“In investing, what is comfortable is rarely profitable.” - Robert Arnott
We hope all is well with you and your family and that you are staying safe and healthy. The markets around the world have experienced a dramatic recovery in the 2nd quarter of the year. All three major indices, the Dow, S&P 500 and Nasdaq, had their best quarter in more than 20 years. The level of volatility was also reduced with only one trading session when the market was down more than 4%. As expected, “growth” oriented stocks have continued to outperform their “value” counterparts given the level of resiliency of this category that we observed in March and April of this year.
The table below summarizes the performance of various domestic equity categories over the past 3-month, 12-month and 3-year periods.
The broad U.S. equity market remained one of the strongest performers in the 2nd quarter of the year. The relative performance of the major markets remained very similar to what we reported in our 2020 Q1 commentary. Developed markets, as measured by the MSCI EAFE Index, were up +14.90% for the quarter (-11.37% year-to-date). Emerging markets as a group were up +19.90% for the same time period (-9.53% year-to-date) as reported by the FTSE Emerging Markets Index. Shares of some of the most prominent Chinese companies increased by +15.13% for the quarter and achieved a positive rate of return of +3.20% for the first half of the year.
Most of the economic updates in the 2nd quarter turned out to be either positive, or at least not a negative as originally anticipated. The unemployment rate fell to 11.1% in June compared to 14.7% and 13.3% in April and May, respectively. This is a far cry from where we were prior to the pandemic but still represents a positive trend in the right direction. The enhanced employment benefits under the CARES Act are set to expire at the end of July. There is a possibility that they will be extended by Congress. One of the proposals calls for gradual reduction in employment benefits once the unemployment rate dips below a certain level. Some question the effects of such policies on the overall labor participation. According to the analysis performed by the economists at the University of Chicago, approximately “68 percent of unemployed workers who can receive benefits are eligible for payments that are greater than their lost earnings”.
The unprecedented level of liquidity infusion by the Federal Reserve significantly reduced the volatility of the domestic bond markets. The Barclays Aggregate Bond Index, one of the main indices for the domestic bonds, returned +2.91% in the 2nd quarter of the year. More aggressive bond categories such as total return and high-yield also posted mostly positive returns for the same time period. The yield on the 10-year Treasury bonds remained at a level of between 0.60% and 0.70% and we expect interest rates to remain this low for at least several quarters.
Domestic Gross Domestic Product (GDP) contracted by -4.8% annualized in the 1st quarter of the year (the 2nd quarter results will be available at the end of July). The 2nd quarter growth is expected to be negative. Most economists and financial institutions are predicting the growth in 3rd and 4th quarters to be positive and in some cases even in double digit percentages. In terms of the full year expectations, the GDP is expected to decline by -3% to -6% with a wide range of expectation of between -2% and -9% depending on the outlook of each forecaster. Most analysts base their expectations on the severity of the potential coronavirus outbreak and related lockdowns. Potential continuation of trade wars with China, nationwide protests and upcoming presidential election in November seem to be secondary at this time.
One of the most common questions and comments in the last quarter was about the shape of the potential recovery. There are multiple points of view between the most bullish “V-shape” and most bearish “L-shape” expectations. The imagination of the financial community created many other options such “W-shape”, “U-shape” and even a “swoosh” or Nike logo-like types of recoveries. Given the unprecedented level of uncertainty, it is possible to envision scenarios for each of these opinions. The market performance in the 2nd quarter of the year appears to resemble that of a relatively quick “V-shape” like recovery. It certainly did not apply to every asset category and we do expect the market volatility to remain in place for a while.
There is little consistency in the definition of the word “recovery” and it changes depending on the context of each analysis, outlook or white paper.Some focus on the historic unemployment rates and conclude that no sustainable market recovery is possible unless the unemployment rate is reduced to a mid-single percentage. Others claim that we are already in the “new normal” and forecasts should be based on where we are now and not in comparison to the pre-COVID figures and expectations. It would be fair to observe that, unfortunately, there has been a significant disconnect between the growth of the economy and stock markets. This has been the case prior to the coronavirus pandemic and applies to both developed and developing nations. The chart below shows the distribution of wealth in the United States.
We anticipate that many of our clients will inquire about our opinion on the upcoming presidential election. Naturally, the pandemic and its effects on the economy have been on the forefront over the past several months. The markets have been gradually shifting their attention from COVID-19 to other issues, including politics. We have seen multiple articles that specifically talk about how to invest or adjust portfolios for a Biden presidency who appears to have a strong lead in polls at this point. We find it interesting that most professional and institutional investors are obviously aware of the polls but not much has happened in terms of market readjustments in June. Healthcare stocks and giant companies such as Amazon have been doing just fine. Major banks are down based on the Fed stress test results but nothing unexcepted with the exclusion of Wells Fargo that reduced its dividends by 85%. Infrastructure stocks haven’t been doing very well even though they are considered to be some of the beneficiaries of a potential “blue wave”. Perhaps the consensus is that Mr. Biden would not shift to the extreme left and instead, at least initially, focus on the economy. We would expect the market reaction to be much more negative otherwise.
As we briefly touched on earlier in this commentary, our base case scenario calls for continuation of the market volatility until the end of the year. Given what we learned about the dangers of coronavirus, we believe that we are better prepared for potential increases in infection cases in the fall (or even earlier). Plus, there is a strong possibility that we could have a vaccine later this year, although most likely in limited quantities and available only to those in immediate need. In short, we do not expect the repeat of the March sell-off later this year.
Our goal is to fully rebalance our managed portfolios back to the targets per the investment policy in July. This would be completed as part of our normal semi-annual procedures. Our main objective is to prepare our portfolios for more market volatility later this year. We also want to ensure that we can take advantage of any unexpected market turbulence just like we did in March and April of this year (i.e. buy low).
Given the market rally in the 2nd quarter of the year, we no longer see many bargains in the stock market and expect to reduce the allocation to equities in most of our managed accounts. Depending on the objective of each client, we may include funds that invest in growth-oriented companies that pay dividends and have a strong history of increasing their payments. We also see limited opportunities on the fixed income side and mainly consider this portion of our clients’ portfolio as a “buffer” for their current and/or future cash needs.
We believe our time-tested cash-flow based approach to investment management is the best way to handle both “bull” and “bear” markets, regardless of the volatility. Your specific allocation should always be adjusted for your personal circumstances and our cash-flow based approach provides a strong and unbiased foundation for these decisions.