The July-September quarter saw continued strong results from nearly all categories of financial investments. Large-company U.S. stocks advanced between 7% and 9%; small-caps lagged with a gain of around 3%. Outside the U.S., developed-market returns averaged about 5%, while emerging markets were considerably stronger, gaining nearly 10% as a group. Most real-estate securities eked out only modest advances, though timber-related issues surged by around 15%. Industrial commodity prices rose some 3%; oil ended essentially flat, while gold gained 6%. Benchmark bond yields inched higher: the 10-year Treasury finished September at 0.68%, compared with 0.65% at the end of June; credit spreads mostly narrowed, resulting in positive total returns from most credit instruments.
Among U.S. large-company stocks, those in the Basic Materials, Consumer Cyclical, Technology and Utilities sectors provided above-average three-month results; Consumer Staple, Energy, Financial Services and Health Care names lagged. Despite a September reversal of the long-standing pattern, growth-oriented shares still trounced the value category by a ratio of three to one (+12% to +4%).
While the third calendar quarter of 2020 lacked the high drama of the previous two, few will likely complain. Pandemic-related developments were reassuringly non-catastrophic; economic reports and earnings releases provided a steady stream of positive surprises; the Federal Reserve maintained exceptionally accommodative monetary conditions. Despite the persistent pandemic and flaring civil unrest, the presidential race was generally steady, with Joe Biden maintaining a significant but by no means insurmountable lead in the polls. Stocks surged higher through August, with large-cap benchmarks eclipsing their pre-pandemic highs. And despite an unnerving dip during the first three weeks of September – as political gridlock blocked additional federal spending to support the economy – the S&P 500 never ventured into negative territory during the period.
A worrying resurgence of COVID infections that hit several large, mostly Southern states in June and July did not overwhelm medical systems and was in retreat during August and September. However, since Labor Day a new acceleration has been brewing in the Upper Midwest, with the Dakotas and Wisconsin posting the worst figures in the nation over the past several weeks. Though the virus’s toll continued to climb at an unrelenting pace, a growing understanding of the varying danger posed to different populations combined with improving treatment protocols reduced nationwide infection, hospitalization and death rates.
The U.S. economy continued to recover more quickly and broadly than feared in the early days of the crisis. Having contracted at an annualized rate of more than 31% in the April-June period, aggregate output probably expanded at roughly the same pace in the not-yet-reported third quarter. Recently released data have been overwhelmingly better than expected, documenting a rapid rebound, particularly early in the period. Purchasing-managers surveys showed robust expansion across both manufacturing and services; consumer confidence posted one of its biggest monthly gains on record in September; and the housing market was on fire: the National Association of Home Builders survey advanced to a post-financial-crisis record, as rock-bottom mortgage rates fueled a pandemic-induced scramble for bigger and/or less urban housing. The all-important employment picture continued to improve: through September, the economy had regained more than half the staggering 22 million jobs lost between February and May; the official unemployment rate fell below 8% from nearly 15% in April. However, the pace of improvement seemed to be abating. September payroll gains were less than half those in July and August, which, in turn, were only one-third June’s unprecedented surge. Meanwhile, with the expiration of federal assistance programs, personal incomes contracted in August. Absent new funding, most economists expect growth to slow markedly in the October-December quarter, resulting in a full-year contraction of around 3%.
Other key constituents of the global economy continued to recover at varying paces. Major European economies recorded deeper contractions than the U.S. due to more draconian lockdowns and more gradual reopenings; and late-summer COVID resurgences likely dented otherwise robust third-quarter rebounds. Japan has handled the COVID crisis relatively well, though idiosyncratic obstacles – last year’s consumption-tax hike; the recent, unanticipated change of government – have weighed on performance. China and the East Asian economies whose fortunes are closely linked to it have turned in the strongest results. Having contained and suppressed the virus by the end of March, China experienced an earlier and shallower contraction than any other major economy; a modest expansion in the April-June period and an expected second-half acceleration will likely make China the only major economy to grow in 2020. Other emerging-market economies (e.g., Brazil, Mexico, India, South Africa) have had great difficulty suppressing the pandemic and limiting economic damage. Double-digit contractions will further suppress global growth, which the IMF estimates will come in at -4.9% for calendar 2020 – an outcome worse than the 2009 Global Financial Crisis (-2.5%).
The Federal Reserve’s September announcement of a widely anticipated change to its inflation-targeting methodology had little noticeable impact on bond markets or market-derived measures of inflation expectations. Fed officials seemed at pains to point out that they have expended their most potent policy ammunition by slashing overnight interest rates and expanding asset purchases to new categories; they repeatedly prodded Congress and the White House to reach a compromise allowing additional federal spending to support the recovering economy.
September notably saw value-oriented large-company stocks outperform their growth-oriented counterparts for the first time in 12 months. This year has also seen an unusual number of days on which one investment style has massively outperformed the other (by two percentage points or more): according to Bespoke Investment Group, 16 such days occurred in the first nine months of 2020 (with each style outperforming eight times), compared to just one in each of the last two years and none between 2010 and 2017. Investors appeared to make aggressive short-term bets on the direction of pandemic developments: growth led on days when the news seemed to point to a WFH/SD (work-from-home/socially-distanced) ‘new normal’ persisting for years, while value took the upper hand when data suggested a relatively early return to some semblance of the ‘old normal.’ Food for thought: similar spates of short-term style divergence have been associated with major market breaks, with the most recent episodes occurring in 1998-2000 and 2009.
To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:
1) Dividend Income (for three months this is the annual yield divided by four)
2) +/- Change in Earnings per Share* (average for S&P 500 companies)
3) +/- Change in Valuation (Price/Earnings Ratio)
= Total Return
* based on forecast earnings for next 12 months (Source: S&P Outlook)
So, what changed during the recent quarter to produce the +8.9% S&P 500 total return?
|Third Quarter (July-September) 2020|
|Dividend Income||+ 0.4%||+8.9%|
|+ Change in Earnings||+9.5%|
|+ Change in Valuation||-1.0%|
|= Total Return||+8.9%|
Our read: The year-ahead earnings figure has turned sharply positive following last quarter’s epic collapse. Further improvement will be needed to validate recent market gains.
Earnings reported by S&P 500 companies during the period (mostly covering April-June) came in well above Wall Street’s subdued expectations; the ‘beat rate’ of 76% compared to an average of 59%. Aggregate profits were nevertheless 33% below the year-earlier figure. Though analysts expect the rate of contraction to improve in the third and fourth quarters, 2020 as a whole is pegged at a dismal -27% vs. 2019. Figures for 2021 are still very much works-in-progress, but they recently pointed to a 40%+ rebound, which – if it comes to pass – would put next year’s total a few percentage points above 2019.
With the benefit of hindsight, the financial-market recovery since the late-March nadir becomes understandable though no less remarkable. While extreme uncertainty and fear prevailed in the early spring, investors now know: the public-health threat is better understood and arguably less frightening; draconian lockdowns were temporary and seem unlikely to be repeated; many countries and some U.S. cities/states have been successful in drastically reducing transmission, hospitalizations and deaths, allowing a substantial degree of reopening; economic damage has been severe but in many respects the recovery to date has been ‘v-shaped’; and the hit to corporate profits, though deep, seems likely to be briefer than feared. Meanwhile, extremely accommodative monetary policy has suppressed bond yields, elevating the value of future interest and dividend payments reflected in the rising prices of financial assets.
Though the past six months have clearly turned out better than expected (or feared), we believe a high degree of uncertainty remains regarding the course of the U.S. economy (and markets) in the months ahead. On one hand, recurring or more severe COVID resurgences this winter, or a delayed and/or less-effective vaccine, could depress activity, leading to a ‘double-dip’ recession. On the other, substantial upside could come from a relatively early and successful vaccine rollout and/or substantial new federal spending flowing from a more cooperative post-election Washington. Additional reasons for optimism include solid consumer finances – bolstered by rising home and stock-market values and low interest rates – as well as a need to rebuild depleted industrial inventories. But the list of potential worries is not short: slowing employment gains; a looming wave of evictions; consumers reluctant to spend in a ‘k-shaped’ work-from-home/socially-distanced economy that works better for some than for others; cash-strapped state and local governments. Businesses in the retail, restaurant, entertainment and travel industries are being decimated while others, such as education, are being radically transformed. Together, these industries represent more than a tenth of the economy and a greater share of employment.
One key aspect of the outlook is notably less murky: rock-bottom interest rates seem set to be with us for years. Via its published growth and inflation projections, the Federal Reserve has signaled its intent to hold rates near zero at least through 2023; a five-year Treasury yield below 0.30% indicates investors believe this promise of ‘lower for longer.’ Persistent low yields have the potential to support lofty stock-market valuations and are a boon to indebted consumers and businesses. But they complicate matters for investors. Consider the traditional “60/40” balanced portfolio: cutting the yield on the 40% bond component from 3% to 1% lops almost a full percentage point from expected returns; the actual impact could be greater if results from other asset categories are pulled lower by near-zero Treasury rates. This is the essence of the “TINA” (There-Is-No-Alternative) argument for stocks: simple math compels investors whose goals call for returns on the order of 6% to 8% to ‘embrace risk’ and shift their portfolios away from safe bonds into riskier alternatives, especially common stocks.
The impending U.S. election has been billed as the most important in decades (some would say much longer). Surely, much is at stake: opinion polls indicate that either or both the White House and Senate could change hands. Less clear is what the election might mean for markets and investors. A messy, contested election or, worse, a ‘Constitutional crisis’ providing no clear outcome, would surely cause a dramatic increase in market volatility. Beyond such unsettling short-term prospects, however, investors probably have less to fear from potential Democratic gains than is widely assumed. As readily documented, the U.S. economy and stock market have historically done as well if not a bit better under Democratic administrations than the alternative. Moreover, the current Democratic platform would boost federal spending, which many economists, including those at the Federal Reserve, think the economy desperately needs. Likewise, a study recently published by Wall Street firm Moody’s Analytics concluded that short-term prospects for the economy would be better under the Democratic plan. The above observations don’t seem to be undermined by recent market performance, which was strong during the April-June period when a Democratic lead was becoming more widely acknowledged, and didn’t waver noticeably following the first Trump-Biden debate or President Trump’s COVID diagnosis.
Near-term uncertainties surrounding the pandemic and election argue for a degree of caution in the positioning of portfolios. Valuation is stubbornly high, but persistently low bond yields are a powerful offset; sentiment surveys and mutual fund flows do not suggest undue investor complacency; the recent ‘bi-polar’ behavior of growth and value stocks may signal an important turning point is at hand. The September stock-market swoon likely dissipated some near-term risk, but additional volatility seems a safe bet. A major stock market set-back could provide an important medium-term opportunity to add portfolio exposure to growth-oriented asset categories, which might be advisable given the reality of depressed bond yields. A more likely scenario featuring intermittent lower-level volatility would nevertheless allow us to build on portfolio holdings of high-quality companies at lower prices.
We hope you and your families are safe and healthy – and welcome your comments and suggestions regarding our management of your investments.