Don’t follow the crowd, because nobody goes there anymore. It’s too crowded. –Yogi Berra
Equity investors have been on quite a roller-coaster ride this year. After hitting an all-time high in February, the S&P 500 Index plunged a gut-wrenching 34% over the next month, marking the quickest bear market in U.S. history. Smaller company stocks did even worse during that period, losing more than 40%. Thankfully, because our client portfolios were not fully invested in equities prior to the decline, our average client account did not experience the full brunt of the volatility. However, the flip side of that conservative allocation means we also didn’t experience the equally surprising and gravity-defying upturn. From the March low, the market roared back to make a new high in September. Talk about whiplash.
However, there is a major bifurcation beneath the surface. The tech heavy Russell 1000 Growth Index is up 15% on the year, but its more conservative Value sibling is down 14%. That’s a stunning 29-percentage-point difference and ranks as one of the widest variations in style returns ever. Historically, wide variations in style differences have been resolved by reversion to the mean over time. If it holds true in this case, either Growth will see future weakness, or Value will strengthen, or some combination of the two.
We don’t rule out the possibility U.S. stocks could revisit their March lows (2,237 on the S&P 500) and if it appears that possibility becomes likely, we would be ready to adjust portfolios as necessary to ensure their long term stability. In the meantime, we like how our portfolios are positioned with attractive medium- to longer-term return opportunities, balanced with shorter term income protections.
WHERE DO WE GO FROM HERE?
THE PRESIDENTIAL ELECTION COULD CAUSE INCREASED VOLATILITY
Between now and year end, there is a risk of increased volatility from the uncertain outcome of the Presidential election. At present, it appears from polling the race is becoming more closely contested. All indications point to a much larger than usual mail in vote as a result of virus concerns, and the biggest risk to the market is a very drawn out and contentious vote count that leads to a narrow victory by either party. That outcome could instigate a legal battle that might even extend into the New Year. The investment markets can thrive under either political party, and actually perform best with a split government of checks and balances, but will react negatively to extended uncertainty.
COVID-19 IS THE MOST IMPORTANT VARIABLE EXTENDING INTO 2021
As always, we see a range of potential economic and financial market outcomes looking ahead over the next six to 12 months and beyond. What is unique about the current environment is how dependent the outcomes are on the course of COVID-19. Significant uncertainty remains as to the virus’s progression, even as economies around the globe have begun varying phases of reopening and relaxing social distancing standards. The timing, availability and effectiveness of treatments and vaccines are also highly uncertain but crucial variables for the economic outlook.
In our view, the key risk to the economy and financial markets is the potential for a widespread second wave of COVID-19 infections, hospitalizations, and deaths that force another large-scale economic shutdown. In that event, stocks could re-test their March lows. But absent a severe second wave (or some other major exogenous shock), and even assuming there are smaller localized outbreaks, we think an uneven but steadfast economic recovery is the most likely scenario looking out over the next six to 12 months at least.
MONETARY AND FISCAL POLICY ARE ALSO KEY
While we view the progression of COVID-19 as the most important driver of the 6 to 12 month economic and market outlook, monetary and fiscal policy are second-most in importance. And, in the policy sphere, the Fed is key.
After the Federal Open Market Committee (FOMC) meeting in September, Fed chair Jerome Powell made it very clear the Fed intends to keep monetary policy extremely accommodative at least until 2023. Powell said, “We are not thinking about raising rates. We are not even thinking about thinking about raising rates.”
In order to achieve that accommodative policy however, global central bank balance sheets, in aggregate, have increased to a record 38% of global GDP. The Fed’s balance sheet stands at a record 33% of U.S. GDP and climbing. Similarly, the European Central Bank stands at 44% of GDP and the Bank of Japan’s balance sheet sits at a whopping 118% of Japan’s GDP.
GIVEN ALL THIS STIMULUS, IS INFLATION A RISK? NOT NOW, PROBABLY LATER
We do not view wide ranging inflation as a near-term risk because there is too much slack in the economy due to the demand shock from COVID-19. It will take a while—likely a few years at least—for the economy to get back to operating at full capacity and full employment. While there is evidence of inflated prices in certain portions of the supply chain (a single 2×4 costs $6 today for example), the slack should restrain consumer price inflation and wage inflation.
As we saw in the aftermath of the 2008 financial crisis, the Fed’s liquidity largesse showed up in price appreciation for financial assets, rather than in price inflation in the real economy. We see this as likely to replay again.
However, there is a strong risk these policies will translate into inflation if they remain extremely loose after the economy reaches full capacity and full employment. The Fed is signaling it won’t act preemptively to curb inflation in this cycle and has even stated its outright intention to let the inflation rate “run a little hot” if necessary to ensure economic recovery.
The Fed is also apparently content to effectively monetize the debt created by government deficit spending. If the Fed continues these policies beyond the COVID-19 crisis, it runs the risk of falling behind the inflation curve. This could lead to an inflationary surprise and a sharp repricing of assets. We will be watching closely for evidence of inflation as this cycle unfolds and we have added inflation protection to most client portfolios in the form of Treasury Inflation protected Securities and gold.
So where does this leave us?
We hold a cautiously optimistic view that even with an inevitable uptick in COVID-19 cases in coming months, the overall social policy response won’t need to be as draconian, and therefore the economic impact won’t be as bad as during this first wave. If the latter public health scenario plays out against a backdrop of extremely loose fiscal and monetary policy, there is a good chance we’ll get a sustainable, albeit uneven, global economic recovery.
If so, corporate earnings are likely to rebound as well. Measured against very low interest rates—and with fears of severe recession (or worse) off the table thanks to the policy response—this would support the view that equities and fixed-income credit sectors are attractive compared to short term cash.
We would also not be surprised to see a continued reopening of global economies, and increased earnings growth spur value/cyclical stocks to take the leadership reigns from growth stocks, potentially marking a new cycle of relative performance in favor of value. Our portfolios would benefit from this change in leadership.
As always, it is important to be invested in a portfolio aligned with your risk tolerance and financial goals. Please don’t hesitate to reach out to our team to update your financial plan or discuss your individual portfolio at any time.
Randy has more than 15 years of experience managing financial assets for individuals, retirement plans and businesses. Randy joined YHB | Wealth Advisors in January of 2018 and serves as the Director of Wealth Management. Prior to entering the professional wealth management field, he enjoyed building entrepreneurial business ventures from start-up to eventual sale and providing accounting services for public and private firms.