Oarsman Outlook: July 2020

The first half of 2020 will be remembered as one of the most remarkable investment periods in history. Following gut-wrenching plunges of 35% or more in a matter of weeks beginning in late February, nearly all asset categories staged equally astonishing recoveries during the April-June quarter. The global resurgence was ignited in late March by aggressive central-bank and government responses to the coronavirus pandemic, fueled in April-May by improving pandemic statistics in many of the earliest and hardest hit regions, and re-energized in June by accumulating evidence of a surprisingly sharp economic rebound.

Both large- and small-cap U.S. stocks posted total returns of just over 20% in the three months through June 30. Overseas developed-markets, as group, advanced 15%; emerging-markets gained 18%. Real estate securities were up 9% to 16%, depending on geography/sector-exposure. Industrial commodities jumped more than 10%; the price of oil nearly doubled, while gold rose 13%. Amid a flood of central bank liquidity, bond yields fell to record lows. The U.S. 10-year Treasury Note, which traded above 1.80% in mid-January, reached a nadir around 0.55% several times during April and finished the period at 0.65%. Credit spreads narrowed from extremely wide levels in March, producing solid returns from nearly all categories of bonds.

Among U.S. large-cap stocks, those in the Basic Materials, Energy, Industrials and Technology sectors provided the strongest three-month results; Consumer Staples, Financial Services, Health Care and Utilities lagged. Growth-oriented issues outperformed their value counterparts by an astonishing 13 percentage points (+26% vs +13%).

Review

Through June, the coronavirus had infected more than 10 million worldwide – killing more than 500,000 – with more than a quarter of both figures coming from the U.S. Governments across six continents responded with unprecedented lockdowns of commerce and everyday life, leading to the most abrupt economic downturn on record. Collapsing economies led unsurprisingly to cratering markets and, worse, a seizing-up of financial infrastructure worryingly reminiscent of 2008. Seeking to arrest a self-reinforcing spiral, global central banks, led by the U.S. Federal Reserve, unleashed into the markets gargantuan infusions of cash via purchases of nearly all kinds of bonds. Meanwhile, governments rushed to provide trillions of dollars of emergency support to afflicted industries and citizens whose ability to work had been curtailed or eliminated.

The pandemic that emerged in central China at the end of 2019 spread rapidly to Western Europe. Belgium, France, Italy, Spain and the UK were hit especially hard in March and April, all experiencing hospitalization and death rates far surpassing any in Asia. A similarly dire situation erupted a few weeks later in the New York City region, while less catastrophic conditions were widespread throughout the U.S. By May, compliance with draconian lockdowns and new personal-hygiene/social-distancing guidelines had suppressed transmission of the virus, most effectively across East Asia and Western Europe, as well as some parts of the U.S. Worryingly, the past several weeks have seen a meaningful increase in infections across most U.S. states, and hospitalizations have begun to rise. Meanwhile, Russia and much of Latin America and Sub-Saharan Africa have largely failed to meaningfully impede the spread of the disease. The net result is that the pandemic is far from contained on a global basis.

Economic damage caused by the pandemic has been catastrophic. Aggregate economic activity (GDP) in the U.S. likely contracted at an unprecedented annualized rate of at least -20% during the April-June quarter: total output is likely have been as much as 7% to 8% lower than in the year-ago period. More than 22 million Americans have claimed unemployment benefits in the past four months; the jobless rate spiked above 14% in April, though it receded to 'only' 11% in June (it stood below 4% at yearend). The immediate damage from lockdowns and other emergency measures was even more severe across much of Europe. In contrast, drawing on experience of the early-2000s SARS epidemic, China, Japan, South Korea, Taiwan and Vietnam, as well as Australia and New Zealand, were all relatively successful controlling the virus's spread and the resulting economic fallout. Estimates based on total hours worked suggest the equivalent of as many as 300 million jobs lost worldwide.

Data covering May and June indicate economic activity across many economies has rebounded strongly with the lifting of lockdowns. In the US, fully one-third of the jobs lost in March and April were added back; the purchasing-managers survey for the manufacturing sector posted its biggest one-month improvement since 1980; retail sales surged nearly 18%; while in Europe, business and consumer confidence saw their biggest improvements in 50 years. As analysts at Capital Economics put it in late June, the recent spate of data suggests a recovery that is 'V-shaped, so far.'

An important legacy of the crisis will be a tremendous increase in indebtedness. Rich-world governments are running deficits of a magnitude not seen since the Second World War, while less-well-off nations are lining up for assistance from the International Monetary Fund (IMF) and other international organizations; worldwide, the sovereign-debt-to-GDP ratio may climb by as much as 20 percentage points. The corporate sector, too, has taken advantage of central-bank bond-buying and resulting ultra-low interest rates to expand balance sheets with what is likely to be a record amount of bond issuance.

What's Changed?

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 changedduring the recent quarter to produce the +20.5% S&P 500 total return?

Our read: The massive increase in valuation indicates investors are 'looking past' the collapse in earnings and expect a monumental improvement in coming quarters. Watch this space.

Outlook

With the pandemic continuing to spread, the economic impact still unfolding, and investors struggling to make sense of rapidly changing data, we gauge the July-September quarter to be roughly the fourth inning of the Covid-19 crisis. How the remaining frames play out will drive investment results through next year.

The massive market rally has to date relied on a powerful combination of surprisingly robust policy interventions, flattening of pandemic-related curves in many of the world's biggest economies, and a broadening stream of better-than-feared economic news. The magnitude of the rebound raises the risk that markets have gotten ahead of the underlying recovery story or, at minimum, are discounting a plausible but rather optimistic future. Central banks' ammunition has largely been expended and emergency spending programs are set to expire soon, while hoped-for extensions/expansions could fall victim to political dysfunction. Meanwhile, the recent resurgence of infections seems sure to dampen the recovery: even absent renewed lockdowns, people will naturally venture out and spend less if they don't feel safe. This phenomenon, already visible in real-time data tracking mobility, restaurant bookings, and hours worked at small businesses, seems likely to persist until highly effective treatment or vaccine is widely available, which could easily be another six to nine months.

Recently published forecasts are sobering. The Federal Reserve foresees a decline in U.S. GDP of -6.5% in 2020 (for comparison, 2009 came in at -2.5%), followed by gains of +5.0% and +3.5% in '21 and '22. On that trajectory, total output won't return to its end-2019 level until mid-2022; unemployment is seen remaining above 5% through the end of 2022. Both the IMF and the European Commission recently downgraded their outlooks: the IMF sees the global economy shrinking by an almost unfathomable -4.9% this year (2009 was -0.1%!), followed by a robust gain of +5.4% in '21 (the latter figure flattered by high-growth emerging markets; developed economies are seen languishing); the EC expects European growth of -8.3% in 2020 and +5.8% in '21. Though recent data indicate many parts of the global economy are snapping back quickly, it seems others could struggle for some time.

Longer lasting economic damage should not be discounted, either. Buried in upbeat jobs reports is a rising rate of 'core' unemployment; in June, the number of 'permanent' job losers increased to nearly three million. Closed daycare facilities and schools will impede the ability of many – mostly women – to return to work. State and local governments face dramatic revenue shortfalls that, because of balanced-budget requirements, could force massive spending cuts or tax increases amid an already weakened economy. The Wall Street Journal reports data from Yelp indicating 140,000 small businesses remained closed in mid-June, with 40% indicating no plans to reopen. As highlighted by Fed chair Jerome Powell, such businesses – which account for nearly half of U.S. employment – face 'acute risks' to their survival. Many displaced workers – who will probably number at least five million – will struggle to find jobs in less impacted sectors; some will never do so.

Against a rapidly shifting public-health and economic backdrop, estimates of corporate profits over the next year or so seem little better than guesses. April/May earnings reports were notable for the legion of companies that eliminated 'forward guidance.' Befuddled Wall Street analysts have penciled in an aggregate profit decline of -23% in 2020 followed by an increase of +38% in 2021. We suspect the 2020 figure may move up and are all but certain the 2021 one will be cut over coming weeks/months. Taking current estimates at face value, the S&P 500 is trading at nearly 23 times expected year-ahead earnings – a figure that has rarely been exceeded and seems unlikely to be followed by strongly positive results (though persistent near-zero bond yields make this less clear-cut).

Finally, if you need other worries, consider political risk. Early (note emphasis) polling shows Joe Biden with a substantial lead in the presidential race, possibly large enough to bring the Senate into play. To re-energize its supporters, the Trump administration may feel compelled to act assertively by, for example, stoking tensions with China and/or the EU. You will recall that prior to the pandemic, one of the most powerful market movers was the ebb and flow of 'trade war' developments. Investors may also begin to discount the likelihood of higher corporate and high-end personal taxes, as well as heavier regulation, possibly including anti-trust enforcement against the mega-cap tech companies. All good excuses to lighten up on stocks before November.

Summing up, an utterly unfamiliar pandemic combined with growing chances of major political change add up to an unusually fluid investment environment featuring plenty of scope for disappointment. To date, DFTF (Don't Fight The Fed) + TINA (There Is No Alternative to stocks in a world of near-zero bond yields) + FOMO (Fear Of Missing Out on a powerful rally) has overwhelmed this radical uncertainty. Much has gone better than feared over the past three months, but we nevertheless struggle to rationalize market prices near year-end 2019 levels when the economic and earnings outlook has turned hugely more uncertain. We suspect unpredictable news flow could also result in unsettling volatility in the months ahead. Accordingly, we think it is prudent to maintain moderate portfolio positioning, while holding some cash ('dry powder') in anticipation of opportunities to add to high-quality growth investments at lower prices.