2020 Mid-Year Thoughts
Given everything that has transpired over the last few months, it is almost hard to believe that there is another half a year to go - a half that much like its predecessor will have its own set of opportunities and risks. We will look back at the first half of the year in our quarterly review, but for this week we wanted to provide our thoughts around the current investing landscape. This piece has been put together after reading numerous research reports as well as multiple conversations with teams we invest with.
We will take a deep look at where things currently stand from an economic perspective, some of the risks on the horizon, and how those two factors combined affect the global equity and fixed income markets.
Thoughts on the Economy
FS Investment's Chief U.S. Economist Lara Rhame wrote that "Our economy is the combination of hundreds of millions of households making decisions about whether to spend or save." A big part of that decision making is household income levels. As long as consumers have a stable income stream and have confidence that they will continue to be employed, they will tend to spend. Companies stand to benefit from consumer spending – after all that is how they make revenue. At the moment, consumers have shifted to spending on home entertainment (Netflix), eCommerce (something that Apple has done well in), or both (Amazon). Consumers, on aggregate, have also increased saving, either as a precaution for a continued pandemic or simply because they have no-where else to spend (travel, sporting events, bars, concerts). Per the Bureau of Economic Analysis, the household savings rate is 33% - by far the highest it has been since 2000. Once there is a green light for things to start to return to normal, the capital to spend will be there. That is precisely why almost all investors are consistently keeping a close eye on high-frequency economic data, such as purchase mortgage applications, U.S. seated diners, TSA traveler traffic, and hotel occupancy (just to name a few).
In our case, we have been keeping an eye on and providing an update on the Goldman Sachs U.S. Re-Opening Scale Number. Given the rapid increase in Coronavirus cases the week of June 22nd, the composite number dropped down to 58 after being at 60. it is the first drop recorded since mid-April, but it is no-where close to the bottom (36). Categories like dining and retail fell week over week while "stay at home" categories re-accelerated.
Moving forward, how the U.S. consumer continues to behave in a potential second lockdown will be closely scrutinized by investors. Expansion of the unemployment program set to expire at the end of July is a must and what that will look like will matter a great deal to investors and consumers alike. As we have written about it before, the current package has outweighed the income lost - there are talks about reducing the benefits. To what degree those reductions look like will impact not only the economic recovery but the capital markets as well.
We would be remiss to not point out that any sort of additional lockdowns could lead to further unemployment down the road. While June saw an additional 4.8m jobs added, there are still questions remaining about how many jobs truly come back and how many of the currently "temporarily unemployed" group become "permanently unemployed.” Lingering unemployment could erode resilient consumer confidence.
Time will tell how many small businesses will survive - businesses with 1–19 workers account for a third of all employment. PPP funds meant to help small businesses retain workers are close to running out. The longer the virus is out there and there are health concerns and possible lockdowns, the likelier it is that businesses will close. While this does not necessarily have a direct effect on the large-cap companies that dominate the S&P 500, it does directly affect a large consumer base whose wallet share those companies are trying to get.
Policymakers will be in the spotlight as they try to come up with a stimulus package that incentivizes those unemployed to seek jobs while preventing a second income shock that could undermine the progress of the current recovery. The biggest risk to an economic recovery is that jobs do not return fully or quickly. While many investors are optimistic that unemployment peaked in April, there is still no clarity on what the world will look like when a vaccine is created. Because of that, companies will be cautious to hire.
Investors are cognizant of all of those economic considerations. After the initial economic bounce back, there is an expectation that things will slow down. To what extent that it slows down will matter most. JP Morgan believes that the second quarter GDP number will fall by about 40% (annualized), following a 5% decline in the first quarter. They do expect real economic growth to average roughly 5% annualized in late 2020 and early 2021, before accelerating to roughly 10% annualized for a few quarters once a vaccine has been distributed. This is similar to what other economists are saying – the broad expectation is that U.S. economic activity to return to its Q4 2019 peak in the second half of 2021.
Thoughts on Broader Risks
The biggest risk in the capital markets, to no surprise, continues to be Covid-19 related. Possible rise of new cases or lack of a medical breakthrough could extend the economic recession past what is currently expected. In addition, there remain political and geo-political risks. 2020 is an election year and we expect to see headline volatility around that alone. JP Morgan's stress test scenarios suggest that a Republican sweep would result in a 6-month appreciation of the S&P 500 by 3.00% while a Democratic sweep would result in a 3.56% drawdown. In the context of the volatility we saw earlier this year (the S&P 500 notched +/- 4% moves in 17 trading days through mid-June this year vs. an annual average of 3.2 days from 1928-2019), neither of these scenarios stands out as significant. The underlying belief is that if there is indeed a Democratic sweep, there will ultimately be corporate & individual tax reforms which will force a re-pricing in the equity market. Per Amundi Pioneer, if enacted, Biden’s tax reform would reduce our S&P 500 earnings estimate for 2021 by roughly $20 per share, from $170 to $150. All else equal, larger multinationals should fare better than smaller companies, which generally have a higher percentage of domestic revenues. A meaningful reversal in the reduction of regulations during the Trump administration will likely hurt financials, big tech, energy, health care, and any labor-intensive business the most.
At the moment, the market is not yet pricing in risks associated with the potential for a Biden presidency and/or Democratic sweep of Congress. Market volatility can be expected to increase if the likelihood of this scenario increases as the election gets closer. While the current administration does not want to further escalate the trade conflict with China (a quick comment around ending the trade deal sent futures markets spiraling down a few weeks ago), it feels inevitable that post-election this relationship will need to be revisited, regardless of who is in the White House. There is a possibility that the Trump administration pulls out of the trade deal if it appears that they will not get re-elected.
Outside the US, we believe the pandemic could exacerbate political risks in some countries and prompt a major reassessment of corporate finances and supply chains. Tension between Hong Kong and China, as well as India and China, presents its own set of challenges. The pandemic in Latin America and Brazil could lead to further political instability and set those countries economies back as much as five years. De-globalization will continue to expand, which would disrupt certain supply chains but also improve certain economies, especially as certain countries are set to re-open faster than the United States. And, lastly, on top of all of that – there is still the issue of Brexit that needs to be resolved.
Thoughts on Equity
One of the biggest concerns around the U.S. equity market is that of valuation – as of June 30th, the S&P 500 had a Forward P/E ratio of 21.72. In comparison, the 25-year average is 16.39x and the last time the Forward P/E ratio was north of 19.5 was the Tech Bubble of the early 2000s. Given the pandemic, as well as the fiscal and monetary stimulus, valuation metrics are difficult to interpret. T-Rowe Price’s international equity CIO Justin Thomson writes that “Aggregate market valuations have never been more meaningless because of the huge bifurcation between companies that are on the right or the wrong side of change. This is very different from the tech boom we lived through 20 years ago. Today’s winners are backed by superior cash flow and cash‑rich balance sheets.” Collectively, the five largest U.S. technology firms by market capitalization—Microsoft, Apple, Amazon, Facebook, and Google—have more than USD 500 billion in cash reserves. This could lead them to acquire start-ups or young companies that are struggling in this environment. As far as the equity rebound – those five names have a larger market cap than the bottom 340 companies in the S&P 500.
With fixed income rates being at historic lows, and very little growth opportunities in other asset classes, investors from across the world have flooded into the U.S. equity market. Despite all the economic challenges that the U.S. equity market poses, for a lot of investors, it provides a better risk/reward profile than fixed income, and they continue to look to the equity market to garner yield. U.S. Treasury Yield is currently ~0.65%, while the S&P 500 dividend yield is near 2%. Between the growth opportunity and better income opportunity, the U.S. stock market has roared back.
While many investors accept the logic behind the comeback of the U.S. stock market, they do believe that it may have gotten ahead of itself and additional pullbacks could occur. Many believe that for the second half of the year, the S&P 500 will be range-bound (JP Morgan has it trading between 2800-3200) and volatile. That said, this environment continues to favor the major tech companies as they can continue to grow earnings and cash flow and gain market share from weaker competitors.
We, like many investors, will be closely watching the second quarter earnings – there should be more visibility for companies and the expectation is that management will be able to provide guidance. The markets are focused on earnings recovery in 2021 (the current consensus is 50% growth from 2020) – anything that comes out from management to deter that will result in a sell-off; on the contrary, any positive (or less bad) news, will lead to stock price appreciation. Over time, investors will look for earnings to pick up and for companies to grow into their valuation.
In other developed parts of the world, Covid-19 cases have come down and economies have begun to re-open. Changing supply-chain dynamics could force the European countries, like Germany, to produce more of the goods themselves and for their citizens. This economic shift should help them in the long run. Despite attractive valuations, there are still poor fundamentals coming out of Europe, and with the risk of Brexit, investors are keeping a close eye on the region but are not ready to increase their allocation to it yet.
In the emerging market realm, Asia being first into the pandemic is also first out and, aside from a few flare-ups, is closest to returning to “normal.” Stronger global recovery or weaker US dollar will benefit EM equities is a possibility but not base case. Looking at it from a longer-term recovery - cyclical sectors and regions will see a stronger earnings rebound. This bodes well for Europe, Japan, and emerging markets. Covid-19 has created a better entry point into this asset class.
Currently, the U.S. equity market is still the investors’ choice for the risk-on trade. However, if we continue to see the rest of the world outpace the U.S. in economic recovery, international equities may finally be set to outperform the U.S.
Thoughts on Fixed Income
On the fixed income side, the Federal Reserve has provided ample liquidity, both through actual purchases and “signaling” – their intent to purchase. The U.S. Government and corporations are increasing their debt level due to low interest rates. However, cities and states are not as fortunate and have seen their budgets gutted. They may need to see further injection by the Fed into the municipal market so that cities and states are able to sustain themselves. Right now, all indications are that that will occur – this is important from a broad economic perspective as city and state governments employ over 20 million workers. Because of this, the municipal bond market continues to heal from its widespread sell-off in March. Fundamentals have remained healthy while liquidity has stabilized due to Federal Reserve support. These trends should continue and there is an expectation that future stimulus measures will provide more direct financial support for state and local governments.
There is a big question around the rising debt levels in the United States. With interest rates staying low, servicing interest rate debt seems manageable. As with any debt issuance, it is not necessarily how much debt the government (or corporation) has - it is whether they can continue to service it. While the U.S. federal debt levels rising is an issue, it will only become a major problem if global investors lose faith in the government's ability to pay interest on it. In the medium to long term, as the economy improves, the U.S. should look to lower its debt levels – this will be a big challenge to whoever is elected to the White House.
On the corporate credit side - any debt issuance is closely scrutinized and is underwritten only if there is a belief that the company will be able to service it (even if the Fed is providing the liquidity). We still expect a large number of ratings downgrades (which will make the new debt more expensive and harder to service). Default rates are now well above long term averages - as of 6.15, the HY default rate was 6.11%, a 10 year high. Long term default rate for a high yield bond is 3.74%. In the financial crisis, the default rate for high yield bonds topped out at 11%.
With regards to Investment-Grade bonds, through May 2020, 11% of bonds have been downgraded: have been within the IG space while 3.6% have been from IG companies falling into high yield (fallen angels). Notably, this is the fastest pace of net downgrades (9.6%) over the past decade. Net downgrades are expected to reach 13%-15% by year-end.
If we apply the same level of optimism to credit markets as investors have to equity markets, there could still be upside for U.S. high grade corporate and high yield bonds. Spreads (the difference in yield between a bond and its risk-free counterpart) have tightened notably since bottoming on March 23, but high yield valuations are in just the 29th percentile. 100 bps of further spread tightening from here is not an unreasonable assumption and would leave high yield still in the bottom half of historical spread history and quite wide relative to current high P/E ratios for equities.
Final Thoughts
The bottom line is that the sustainability of rallies in equity and credit markets will depend on the trajectory of the coronavirus and the strength of the economic recovery. Unlike in March when investors were, for lack of a better word, “flying blind,” there are a lot more “known unknowns” now which has helped price risk. Second quarter earnings will be closely scrutinized, as will the economic data that comes out in the ensuing months.
On our end – we have been doing a lot of research into ways we can better improve the risk/reward profile of our portfolios and whether any changes are necessary now or down the road. As always, we will continue to be transparent with our thoughts and any ideas that we are evaluating. Please do not hesitate to reach out if you have any questions or comments about anything in this piece.