News & Insights

It is quite clear that as COVID-19 goes, so goes economic activity, which leads political response and tests the remarkable ability of people to adapt.

The path of the virus over the past few months is evident when examining what is surprisingly fairly solid economic data. Fourth quarter GDP grew 4%, capping a year that saw GDP fall 3.5% as large sectors of the economy, particularly travel and hospitality, were off limits to consumers. After COVID-19 case counts declined during the summer, a resurgence of the virus in the late fall and through the holidays spurred the reimposition of stay-at-home orders and retail closures for restaurants, gyms, and other gathering places. With less opportunity to move about, consumers still boosted their spending a respectable 2.5%, but this was short of what economists expected during the critical holiday season.

In 2020 governments around the world responded to COVID-induced economic shock with fiscal rescue policies that injected trillions of dollars into their economies and added similar amounts to sovereign debts. The Department of the Treasury’s Data Lab (datalab.usaspending.gov) recently estimated the total bill for U.S. fiscal relief at $2.6 trillion of stimulus plus $900 billion of tax relief, for a total of $3.5 trillion. That total grows closer to $4 trillion including the stimulus that President Trump signed in December.

On January 5, a surprise result in the Georgia Senate runoff turned what initially looked like a mixed U.S. election result into a “blue wave.” With a willing Congress behind him, President-Elect Joe Biden has promised to make more fiscal stimulus his top priority, proposing a $3 trillion stimulus and infrastructure plan.

As we wrap up 2020 it is worth highlighting what a roller coaster year it was for the market. Midway through December the S&P 500 has advanced more than 13%, a result that ap­peared highly unlikely during late March when shares fell sharply on COVID-19 fears. However, the market is forward-looking and global support in the form of fiscal and monetary stimulus has helped drive markets higher since the spring. Currently, the prospect of further stimulus combined with the fastest development of a vaccine ever recorded has boosted investor optimism and provided hope that a return to a more normal environment is on the horizon.

While several vaccines are on the way, the U.K. was the first country to authorize the Pfizer-BioNTech COVID-19 vaccine, starting distribu­tion on December 8th. U.S. health regulators authorized use of the same drug on December 11th with the first vaccinations taking place December 14th. Initial supplies of the vaccine are limited, but production is expected to increase meaningfully over the next several weeks. Pfizer shipped out three million doses initially with an expectation of 25 million doses available in the U.S. by yearend. Health workers are first in line for vaccinations followed by other higher-risk populations. Americans are expected to broadly be able to get the vaccine by the end of March

The election season is almost over, with a few disputes remaining to be resolved along with several incomplete congressional elections. Control of the Senate is up in the air, with 50 Republicans and 48 Democrats seated and two runoff races in Georgia set for early January.

Voters opted for divided rule. Democrats picked up the White House and at least one Senate seat, and retained control over the House. Republicans added one governorship and several state legislatures, sharply narrowed Democrats’ majority in the House, and likely retained a slim majority in the Senate. Neither party has run the table; both parties will have to work together to accomplish anything. This setup increases the odds of cooperation, moderation, and stability, a rarity in these partisan times.

We have a long way to go, but so far the post-COVID economy looks surprisingly robust. If colder weather does not bring a resurgence of the virus, then it feels safe to say that we are firmly on the road to economic recovery.

From peak to trough, U.S. GDP contracted by 10%, the third largest decline since at least 1910. The second-quarter average was -9%. More recently, September’s unemployment report published by the Bureau of Labor Statistics measured unemployment at 7.9%, down from a peak of 14.7% in April. This probably overstates the rebound slightly, as the labor force participation rate ticked down to 61.4% and is about 2% below its pre-pandemic levels. Some workers have stayed on the sidelines and aren’t counted as unemployed.

While the economy had a rough time in the first half of 2020, the recovery since stay-at-home orders began lifting has been much swifter than expected. GDP contracted at an annualized rate of 31.7% in the second quarter but since June has rebounded strongly. As of September 16th, the Federal Reserve Bank of Atlanta’s GDPNow third quarter GDP estimate calls for annualized growth of 31.7%. Continued recovery will depend on the rate of new COVID-19 cases that, for the most part, have continued to decline, encouraging states to loosen restrictions on service-based businesses such as restaurants and gyms.

Other economic indicators confirm the recovery while at the same time differentiating the impact of COVID-19. The August Institute for Supply Management index of manufacturing rose to 56 from 54.2 in July, extending its rebound since the 41.5 level of March (above 50 signifies growth, lower than 50 contraction). Commerce Department figures show that monthly spending on goods for July is 6.1% above February’s peak level while spending on services has fallen 9.3%. This dichotomy reflects pent-up demand for goods that would have been purchased during business lockdowns while also reflecting the inability and/or lack of desire of consumers to purchase services like air travel, restaurant meals and haircuts.

Uncertainty makes people uncomfortable, and there is plenty of uncertainty to go around. The virus continues to stubbornly stick around; we don’t know how widely it will spread if schools and colleges are opened to in-person learning; we don’t know if one or more vaccines will be effective; and then there is an election this fall in case you haven’t heard.

It is said, “The market runs from uncertainty.” Yet the S&P 500 and NASDAQ indexes just reached all-time records. The Dow Jones Industrials Average is about 5% below its all-time high while the Russell 2000 index of small stocks is 8% below its high. Stock indexes at all-time highs don’t sound like a market running from uncertainty!

“If you see that kind of disconnect, it doesn’t go on indefinitely. Those normally will get reconciled, and this will too.”

These were the words of Federal Reserve Board Bank of Dallas President Robert Kaplan when interviewed by CNBC on July 13th. He was referring to the disconnect between the financial markets, with an upbeat view of the future, and the performance of the economy, which remains under stress. The question for investors, of course, is will the markets move towards the economy or the economy towards the markets?

The U.S. has officially tipped into recession, defined as two straight quarters of negative economic growth. Q1 GDP contracted at a 5% annualized rate. Q2 will feel the full brunt of lockdown. Trading Economics reports consensus Q2 GDP growth estimates as -17%. Continuing jobless claims are hovering in the 21 million range, more than ten times their pre-pandemic level. Supplementary unemployment benefits of $600 per week are scheduled to cease at the end of July, unless lawmakers negotiate some kind of modified extension. It won’t be easy to spur a broad-based return to work. The jobs have to be there, and people have to be incentivized to accept them.

The stock market, meanwhile, is anticipating a robust recovery. After a jarring 35% March plunge, the market’s subsequent recovery has been just as stunning. The S&P 500 is currently down just 4% on the year. The Nasdaq 100, burgeoning with beloved, recession-resistant software companies, is up 13%. Japan’s Nikkei 225 has performed similarly to the S&P. European stock averages have been a little weaker, mostly down low-double digits so far this year. Valuations were not exactly cheap before the pandemic started. So what happens next?

After a dizzying late February and March that saw the stock market fall into bear market territory (down 20% or more) at the fastest pace in history, the recovery from the S&P 500’s low of 2,237 on March 23rd has been almost as breathtaking, a roughly 30% advance. For 2020 the index is down about 10% for the year, substantially better than might be expected given the health and economic damage inflicted by the COVID-19 pandemic.

Recent statistics on the health impact of the virus are daunting. Johns Hopkins’s COVID-19 dashboard reports over 4.2 million cases worldwide and approximately 290,000 deaths. The U.S. alone now has over 1.35 million cases and approximately 81,000 deaths, 27,000 of which have occurred in New York State. The human toll COVID-19 has wrought is tragic.

The S&P 500 followed up its more than 30% total return in 2019 with a decline of 20% in the first quarter of 2020. That understates the severity of the move, as small- and mid- cap stocks were down 30%, and at its lows the S&P 500 was 35% off its recent peak. In March, the S&P 500 moved an average of 5% per day, the most of any month on record.

Nobody is certain about the extent of the damage done to the economy as a result of efforts to combat COVID-19. We do know that there has been a severe demand shock that will result in a sharp economic contraction and a meaningful decline in corporate earnings. In response to these concerns, the Federal Reserve Board, Administration, and Congress moved to support workers and businesses with programs to preserve as much of the economy as possible while large portions of the country are shut down.

We are all concerned about the potential impact of the coronavirus outbreak on our families and friends, particularly those who are elderly or who are already dealing with other medical issues. We hope you are well and urge everyone to exercise appropriate caution. Although it is uncomfortable to lose our social avenues, we hope the closing of public facilities will severely limit the opportunity for this virus to spread further.

Investment Comments typically focuses on economic and market developments, and the outlook. Recent economic statistics primarily reflect the pre-coronavirus economy, which is now a matter of historical record rather than an indicator of where we are headed. The economy has clearly taken a hit—we can see it with our eyes, and the market movement has confirmed it.

In January, after spending much of two years wrestling with trade issues, the U.S. signed two important pieces of legislation. The first, and likely more important, is the United States-Mexico-Canada Agreement, an update to NAFTA covering trade rules for North America. The second was a “Phase 1” agreement with China that reduced the likelihood of further tariff escalation and laid out a negotiating timeline to work through difficult discussions such as protection of intellectual property. The markets breathed a sigh of relief and began to rally on the thinking that businesses could now rely on (relative) certainty of trade and tariffs to support long-term product sourcing decisions.

Then along came the coronavirus (COVID-19). According to the World Health Organization, as of February 18, the virus has sickened more than 73,000 and killed 1,853. With most of these cases concentrated in the country of origin, China, the world has responded with various degrees of isolation. More than 30 airlines have suspended service to China and a 78-nation matrix of rules and quarantines from the U.S. to Singapore have all but banned Chinese travelers from foreign soil.

The S&P 500 produced a total return of 31.5% in 2019.  That huge advance is particularly astonishing considering that aggregate corporate earnings barely grew at all.  According to the 1/10/20 edition of FactSet Earnings Insight by John Butters, analysts expect full-year 2019 earnings to average a meager 0.2% growth with revenue growth of 3.9%.  Roughly speaking, this means the year’s entire rally is currently manifested in higher P/E multiples.  We can think of some reasons why the current investment climate supports higher valuations than the climate of just 12 months ago, but 31.5%? That is a lot to explain.

For starters, those modest corporate growth numbers are a bit of a red herring, weighed down by low energy prices and industrial sector softness that will probably turn out to be temporary.  More on this below.  Overall, the U.S. economy remains on solid footing.  Measured unemployment is holding steady at 3.5%. Normal wage growth is running at approximately 3%, fairly strong.

This has been a very good year for investors, with the S&P 500 on pace for its strongest year since 2013.  Total returns including dividends through November stood at more than 27%.  The headline number is aided by 2018’s lackluster performance, which was the S&P’s first decline in a decade despite posting 20% earnings growth.  Earnings in 2019 appear headed for low single-digit growth, and early projections for 2020 are for a near double-digit advance.  The forward P/E multiple is approximately 17.5x, above the 5-year average though lower interest rates support the case for a higher-than-average multiple.  Yields on 10-year Treasury bonds started the year at 2.6% but more recently were closer to 1.8%.

Despite concerns about slowing global growth, which have been reflected in modest business investment and a contraction in manufacturing activity, the economic backdrop looks generally favorable.  GDP growth in 2019 should be in the neighborhood of 2%, consistent with expectations for 2020.  This isn’t particularly inspiring, but it could certainly be worse. 

As we look toward year-end, global stock markets have had a remarkable year despite tepid growth outside the U.S.

Stock markets in the U.S., Japan, and Germany are up greater than 20%.  China’s index has also risen by more than 20%, but remains well below its springtime high for 2019 and far behind its record high from early 2018.  Canada’s major index gained 15% so far this year.  Even the U.K. is up in the high-single digits despite all the commotion surrounding Brexit.  These returns are in local currency.  Therefore, U.S. investors in overseas markets have experienced lower returns because of the strength of the dollar versus other currencies.

U.S. economic growth is hovering around 2%, down from 2.9% for 2018 but well above other developed economies.  Europe experienced 0.8% growth in both the second and third quarters even as certain key economies are flirting with recession.  GDP growth in Canada and Japan is running at 1.3% with the caveat that an October 1st sales tax increase in Japan will likely lead to weak economic conditions judging from reactions to past tax increases.  Growth in India was 5%, but trends appear to be slowing.  In China, 6% GDP growth was the slowest in 27 years.  Anecdotal reports from companies doing business in China paint an even less optimistic portrait of economic conditions there.

From listening to the media, it is hard to believe the market is again flirting with all-time highs.  An “inverted” yield curve, trade policy uncertainties, overseas economic weakness, and always-present political instabilities, such as the recent attack on Saudi Arabian oilfields, should surely be enough to make anyone run for cover.

 But these concerns don’t seem to be holding back equity investors.  The forward 12-month P/E ratio for the S&P 500 is 16.8, just slightly ahead of the 5-year average of 16.5 and about 14% above the 10-year average of 14.8, a period that includes very weak earnings from 2009 and 2010.  Further, unlike a year ago, analysts aren’t expecting double-digit earnings growth.  For calendar years 2019 and 2020, earnings are expected to grow 4.3% and 5.6%, respectively.

Cautionary Signs or False Signals?

The 30-year Treasury bond recently yielded just over 2%, an all-time low.  Think about it:  investing one’s money for three decades for a negative return after taxes and inflation are factored in.  Usually long-term Treasuries perform well during periods of economic uncertainty, especially at the onset of a recession.  That’s the initial message investors perceive from this low bond yield.

 Another cautionary sign is that the Treasury yield curve is partially “inverted.”  A “normal” yield curve is upwardly-sloping, meaning that investors demand a higher yield in exchange for taking on the risks of investing over a longer period of time.  The 30-year Treasury typically yields more than the 10-year, and the 10-year more than the 2-year or a 90-day Treasury bill.  An inverted yield curve occurs when the opposite is true, that short-term Treasuries pay better than long ones.  This is rational only when the outlook is for lower interest rates as long-dated bonds will appreciate more than shorter bonds when interest rates fall.  Recently, shorter maturities like the 2-year and 5-year Treasury and the 90-day bill yielded more than a 10-year Treasury.  The 30-year bond still yields about half a percentage point more, hence the term “partial inversion.”