Economic & Financial Market Review & Outlook- Summer 2020
July 20, 2020
The U.S. is suffering its worst economic downturn since the Great Depression with GDP estimated to have plunged at an annualized pace in excess of 30% in the most recent quarter after a 5% drop in Q1.1 The velocity of the decline is as stunning as its magnitude. This recession was, of course, self-imposed as much of the economy was shutdown beginning in March to halt the spread of COVID-19.
With the partial reopening of the economy in May, data indicate that the economy did, in fact trough in April with a material increase in the employment numbers in May and June. That being said, the June unemployment rate stood at 11.1%, which was down significantly from the April peak of 14.7%, but still higher than during the depths of the Great Recession of 2008-2009. Weekly jobless claims have also steadily declined but remain very elevated with permanent job losses climbing, which is evidence of a significant churn in the labor market. All told, approximately 14 million fewer people are working in the U.S. than in February.2
The recent surge in COVID-19 cases is, of course, of concern. Some of the most important data including monthly employment and consumer confidence are based on mid-month surveys. Consumer confidence also rebounded smartly in June. Business sentiment indicators including the ISM manufacturing and service sector surveys also exceeded expectations. Could this reverse?
The consensus view is for growth to snap back at a 20% rate in the summer quarter.3 The disturbing increase in COVID-19 cases across the South and West, and the resulting mitigation efforts suggests that the recovery will be bumpier than initially thought. However, such measures are unlikely to be as drastic as what transpired in the spring and the increase in economic activity should still be quite substantial. Growth should moderate in the following quarter and continue into 2021 but a complete recovery in output to peak levels and a return to full employment is unlikely to occur before 2022 or beyond. While the descent from steady growth into a severe recession was virtually instantaneous. It is clear the road ahead to recovery will be long and arduous given the massive disruption from the virus and the challenges it poses to our way of life, and the way of doing business. While the reopening thus far indicates huge pent up demand from consumers to get back to restaurants and to travel, some changes are likely to become more or less permanent. The trend towards a digital economy has obviously accelerated. Major elements of our health care system will need to be reassessed. Many consumers have experienced a shock unlike anything felt previously.
In this environment, one would expect investors to exercise great caution. In reality, risk aversion lasted for a little more than a month, if that. While the U.S. was in the deepest recession of a lifetime during the June quarter, financial market returns were nothing short of spectacular. The S&P 500 Index, with a gain of 21%, turned in its best quarterly performance in more than two decades while bonds posted solid gains with the riskiest sectors outperforming their benchmarks.3
The positive response of the markets is not without precedent. Financial markets are forward looking, discounting mechanisms. The stock market will typically decline as the economy peaks and monetary conditions tighten while bull markets often begin in recession as monetary and fiscal stimulus is applied. What was unprecedented was the massive scale and scope of the Federal Reserve and the Federal Government’s response to the economic shock from the Coronavirus pandemic. The Wall Street adage of “Never fight the Fed (Federal Reserve)” was never better illustrated.
During March, the Fed cut the Federal Funds (overnight) interest rate to near zero and resumed quantitative easing via the purchase of long-term bonds. In addition, it announced a broad array of facilities to shore up nearly every segment of the credit market including municipal bonds, corporate debt, and even junk bonds. The programs were expanded and refined during the recent quarter and include direct lending in addition to secondary market purchases. Congress enacted a $2.5 trillion support package which included a small business lending program, cash payments to low- and middle-income taxpayers, supplemental unemployment benefits, in addition to aid to state and local governments and loans to severely impacted industries.
These programs have been essential in keeping many consumers and businesses afloat and will need to be extended if the U.S. is able to return to sustainable growth in a relatively short time frame. The Fed, for its part, has indicated that its commitment to provide stimulus is open ended. In his June press conference, Fed Chairman Powell emphasized that the Central Bank’s priority is to restore lost jobs. Additionally, the Fed insists that it will continue to strive to boost inflation to its 2% target. It will be at least two years, or more likely, even longer before the Fed scales back its support for the economy. Congress and the Administration still need to agree on additional aid. The small business lending program was extended until early August and is likely to be renewed through year-end. However, the supplemental unemployment benefits will expire at the end of July and their extension has been more controversial. Additional support for state and local government is also needed to avoid layoffs of government workers. All told, an additional $1 - $2 trillion will need to be appropriated to prevent further economic damage.
Our assumption is that additional fiscal support for the economy will be approved. Another important factor is containment of the disease and recent trends have not been favorable. Investors are looking past this recent spike and we are optimistic that progress on treatment will continue as well as on the development of an effective vaccine to be widely available in 2021. Of course, there are no guarantees.
While we are reasonably confident that a return to sustainable growth will occur by 2021, the strength of the rally has made the market outlook more challenging. Stocks are not cheap. Investors are clearly looking past a 2020 earnings disaster with a probable decline for the S&P 500 Index of at least 25% to $122 per share. Should 2021 earnings recover to our single point estimate of $155 per share, the S&P 500 Index is trading at a lofty P/E ratio of 20x next year’s earnings compared to a historical average of 16x.5
Washington Trust’s valuation work for stocks currently employs a price/earnings multiple range of 15x to 19x. The high-end of our “normal” valuation range has now been exceeded in a period of great uncertainty. Are stocks overvalued or is it different this time? The Federal Reserve has investors’ backs as never before by clearly signaling that they will hold interest rates near zero through 2022. Fed policy is also suppressing longer-term rates across the yield curve and will keep markets awash in liquidity. The Central Bank is effectively encouraging investors to move out on the risk spectrum. While monetary policy risk appears off the table, other risks still abound. Our banking system is well capitalized compared to past crises, but questions remain. While central banks can ensure liquidity, they cannot ensure solvency and a distressing number of bankruptcies are in the news. Additional fiscal support from the Federal Government is still needed near term. Medical progress against COVID-19 is required but not assured. Finally, the litany of geopolitical risks moved to the back burner due to COVID-19, but has only intensified.
Three months ago, coming off a 20% loss in the first quarter, we recommended investors take a long-term view regarding asset allocation and to maintain equity exposure. We had no expectation of a 21% rally in the subsequent quarter. The same advice still holds. At this time, however, investors may want to be sure they have sufficient liquidity looking ahead and, perhaps, trim equities if they are at the high-end or have exceeded targets.
The views expressed here are those of Washington Trust Wealth Management and are subject to change based on market and other conditions. Investment recommendations and opinions expressed in these reports may change without prior notice. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. Investing entails risk, including the possible loss of principal. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions.
Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments, including floating rate bonds, involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. Past performance does not guarantee future results. The S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock-market performance. In addition, the S&P 500 Index cannot be invested in directly and does not reflect any fees, expenses or sales charges. Further, such index includes 400 industrial firms, 40 financial stocks, 40 utilities and 20 transportation stocks. The information we provide does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. Please consult with your Portfolio Manager, Financial Counselor, attorney or tax professional regarding your specific investment, legal or tax situation.
1 Bloomberg, Bureau of Economic Analysis
2 Bureau of Labor Statistics
4 Washington Trust Wealth Management