment, the recent trend is good. New cases in the United States are finally showing sustained signs of receding (down 15% in last two weeks), even in trouble areas like Florida and California (and potentially even Texas). The mortality numbers seem to have plateaued, and if they follow the usual pattern of trailing new case counts by about two weeks, should begin to decline shortly.
If this decelerating pattern for the virus holds true, this may fuel another leg up in an already frothy stock market, as a new round of economic openings and optimism for a suppression of COVID builds. Whether this new wave of hope pushes stocks to new highs which are eventually supported by a true resurgence in the economy, or if this is a final speculative peak which proves to be fools folly before the reality of a deeply damaged economy and debt-laden government erodes investor optimism, remains to be seen. At North Pier we never count out the resilience of the U.S. economy or its people. However, with all the economic and public-health uncertainty that lies ahead, we view continued bullishness as speculative (though some speculative bets in life do pay off). As such, we urge prudent caution.
We recommend that investors take this moment in time as the gift that it is. Much if not all recent portfolio damage has been erased. This is a moment to reflect on time-horizons and objectives, as well as to assess what downside scenarios one can truly live with. Then set your risk-stance accordingly. Even if you are a raging bull, make sure you can live to run another day if things don’t work out as rosy as you’d hoped.
Wishing you and your loved ones all the best in health and spirit,
Jim Scheinberg, Managing Partner