9 minute read
The following is a summary transcript of our quarterly commentary video. If you haven’t seen it yet, we invite you to view below.
Believe it or not, 2020 is now more than halfway over. And it is time for our quarterly investment commentary and midyear outlook.
Second Quarter Recap: Staying the Course Was Challenging but Paid Off
So, let’s start off by explaining what happened to the markets in the second quarter.
Second quarter was all about recovery. The markets bottomed out in March and then had a rise of over 20%. It went back to “risk-on” when the markets realized that interest rates were going to be at low levels for an extended period of time. “Risk-on” meant buying all those assets that had been sold off and putting capital back to work. If anyone was planning to rely on cash or Treasuries for their source of income, that was going to be close to zero. The third quarter will continue to be about the recovery.
Help us appreciate the movement from tough in March/April to near record highs in June. How did we get there?
The market hit the low on March 23, down significantly off its highs. Right when the lockdown was beginning, we saw terrible economic data as many expected. And it looked like we were going into a recession or even depression. Learning lessons from 2008, the Fed took no chances and moved quickly. The bond buyback program started as a capped amount and then went unlimited. Simultaneously, the government provided the CARES Act. Since then, we have had an unprecedented amount of stimulus globally, 534 initiatives to be exact. Clearly this signaled that everyone was erring on the side of doing more. All this effort proved helpful and allowed us to focus on the medical impact of the pandemic.
The bond market reacted favorably, which has helped the equity markets rise as well. The equity markets are up 30+% off their lows and only down a couple percent now. So even though it has only been several weeks, this has all felt like an eternity.
What was the driving force behind the market movements?
The low yield environment is not a reliable return indicator for individuals’ retirement plans. Many of the retirement plans have a stated required rate of return of 5% or 7%, and you are not going to get that with only exposure to fixed income. So many investors went risk-on, or put money to work in areas that would provide a better rate of return such as in the companies that would benefit from the stay-at-home orders. Notably, larger tech companies and U.S.-based retailers such as Lowes, Target, and Walmart.
How challenging was it to weather the volatility?
The hardest thing to do is buy low, because this requires a discipline to buy in the face of really bad news. In 30 years, this situation had the worst potential. Clients were understandably uneasy, and the last thing we were going to do is let them sell low. So, we had to help them navigate through this. It does seem like we now experience the “100-year flood” event every ten years. The 2008 crisis was indeed severe but, like this one, it required discipline to stick to the plan. It is hard to see the light when you are in the eye of the storm. This latest crisis was a steep and fast decline, but the ride back up was also fast. Over time, the best course of action is to stick to the plan.
What Did the Fed Do and Was It Enough?
Which Fed policies were enacted during the quarter?
The Fed instituted six credit facilities, ranging from Treasuries and municipal bonds to corporate bonds, to main street, to the Payroll Protection Program. Each of these are targeting a specific sector of the fixed income market. They served as a backstop. As many know, credit allows companies to thrive and grow, and it was important to ensure these areas of the economy were protected.
Do you expect the Fed to do more? What else can the Fed do?
The Fed has done extraordinary things already. Through its six mandates, the Fed expanded its balance sheet by $3 trillion. They intend to maintain the purchases of corporate bonds and other assets. This means a massive source of liquidity in the market. And remember, whoever they buy from now has cash to buy something else. As we have spoken about, the light at the end of the tunnel is getting brighter and this is in large part due to the Fed’s actions. Many of the economic statistics we tracked in June far exceeded the estimates to the positive, which portends an economic recovery.
So Much Info on the Pandemic Data, What about the Economic Data?
Which economic data points related to the economy were most meaningful?
We saw the first quarter GDP come in at negative 5%. And that only represented about three weeks of March. The second quarter plunged, and we are seeing estimates of 30% contraction of GDP for the quarter. The most current economic number is the jobless claims. This number still shows a very uncomfortable total. We need to start seeing continued improvements. And many of these numbers are now closely related to the numbers of the virus. Case and death counts translate to the opening of businesses and schools.
Are there some hidden dangers in the data?
For the pandemic, the data we see is sometimes suspect, or at least worth looking into. For instance, the case count of the virus is based on the date reported not necessarily the date of infection. Moving averages help normalize for that.
When looking at economic data it is important to remember that it is a backward-looking point in time. Especially in times like this, it is important to remember that we need to be more concerned with what is in front of us.
What data points are we monitoring going forward?
Right now, we are closely monitoring employment. The June increase showed a rebound. But what is more important is looking at the trend. The key data points will be the weekly initial jobless claims and the manufacturing and non-manufacturing service numbers. There has been a nice surprise on the upside. We historically see the market tend to oversell on bad news, which is where we were early in the quarter. The current data tells us it wasn’t as bad as markets predicted. We will closely be watching the trend.
How is the election playing into our view of the economy?
No doubt, the election will play a big role this year. One of the big movements in the markets are the corporate tax rate plans. The president isn’t the biggest component, it is the House and Senate. If all three swing to the Democratic party, the market would likely be concerned with re-regulation. This could impact industries adversely but could lead to buying opportunities for us.
Looking at the Various Asset Classes: U.S. Equities and Beyond
Equities have done fairly well, what else can you share about the strength of the equity markets?
It has been a little unusual because the big companies have rebounded the strongest. Small businesses were predominantly shut down, which in turn caused the biggest transfer of wealth from small business to big business. Big businesses – Lowes, Target, Walmart – remained open and therefore did really well. This also created a situation that was very different from past events, which was big businesses were leading the way out of the recession. Usually it is small businesses that lead the recovery. From an investment standpoint, most of our U.S. allocation was already in big business as we were starting to get defensive for a potential recession, albeit our belief was that this wasn’t necessarily going to occur in 2020. That said, we went into all this already well-positioned. The big cap stocks, mostly led by the large tech companies, are positive for the year. Yet the rest of the S&P 500 is down 10% or more. And for our clients, most of our U.S. exposure has been in the S&P 500 and we still think that is the best place to be as we anticipate a choppy recovery. Every time there is a pause in the recovery, the big companies will likely fare better than the smaller companies.
What is going on in the bond market?
March 23 was a day that will forever define this crisis. That is the day the Fed essentially backstopped the bond market. They knew (from past experience) that if the bond market wasn’t functioning well, there would be no chance for the economy to make it. The Fed’s action started with treasuries, then mortgages, and for the first time ever they are buying investment-grade corporate bonds, muni-bonds, and high-yield bonds. And as noted they are purchasing an unlimited amount. As a result, the bond market is functioning well. Companies are able to raise capital, even riskier companies like cruise liners. Back in 2008, many of these companies would have gone out of business. Now they can sell bonds to the Fed to raise capital and keep operations going. As we position our bond exposure across our portfolios, we want to be where the Fed is actively purchasing bonds.
Also, the Fed took interest rates all the way down to zero. Makes it difficult for clients to find yield. The 10-Year Treasury is at 0.65%, which is historically low. Corporate bonds are also trading at record lows of 1.25% and 1.50%. Even with very little yield we believe that the Fed’s involvement mitigates the risk to some degree, and so the bond market still holds some attractiveness for investors.
How are we viewing emerging markets and international investments vis a vis the U.S.?
As we have mentioned in past commentaries, the U.S. has really been the best place to be in the past few years. Much of this has to do with the large technology companies – Amazon, Facebook, Google, Apple – which reside in the U.S. China has some companies that are similar, but for the most part big tech is in the U.S. and has been driving growth globally. We still like the U.S. the best, but the valuations are really high compared to international companies. Emerging markets have potential for growth. China was of course the first country that went into the pandemic, but it is also the first one out and we are seeing a recovery there in terms of the emerging markets numbers. Brazil, on the other hand, is in the middle of the pandemic so they are seeing some downside. It is a little choppy across the international front, but we like emerging markets and international developed. They have lagged the U.S. but it makes sense to have some exposure outside the U.S. as the valuations are more attractive.
Looking Ahead: Choppy Improvement on the Horizon
How would you summarize our general portfolio positioning heading into the second half of the year?
We want to be able to play offense and defense at the same time. We know we are not out of the woods yet. The second quarter will likely go down as the worst quarter in history, with the markets down 40% to 50%. We are however seeing the numbers really improve. Whether it is housing starts or auto sales, manufacturing indexes, we are seeing some signs of recovery. Also, we have seen about one-third of the jobs come back. Continued choppiness with the eventual trend of improvement. On the topic of offense and defense, we like stocks as offense (particularly large U.S. companies), and defensively on the bond side, we like the categories where the Fed is involved. And our third area of investment is in the income-producing categories such as real estate. For defense, I would also add that we have been invested in gold as a hedge against interest rates. Now we are focused on when we can get back to normal which we are pegging as the fourth quarter of 2021. The market is not as cheap as it was and is now trading at 18-20x earnings; but interest rates are super low, so there is no easy investment so to speak. The risk-free investment is at zero and we think it could stay that way for a long time.
The third quarter is “risk-on” and we want to maintain our equity exposure. If things deteriorate badly, we will make adjustments. But our base case is predicated on an improving economic environment. Some areas will no doubt have a hard time, including retail and commercial real estate.
For our clients’ portfolios, it starts with diversification and owning different investments, some that have offensive attributes and some that have defensive attributes. The defense provides some stability if there is a hiccup along the way. By the same token, the offense provides some upside potential.
Again, we are here and ready to do our best to answer any questions you may have or to just simply talk things through at times when you feel it may be helpful. We can navigate this current together; we are here for you.