Market & Economic Outlook
Market Commentary - Q4 2020
Fourth Quarter 2020
The third quarter of 2020 included a run-up to election day, strong equity returns around the globe, and a dramatic change in Federal Reserve (Fed) policy. Meanwhile, record savings levels fueled hopes for a consumer-led economic recovery. In this issue of Perspectives, we discuss global markets and our outlook for the fourth quarter of 2020.
Markets Appear Unfazed by Election Day Jitters
As the nation stumbles towards an election day marked by a lengthy campaign season many observers liken to the philosopher Thomas Hobbes’ description of the natural state of society as “nasty, brutish and short,” several topics surface:
A K-shaped Recovery May Reflect Two Different Realities
Economic data appears to be improving as signs of recovery include new home sales at the highest level since the fall of 2006; capital investment recovering with new durable-goods orders rising 12% month-over-month in July; and a job market that is slowly healing with unemployment trending in the right direction. While the economic healing process looks to be underway, building confidence and eliminating some of the uncertainty are still long-term risks that might, in the long run, outweigh the impacts of which party wins in November.
One risk is the possibility of a “K-shaped recovery” which reflects a bifurcated society in the U.S. where white-collar, tech-savvy workers continue to thrive while hourly, gig-economy and other blue-collar workers continue to suffer. Such a recovery would have impacts on consumer spending, income inequality, and market instability. This bifurcation is playing out in the stock market, with clear winners and losers. Large companies that have the capital to invest in multiple distribution channels, including both brick and mortar and e-commerce, have been able to nimbly cross-pollinate and survive whereas many small- and medium- sized businesses are falling by the wayside.
To the extent that the country succeeds in combating the economic downturn caused by the COVID-19 pandemic, the recovery is less likely to be K-shaped. But if the virus persists and new outbreaks occur, a K-shaped recovery becomes more likely. Winners and losers in November aside, this possibility might be behind Fed Chairman Powell’s repeated appeals for additional fiscal action by Congress and the President.
Climbing a Mountain of Debt
The U.S. national debt is nearing $27 trillion and constitutes constitutes 108% of GDP as of first quarter of GDP for the first time since World War II due, in part, to the impact of COVID-19 on the economy. Neither candidate has discussed the deficit directly, however. While avoiding the topic of how the country will pay off its debts may be understandable given the ongoing pandemic, kicking the can down the road only prolongs the need to develop fiscal strategies to address the deficit. Alarmingly, by 2030, the debt could rise to between 118% and 130% of GDP.
Thus far, both parties have pretty much stuck to familiar scripts—more spending and higher taxes by the Democrats and tax cuts by the Republicans, including a potential payroll tax cut. Setting aside the impact on the deficit from fiscal and monetary responses to the pandemic, taxation and spending plans will alter the debt trajectory for better or worse going forward, particularly in the “untouchable” realms of Medicare and Social Security.
While President Trump’s views on taxation are pretty straightforward, Biden’s are less clear. The Democratic party platform includes ambitious spending goals, and Biden may disappoint the more progressive members with a less ambitious program that avoids or downsizes controversial proposals such as Medicare for All and a “Green New Deal.” While it might seem like ancient history, of the nearly 30 Democrats who vied for the nomination, Biden was arguably the most moderate candidate. His moderate fiscal stance, which included at one point in his long political career calling for a freeze on all government spending, might be more in play than some believe.
Perhaps the greatest concern, regardless of which party prevails in November at both the presidential and congressional levels, is the possibility that U.S. debt might be downgraded again due to the deficit. This could stress and rattle markets, which might not have begun to think through the ultimate implications of Treasuries losing their status as the most risk-free of all global investment instruments.
Keep Calm and Carry On
Lost in the turmoil over an election season marked by discord is the fact that, as Ruchir Sharma, Morgan Stanley’s chief global strategist pointed out, research back to the late 1800s indicates that “ ... the market has no clear bias in favor of either party and market volatility in the runup to an election is perfectly normal. The market is an economic barometer, not a political one.” While politics are one factor among many that investors and traders include in their decisions, “The leader that the market listens to most carefully is the head of the Federal Reserve, not the President.”
We agree with this assessment. The stock and bond market recoveries from the lows of March began not when a political figure announced a response to the economic impact of the virus, but when the Fed unleashed its “policy bazooka.” More recently, market volatility appears to be triggered by profit taking and the ups and downs of Congress’s attempts to provide new fiscal relief rather than by which presidential candidate leads in the daily polls.
As we approach the task of investing for our clients, our focus is on assessing both the macroeconomic and company-specific drivers that impact returns to markets and individual holdings, while remaining focused on meeting each client’s individual investment needs. While the ups and downs of politics can, at times, create distractions from our mission, we continue to believe that active portfolio management will shine in a climate where investors need to discriminate between winners and losers—regardless of which party runs the ship—and focus on investment discipline to outperform and add value amid an uncertain outlook and recovery path.
Market Overview: No Clear Prognosis Yet
Entering the fourth quarter of a calamitous year, financial markets remain keenly focused on a host of short- and long-term challenges facing the global economy in the wake of the COVID-19 pandemic. A record worst U.S. real Gross Domestic Product (GDP) growth rate in the second quarter of –31.4% annualized was emblematic of the economic distress the rest of the world encountered as governments scrambled to contain the spread of the infection. Meanwhile, a voracious rally in the global stock market from April through August would suggest investors believe at least the worst of the economic storm may be in the rear-view mirror. Yet, lingering questions remain about what lies ahead in the aftermath.
Confronted with a crisis of epic proportions, policymakers swiftly unleashed unprecedented levels of fiscal and monetary relief, in effect acting as a defibrillator that revived financial markets and an economy in cardiac arrest. The treatment may have revived the patient and resolved the acute trauma, but a longer-term prognosis is far from clear. In other words, while the economy’s recent vital signs look encouraging, the patient may not be out of the woods yet.
On the surface, economic data from employment to consumer spending has recovered at a heartening pace as the global economy emerges from the depths of a major health crisis. The headline statistics, however, may distort a recovery trajectory that is not as uniform as it may appear. Major segments of the economy, including the travel and hospitality industries, remain hamstrung by virus-driven restrictions prohibiting the resumption of pre-pandemic activity levels. It remains to be seen if this weakness will remain isolated from the broader economy or if it begins to weigh on it.
Such unusual circumstances have left economists to debate the ultimate shape of an ongoing recovery, placing a proverbial alphabet soup of scenarios on the table that range from “V” to “U” to “W” and now to “K.” The “K” represents the bifurcation of the recovery into the “haves” (segments of the economy with the ability to recover and even thrive) and the “have nots” (segments of the economy that remain in dire conditions) and leaves an open question about how the two might converge down the road.
Financial Markets Forge Ahead
Perhaps almost as unexpected as the pandemic-induced equity market sell-off itself was the speed of its recovery. To the surprise of many, the S&P 500 Index recovered all of its 33% peak-to-trough first quarter loss and found its way to new all-time-highs during the third quarter in spite of the ongoing economic headwinds created by the virus. As of the end of the third quarter, the U.S. large cap index had risen 1%, including dividends, from its February 19th high. The roundtrip from all-time highs to a bear market and back to all-time highs was a record quick six months. Since the inception of the S&P 500 Index, the average roundtrip from high to bear market low and back to high averages about six years.
In contrast to the snap back in global stock prices this year, interest rates on U.S. Treasury bonds have yet to see the same reversal of fortunes. Yields across all maturities took a sharp dive downward at the onset of the crisis and have remained at historically low levels since the first quarter. At the beginning of the year, the yield-to-maturity on the bellwether 10-year Treasury Note stood at 1.9%. Since early March, following an investor flight to safety, the yield has mostly traded in a tight range between 0.5% and 0.8%. Factoring in expected inflation implied on 10-year TIPS (Treasury Inflation Protected Securities) of 1.6%, real yields were near–1% at the end of the third quarter.
Combined with a stabilizing economic outlook, increasingly paltry returns offered by safe haven assets have driven investors back into riskier assets. Looking beyond equities, a similar story is playing out in the debt markets. Yield premiums on bonds with credit risk have largely followed the path of the equity market–widening out to post the 2007 to 2009 Global Financial Crisis (GFC) highs before narrowing back to near-historical averages. Despite a deterioration in fundamentals and a pickup in both issuance and defaults, investors have jumped back into credit markets with both feet after abandoning low- to non-yielding government bonds and cash.
Not Everyone Gets a Trophy
The rapid rotation back into riskier assets has not been without discrimination. Demand for securities of large, financially stable companies with the most exposure to secular growth trends has been insatiable of late. On the other end of the spectrum, smaller companies with higher economic cycle exposure have all but been forgotten about. Investors have made a clear distinction between companies that can grow regardless of economic conditions (commonly known as “growth” stocks) and those that will be challenged to grow earnings without a strong economic recovery (commonly known as “value” stocks).
To a large degree, differentials in sector weights among the indices that represent equity sub-asset classes go long way in explaining this divide. The Russell 2000 Value Index, for example, is composed of roughly 45% in financial and industrial firms and just 6% in technology companies, whereas the Russell Top 200 Growth Index holds 44% in the technology sector alone. The representation of technology stocks shows up in valuation metrics such as the Price-to-Book Value ratio (P/B). This metric shows small cap value stocks currently at around 1x P/B and large cap growth at 12x P/B.
While there has always been a valuation premium afforded to large cap growth relative to small cap value (on average 3.7x over the last 20 years), this divergence has grown to exceed even the disparity seen during the Dot Com Bubble. The expansion in the valuation multiple of large cap growth stocks has led the performance differential over the past 12 months between small cap value and large cap growth to 56%, an extraordinary divergence that is not apparent in broad market averages.
In times of great disruption, it can be most comfortable to follow what is working. While this may pay off in the short term, the late financial historian and economist Peter Bernstein reminded us in an interview with CNN in 2004, that “I view diversification not only as a survival strategy, but as an aggressive strategy, because the next windfall might come from a surprising place.”
Goodbye to the Phillips Curve
The long-awaited changes to the Fed’s policy-making framework were unveiled in late August at the Fed’s annual central banking economic symposium. The underlying changes have a significant effect on the rate-setting activity of the Federal Open Market Committee (FOMC), which has guided monetary policy decisions for the last few decades. We believe this new framework has significant implications for monetary policy, the economy, and financial markets going forward.
For more than three decades, the Fed has conducted a symmetric monetary policy that attempts to balance the Fed’s estimate of full employment versus a reasonable, yet low, inflation rate. This trade-off is embodied in the Phillips curve, an economic concept stating that inflation and unemployment have a stable and inverse relationship.
The concept claims that economic growth results in job growth and lower unemployment, yet also sparks an increase in inflation. As economic growth improves and the unemployment rate approaches the Fed’s estimate of maximum employment, known by the acronym NAIRU, the Fed typically tightens monetary policy by increasing the federal funds target rate and the discount rate to prevent the economy from overheating and future inflation from rising above the Fed’s long-term core inflation target.
Because changes to monetary policy have a delayed impact on the economy, the Fed seeks to implement rate changes proactively, rather than reactively, in order to balance inflation and employment. This policy framework worked well in the 1970s and 1980s and helped the Fed conquer what was at the time an inflation problem, as shown in the chart below.
Recently, however, factors such as technological innovation, productivity enhancement, and globalization may have changed the slope of the Phillips curve and caused disinflation, if not outright deflation, in some products and industries. As a result, some market pundits question the Fed’s monetary policy-tightening actions over the past two decades, which typically focused on preempting an unwelcome rise in inflation as economic growth increased and unemployment approached NAIRU. As shown in the chart below, the Fed preemptively increased interest rates on several occasions over the past two decades when the unemployment rate fell below 5%, despite core inflation falling short of 2% at the time.
Revising Maximum Employment, Inflation, and an Asymmetric Policy Relationship
The new Fed policy-making framework modifies the Fed’s employment and inflation objective as well as the link between the two. The Fed refined the definition of the maximum level of employment it strives to achieve as being “broad based and inclusive.” Implicitly, this revised definition recognizes unemployment differences among age, gender, and ethnic group which, in turn, puts a greater emphasis on lower overall levels of unemployment.
Further, policy is now geared toward shortfalls in employment relative to the revised “maximum level,” as opposed to deviations from this “maximum level.” This means that employment can run at or above current estimates of maximum employment without necessarily causing concern or the need to tighten monetary policy. The caveat to this new view of maximum employment and tightening is that it cannot be accompanied by signs of unwanted increases in inflation or the emergence of other risks such as financial bubbles.
The Fed also refined its inflation target toward an average level of core inflation over an undefined period of time as opposed to a targeted line in the sand, which previously was 2% as measured by the core PCE. Using an average allows inflation to run above 2% for a period of time if the prior period was persistently below 2%. In turn, this new asymmetric policy framework allows the Fed to retain an accommodative monetary policy until after “full employment” has been achieved and inflation has returned to, or exceeds, a 2% average over an unspecified time period.
The Fed wasted no time in putting this new policy-making framework into action. At September’s FOMC meeting, the Committee incorporated the new framework into both its policy statement and its forward projections. Specifically,
Consistent with the Fed’s new strategy and policy statement, the FOMC September Summary of Economic Projections showed a vast majority of the Committee does not forecast both economic triggers, “maximum employment” and average inflation, to be met until the end of 2023. In turn, the Committee’s economic projections also forecast holding the federal funds target rate near zero through 2023. The FOMC does retain a get-out clause whereby the Fed “would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee’s goals,” which is likely a reference to financial stability risks including systemic asset bubbles.
Economic and Market Implications of the New Fed Era
The implications of the Fed’s new framework are vast. In general, the new approach should allow for more accommodative monetary policy for the foreseeable future which, in turn, is a positive tailwind for economic growth and broad-based labor market outcomes. Essentially, the Fed will let the economy run hotter than prior policy would recommend and won’t pre-emptively tighten policy, thereby lengthening the economic cycle. Further, continuing a lower-rate stance should benefit risk assets near term, as lower rates further fuel the yield hunt rotation out of risk-free assets such as Treasuries, benefit corporate profits, and help justify high equity valuations given a lower discount rate for longer periods. In the long term, however, this new and untested Fed policy making framework could lead to a monetary policy mistake in hindsight. Specifically, this mistake could be one of inaction by the Fed when they should have increased the Fed Funds rate and removed excess policy accommodation.
Given that the impact of monetary policy has a delayed effect on the economy, one result could be an upside surprise in the rate of inflation over the longer term, leading to higher intermediate and longer maturity interest rates, as well as a steeper U.S. Treasury yield curve. Further, the Fed’s new policy framework could also perpetuate asset bubbles over the longer term and, should additional economic shocks occur prior to the removal of monetary policy accommodation, the Fed could well be left with a limited toolkit to fight future downturns.
Will Consumers Help Rescue the Economy?
With the exception of the 2008 GFC, the COVID-19 pandemic has had unparalleled impact on consumers and businesses globally. While questions remain around the duration of the pandemic—as the world waits for vaccine developments, approvals, distribution and acceptance—it is clear that consumer and business behavior has structurally changed.
To begin with, the pandemic has fast-tracked many trends that were already underway pre-crisis. These trends include consumer adoption of e-commerce at the expense of traditional retail, an increased demand for enterprise and industrial automation, a growing consumption of digital entertainment and a surge in the usage of food delivery applications and services. All of these trends reflect an acceleration of the digital transformation of business and the economy—a trend with both positive and negative implications for various domestic and global industries.
Shared and Service Economies Unravel
One pre-COVID-19 trend that has clearly been impacted by the pandemic is the growth of a movement towards a “shared economy”. It is not surprising that many consumers continue to be hesitant about jumping back into booking vacation rentals on-line or using ride-sharing services. The “rent-not-own economy” in development since the GFC-era housing crisis has also shifted as some consumers leave large urban centers to buy homes in less dense areas. While this “flight to safety” has negatively impacted apartment rentals and commercial real estate, the Housing and Automotive sectors have seen some of the swiftest post-recession recoveries. This has been in part due to the shift away from urban centers, but also due to the historically low-interest rate environment enabling more affordability to purchase a new home or vehicle.
Inarguably though, the sector of the economy most deeply impacted by the COVID-19 crisis has been the service sector, given the challenges resulting from forced business shutdowns followed by either voluntary or mandated social distancing procedures. This has most negatively impacted the retail, restaurant, travel, and leisure industries, which combined make up 18% of U.S. GDP and 27% of the U.S. job market. If the unraveling of the shared and service economies persists, it will continue to weigh on the recovery of a significant part of the economy and increase the risk of a higher level of what could potentially be permanent U.S. unemployment.
Stimulus Jolt for Consumer Wallets
As evident in comparison to the GFC, the COVID-19 recession carries its own set of unique impacts and outcomes. The COVID-19 recession has been defined and affected by the ongoing uncertainty of combatting the virus, the ramifications ofcthe November U.S. elections, and the potential challenges confronting the economy into 2021. One of those challenges is the maintenance of a healthy level of consumer spending. Accounting for nearly 70% of U.S. GDP, spending will be a major factorcin determining how effectively and how quickly the economy heals. The good news is that various fundamentals of the consumer backdrop provide some glimmers of hope that U.S. consumers could be more resilient than expected.
One critical difference today versus the GFC is the impressive boost of consumer liquidity triggered in March by the historic Coronavirus Aid, Relief and Economic Security (CARES) Act. An intentional lack of spending by consumers during the early months of the crisis coupled with the passage of the CARES Act created an exceptional surplus of unspent consumer capital. Since the stimulus hit consumer wallets, U.S. Bureau of Economic Analysis data indicates consumers have built up excess savings of over $12 trillion.
In comparison, savings rates during the GFC, and for three years after the recession ended, averaged 6.6%. This translated to weaker levels of consumer confidence and a slower recovery in consumer spending, in comparison to the 17.8% savings rate as of July 2020 shown in the chart below. This excess savings may have been a factor in U.S. retail sales that, as of August, are now above pre-COVID-19 levels. As a yardstick, the country’s return to “spending as usual” has taken six months during the COVID-19 crisis versus 33 months during the GFC recovery.
The employment picture has also been distinctive in the COVID-19 crisis. Shortly after the March economic shutdowns across the country, the U.S. unemployment rate quickly spiked to 14.7% at its peak in April. This was followed by a similarly dramatic decline to an 8.4% unemployment rate in August. The job recovery, to date, has been one of the fastest in modern history, but there is still a looming uphill battle: employment and consumer confidence continue to lag the GFC recovery.
Will Consumer Spending Lead the Recovery into 2021?
Two key inputs have historically been factors in determining a consumer’s propensity to spend: their savings and balance sheets. As we enter the critical holiday season, analysts wonder if the excess savings, in addition to higher consumer balance sheets, will carry through to higher spending—despite the headwinds on employment and consumer confidence. For context, U.S. consumer net worth increased by $2.5 trillion to an all-time high of $119 trillion in the second quarter, as shown in the chart below.
Despite this spending potential, uncertainty may continue as the service economy struggles with potentially greater levels of structural unemployment that will weigh on consumer confidence and spending intentions going into 2021. One metric that might provide some insight to the spending recovery from here is known as the Marginal Propensity to Consume (MPC). This is a Keynesian economic theory which compares the rate of change in consumption to the rate of change in savings.
The U.S. has historically had a relatively higher MPC compared to other countries and thus a lower savings rate. This indicates the potential for a continued consumer spending recovery by looking at the high savings balances and consumer net worth as we enter the final quarter of 2020. The question remains whether the uncertainty around the November elections, the continuing impact of COVID-19, and the unraveling of the shared and service economies will prevent the continued healing of the economy as we enter 2021. We believe there are indications that consumers can indeed withstand these headwinds near-term and potentially aid the economic recovery by continuing to spend down excess savings over the next several years.
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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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. 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.