QUARTERLY MARKET UPDATE as of July 2020
The stock market had a remarkable recovery in the second quarter. After a dismal first quarter from the double shock of Covid-19 and the energy price collapse, the massive stimulus provided by the Federal Reserve Bank and the Treasury made a big impact. U.S. large cap stocks as measured by the S & P 500 were up 20%, the best quarterly gain in twenty years. All sectors finished higher, with the Technology and Energy sectors having the strongest rebound. International stocks also did well, moving up over 15% as measured by the MSCI EAFE index. Oil prices recovered from the collapse in April to end near $40/ barrel, but still off from $60 at the start of the year.
While stocks surged, U.S. Treasury yields remained low. The longer term Treasury bond yields ended the quarter close to the same level as they started. The 10-year rate climbed early in June after optimism of an economic reopening, but finished back at the same rate, 0.65%. An escalation of Covid-19 cases in the southern states drew concerns of a more subdued recovery. Shorter term interest rates are still under 0.25%, while several of our largest trading partners in the EU and Japan have negative interest rates.
We can point to the Federal Reserve Bank’s actions in the credit markets for a partial explanation for the rapid rise in the stock market, despite the near collapse in the economy. In an unprecedented intervention measure the Fed has purchased billions of dollars of corporate bonds, mortgage backed securities, as well as exchange traded bond funds. This was in addition to the purchasing of Treasury and Municipal bonds.
The Fed bond buying program provided a significant boost to large borrowers and ensured banks had the liquidity needed to continue lending to businesses and households. It also helped lower the perception of risk for companies with higher debt levels. This produced a healthy credit market that allowed many companies to refinance their debt at lower rates, and in turn brought in a surprisingly large number of bond buyers.
Alleviating credit concerns in an ultra-low interest rate environment helped push investors towards stocks. The market sentiment could be expressed with two acronyms, TINA, for there is no alternative, and FOMO, for fear of missing out. Combined with the stimulus from the CARES Act, it drove the market higher. Interest rates are close to zero and international markets are not receiving as much stimulus as the U.S.
There is also a perception that Covid-19 will fade away next year. The uncertainty of that last prediction is high, but it contributed to investor bullishness. While infection rates continue to climb, an optimistic scenario is currently allowing the bulls to beat the bears. It is true that treatment for the virus is improving, and mortality rates are declining. Less certain is whether that rate will change in the fall; and whether expectations for new drugs with improved efficacy are just a few quarters away; or a vaccine will be available early next year. Will the economy open back up, or should it be closed down in some locations, or shut down again if a more deadly surge occurs in the fall?
That backdrop is the basis for making current market predictions. Upcoming earnings reports are expected to decline 44% per data from Bloomberg Intelligence, and contract by double digits in the third and fourth quarter. Optimists are ignoring the current economy with expectations for vast improvement and normalcy next year. We understand the reasoning for looking to the future versus the present in determining opportunity. But we also are tempering our enthusiasm due to higher than usual levels of uncertainty. Potential for higher inflation and lower growth, Stagflation, may be on the horizon.
The first and most obvious uncertainty pertains to the virus, but also current debt levels and the funds needed for future and ongoing social service funding. The generous and extended unemployment benefits provided by the CARES act will expire at the end of July. An extension, which is likely in an election year, may add another trillion to the government debt. Increased government health care coverage, along with a rapid rise in Social Security payments, Medicare, and local government funding all point towards the likelihood of various tax increases. That does not seem to be factored in right now.
Neither is the risk of inflation. The trillion dollar government stimulus program made direct payments to businesses and consumers. The impact was evident in the latest consumer spending report which increased at a very healthy 8.2% after a record decline in April. If economic activity continues to recover we would expect to see a resurgence in inflation. But if economic growth is not high enough, or insufficient in the reopening of the service economy, then unemployment at 11% will take longer than expected to come back to pre-corona virus levels. Hence the possibility of both inflation and low growth.
We are not anticipating a bear market, but see the rapid rise in stocks this past quarter as reason to expect a pause. While some tech stocks are trading at 52-week highs, there are far more companies that are just starting to rebound off of their lows. The overall market may go sideways, but we see opportunity in companies with quality characteristics: solid balance sheets with positive cash flow, paying higher than average dividends.