Market & Economic Outlook
Market Commentary - Q3 2020
Third Quarter 2020
The first half of 2020 has been one for the record books. A pandemic-induced panic selloff in equity and credit markets was halted and reversed by a sharp rebound on the heels of an unprecedented globally coordinated fiscal and monetary policy response. During the second quarter, reopening announcements and progress on vaccines and treatments further fueled animal spirits, overcoming a slew of ugly economic data points and forecasts.
Underpinning the five-week long purge of stocks and other risk assets that began in mid-February was mounting uncertainty surrounding the full scope of the economic impact of social distancing measures, both voluntary and mandatory, intended to combat the spread of COVID-19. As businesses shut down and mass layoffs piled up, sources of optimism became increasingly scarce and capital market volatility exploded.
Potential economic casualties of the novel coronavirus were being compared to the Great Depression for good reason. Filings for U.S. unemployment claims tallied up to 6.9 million in the last week of March, exceeding the worst week of the Global Financial Crisis by a factor of ten. The U.S. experience was by no means unique. Economic shutdowns were taking a dramatic toll worldwide. In the absence of a proportional and timely policy response, it was anyone’s guess where the downward spiral would end.
Thankfully, there was no ambiguity about the urgent need for supportive measures and policymakers stepped up to the plate quickly armed with lessons and tools from past financial crises. The global equity market’s historic rally began on March 24 following an announcement by the Federal Reserve (Fed) that the U.S. central bank would effectively do “whatever it takes” to stabilize the economy and financial markets. In concert with a barrage of lending facilities, limitless Quantitative Easing, or “QE Infinity” as some have called it, was just the antidote investors were looking for.
Market Returns Summary
Source: Morningstar Direct
Periods greater than one year are annualized.
The S&P 500 Index surged over 9% on March 24 and continued to regain lost ground through the end of the second quarter: the index’s best quarterly return in more than 20 years. Non-U.S. stocks also benefited from the bullish sentiment ignited by a flood of liquidity, albeit to a lesser degree than domestic peers.
Bonds with credit risk, including both investment grade and non-investment grade issues, followed a similar path as the stock market. After widening out to levels not seen since the Global Financial Crisis, spreads, or yield premium relative to government bonds, narrowed considerably.
Government bonds were the lone asset class not whipsawed by the oscillation in sentiment. Yields across all maturities fell dramatically during the first quarter and remained low during the risk rally with the Fed buying up supply as investors rotated out of safe haven assets.
While ultra-dovish monetary policy acted as the initial catalyst for the equity and credit market pivot, the March 27 passage of an equally awe-inspiring $2 trillion fiscal aid package that amounted to over 10% of GDP would further serve to reassure investors that a worst-case economic outcome could be avoided. The Coronavirus Aid, Relief, and Economic Security Act, or “CARES” Act, featured supplemental unemployment benefits and direct payments to most American households in addition to support for small businesses.
As state-mandated business restrictions were lifted and activity resumed, in some cases more rapidly than expected, this reopening added wind to the sails of the “glass half full” outlook. Market participants paid close attention to China as the first nation to confront COVID-19 with broad-based economic lockdowns and the first to reopen once it had the spread under control. China’s rapid economic recovery was viewed as an encouraging leading indicator of how quickly other countries might snap back after dealing with similar circumstances.
In the U.S. and elsewhere, positive surprises in economic data were interpreted as “green shoots” that would suggest the global economy is already on the fast track to recovery. Headlining this promising data was the U.S. non-farm payroll reports for May and June, which reported a claw back of 7.5 million of the more than 22 million jobs lost in the prior two months. Confirming signals were observed in global manufacturing survey data that indicated the pace of the world’s economic downturn was slowing. In May, the JP Morgan Global Manufacturing Purchasing Managers Index rose from a record low of 36.1 in April to 39.8. The June reading showed further improvement to 47.8 (values below 50 indicates contraction).
Ahead of the Curve
Looking forward, close attention will be paid to how much of the economic damage will be long-lasting versus merely short-term in nature. The initial stages of the rebound could be more pronounced because of the sharpness of the decline— a phenomenon called the low-base effect. The markets appear to be extrapolating the green shoots in a linear manner. However, it is important to keep in mind that economic data points can be unusually difficult to explicate under such extreme conditions. In a period of forced economic shutdowns, even classifying workers’ employment status has become a challenge with survey respondents deemed employed but not working according to the Bureau of Labor Statistics categorization of methodology, which counts workers as employed but absent from work due to vacations, illness or “other reasons.”
Fed Chairman Jerome Powell, in testimony before Congress, stressed the point that the U.S. economy is not out of the woods yet by saying “the levels of output and employment remain far below their pre-pandemic levels, and significant uncertainty remains about the timing and strength of the recovery.” Of course, overhanging the positive economic momentum remains the ongoing threat of the continued spread of the virus in many parts of the world, including a resurgence of infections in the U.S.—a point the Fed Chair emphasized to Congress when he said, “Much of that economic uncertainty comes from uncertainty about the path of the disease and the effects of measures to contain it. Until the public is confident that the disease is contained, a full recovery is unlikely.”
Investors have taken comfort in the expectation that human ingenuity will solve this health crisis relatively quickly. Hundreds of potential treatments remain under investigation with two, Remdisivir and Dexamethazone, receiving authorization for emergency use by the FDA so far. Therapies that reduce hospitalizations and mortality are expected to act as a bridge to vaccines that will officially put the pandemic behind us.
An equally vigilant discovery effort is being undertaken on the vaccine front. According to the World Health Organization (WHO), more than 140 vaccine candidates are currently under investigation with 18 in early stage clinical trials in hopes of identifying at least one that is proven both safe and effective as soon as year-end. And just as important as discovering a viable option is having sufficient supply ready to distribute as soon as possible. In this vein, many biopharma firms in the vaccine race have already begun manufacturing doses in the event their candidate gets approved. Such heavy investment in preapproval production is virtually unheard of and underscores the urgency and dedication these companies have to solving this crisis.
With a policy lifeline thrown out to carry businesses and consumers through these unprecedented times on the way to a vaccine, market sentiment has justifiably shifted in a positive direction. However, unanticipated setbacks could prove the consensus outlook for a full recovery next year to be Pollyannaish. If the early pace of the rebound cannot be sustained, it could call into question the justification for the strong equity market snapback. Current elevated valuations in global equity markets raise the risk of falling victim to the curse of high expectations. For this reason, we advise clients to avoid becoming complacent and taking on additional equity and credit risk in pursuit of higher returns.
Hidden Dangers of Passive Investing
Increasingly, investors have turned to passive market index-based funds as a lower-cost alternative to more expensive active strategies that seek to outperform the representative index. However, in the noble pursuit of lowering investment expenses one should also consider the composition of the market index in which they are looking to invest.
Within equities for example, the most common indices weight individual holdings by market capitalization. In other words, the largest companies make up the largest exposure. It’s a very straightforward and logical approach for measuring market performance, but may lead to a mirage of diversification and leave an investor’s portfolio vulnerable to shifts in market preferences.
Levels of concentration will vary over time and by market, but most capitalization-weighted indices are considered top heavy. For example, despite holding 500 individual stocks, the top 100 (20%) largest companies in the S&P 500 made up nearly 70% of the index as of June 30. Perhaps even more eye catching is the concentration among the top 10 holdings, which now constitutes 27% of the index. Conversely, as of August 31, 2015 the top 10 holdings accounted for only 17% of the index.
The nature of market capitalization weighting means the index naturally increases its weighting in companies with the best performance and decreases exposure to underperformers. This dynamic can be particularly beneficial when the price momentum of those largest companies outpaces the rest of the market, as it has recently, but such trends cannot be expected to last forever. The years following The Nifty Fifty and Dot Com Bubble are two periods in market history that have exemplified the risks of market capitalization portfolio construction when the tide goes out.
While active management is by no means a guarantee to deliver outperformance relative to a representative market index, it can provide a valuable source of diversification to traditional passive investment strategies. Passive alternatives to market capitalization weighted indices include equally-weighted or fundamentally-weighted index options.
Bad Breadth Warrants Caution
While we are encouraged by the equity market’s positive reaction to the massive fiscal and monetary stimulus measures aimed at stabilizing the economy, we remain cautious regarding the foundation on which the rally has been built. More specifically, the narrow leadership of the largest names in the index might suggest that the overall health of the equity market is not as strong as the broad index level and passive index-tracking funds currently suggest. Investors who have voted “passive” over “active” may be surprised to learn of the concentrated nature of their equity investment.
A lack of breadth (a large number of companies driving the returns of the overall index) is one reason we remain reluctant to declare “all clear” in the equity markets just yet. In the case of the recent rally, the five largest companies by market capitalization—Alphabet (Google), Microsoft, Apple, Amazon and Facebook—have meaningfully outperformed the rest of the market. The impact of these stocks is reflected in 7.76% of outperformance between the market-capitalization weighted S&P 500 Index and its equally-weighted version year-to-date through June 30.
A League of Their Own
It is not surprising that these Big Five tech giants, or FAAMG, have been standout performers this year. Each is highly innovative with a wide competitive moat around its business model and has a strong balance sheet with ample cash reserves, and all benefit to varying degrees from lifestyle changes under the threat of COVID-19. This is not to say that these firms are completely immune from economic fallout, but rather that they are no doubt in an enviable position relative to peers.
Increasing concentration among the five largest companies in the S&P 500 Index had been a growing concern well before the recent market turmoil. The long-term average weight of the five largest names in the S&P 500 Index is 14%. However, the Big Five now represent over 20% of the total value of the index—the highest level of concentration since 1980. And, as shown in the chart below, as of June 30, the technology sector in the S&P 500 Index has risen to its highest point since the Dot-Com Bubble.
While narrow breadth is not necessarily a harbinger of market selloffs, it does introduce a degree of fragility that investors, particularly those whose asset allocation is concentrated in passively-managed instruments, should be mindful of. In other words, a more broad-based stock market rally would give us more confidence in the durability of the equity market’s recovery.
Investors should respect the fact that the positions of Alphabet (Google), Microsoft, Apple, Amazon and Facebook are more of an exception than the rule when it comes to exposure to the ongoing global recession. What remains uncertain is how the fundamentals of the Big Five’s command of 20% of the equity market will fare as the evolving impact of this event-driven economic downturn is fully understood.
Investors who select a passively managed, market capitalization-weighted index fund might be making an assumption that the performance of the largest technology names indicates the worst is behind us. Active management, on the other hand, balances a forward-looking assessment of both broad economic conditions and individual stock prospects to build a portfolio that is positioned to succeed under a variety of economic and market assumptions.
Why Hong Kong Matters
On June 30, China’s Communist government announced new security laws that would fundamentally alter the political and economic freedoms the former British colony has enjoyed since the 1997 transition to a “one country, two system” arrangement with China.
Reactions to China’s plans to punish protests and dissent in Hong Kong have been building since reports of the new measures surfaced in the spring. Britain’s Prime Minister has promised to allow as many as three million Hong Kong residents to move to Britain, while the U.S. has imposed sanctions on businesses and individuals that help China restrict Hong Kong’s autonomy. Designed to slap China’s wrist, these political maneuvers will hopefully avoid damaging ongoing trade negotiations in the process.
President Trump warned that China’s new repressive measures could lead to revoking Hong Kong’s “special treatment” status which views Hong Kong separately from China in terms of customs, tariffs and travel regulations. He also announced plans to cancel the visas of thousands of Chinese graduate students who might have links to China’s military due to concerns of spying and intellectual property theft on U.S. university and college campuses. These moves follow a series of tit-for-tat expulsions of journalists on both sides.
Finding an effective way to indicate displeasure with China’s actions, while not damaging the Hong Kong/China financial links that enable global commerce, is proving difficult. Subjecting Hong Kong to the same tariffs and regulations imposed on China could be a pyrrhic victory—the U.S. could suffer as much, or more, than China if Hong Kong’s ability to function as a go-between is diminished. Hong Kong’s status as an open financial center is reflected in its third-place ranking, behind the U.S. and Singapore, in The World Economic Forum’s annual Global Competitiveness Index compared to China’s ranking at 24th.
China has benefitted from Hong Kong’s role as financial intermediary for decades, so why is the country now cracking down? One reason could be timing: with much of the world focused on battling the coronavirus, China might assume attention is diverted. Another reason is purely economic—Hong Kong does not matter as much to China these days.
As shown below, Hong Kong’s economic output has declined from a high of 27% of China’s total Gross Domestic Product (GDP) in the years before the handover. During this period, Hong Kong’s financial ties to the world enabled China’s rapid economic development. More recently, Hong Kong’s share of China’s GDP had fallen to less than 3% at the end of 2017. Investors remain attracted to Hong Kong’s rule of law, business transparency and low taxes, but have become increasingly comfortable doing business on the mainland.
Source: World Bank, World Development Indicators (GDP measured in current U.S. Dollars)
A World of Tensions
While developments in Hong Kong seem to have pulled the lid off a simmering pot of U.S./China disagreements, Hong Kong is not the only flashpoint in China’s relations with the world. Among other hot spots are the addition of military capabilities to man-made islands in the South China Sea; increasingly bellicose statements and actions towards Taiwan; and a “Road and Belt Initiative” that has left many countries in positions of dire debt and subject to debt for equity swaps that transfer ownership of ports and other infrastructure to China. Recently, a border skirmish with India left several dead and sparked concerns that the two nuclear powers could be edging towards armed conflict.
As the war of words heats up between the U.S. administration and China’s ruling party, trade negotiations continue, but at a halting pace. “Nothing really new out of latest US-China talks” read the press coverage of a recent meeting between the two countries. As of now, corporate investment plans remain clouded by the lack of a permanent resolution to the trade war. Tariffs on some $460 billion of Chinese imports and exports remain in place and, other than a few upbeat reports of increased U.S. agricultural exports, the situation is unchanged.
Efforts to diminish China’s outsized role from the global supply chain and boost onshore production also show mixed results at best. In Japan, a $2 billion program to help firms shift production from China to Japan has only been tapped by one company and many other firms feel “shifting output back home is simply impractical and uneconomical” because many of the products they produce are for Chinese consumers and require onshore production to meet “just-in-time” targets. Firms in the U.S. increasingly say they believe “decoupling” from China is possible, but in one survey only 16% said they plan to shift production out of China.
Investors wondering what to make of what appears to be a new “cold war” between China and the U.S. and, for that matter, between China and many other countries, look back on several years of summit meetings and statements from both sides that swing from accommodative and positive to exclusionary and hostile. It seems that for all the talk, not much has been accomplished.
What could be different in the coming months and years is a change in how China conducts itself on the international stage. Described as “Wolf Warriors,” China’s new breed of younger diplomats does not hesitate to use Twitter and other social media to prod officials in the U.S. and other countries into harsh Twitter wars. Their tone tends to be incendiary—the word “lies” is a frequent go-to when describing statements from the West—and China’s ruling party appears uncertain whether to embrace these “warriors” or tell them to cool it. But many in China have already voted with their Twitter accounts—one famous Wolf Warrior has built a 500,000-follower base in the last eight months.
Economic and Market Perspectives is a publication of HighMark Capital Management, Inc. (HighMark). This publication is for general information only and is not intended to provide specific advice to any individual or institution. Some information provided herein was obtained from third-party sources deemed to be reliable. HighMark and its affiliates make no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication and bear no liability for any loss arising from its use. All forward-looking information and forecasts contained in this publication, unless otherwise noted, are the opinion of HighMark, and future market movements may differ significantly from our expectations.
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HighMark, an SEC-registered investment adviser, is a wholly owned subsidiary of MUFG Union Bank, N.A. (MUFG Union Bank). HighMark manages institutional separate account portfolios for a wide variety of for-profit and nonprofit organizations, public agencies, and public and private retirement plans. MUFG Union Bank, a subsidiary of MUFG Americas Holdings Corporation, provides certain services to HighMark and is compensated for these services. Past performance does not guarantee future results. Individual account management and construction will vary depending on each client’s investment needs and objectives. The benchmarks referenced in this piece are used for comparative purposes only and are provided to represent the market conditions during the period(s) shown. Benchmark returns do not reflect the deduction of advisory fees, custody fees, transaction costs, or other investment expenses, but the returns assume the reinvestment of dividends and other earnings. An investor cannot invest directly in unmanaged indices. Investments employing HighMark strategies: • Are NOT deposits or other obligations of, or guaranteed by, the Bank or any Bank affiliate • Are NOT insured by the FDIC or any other federal government agency • Are subject to investment risks, including the possible loss of principal invested.