Key Takeaways:
When it comes to economic cycles, 2020’s experience is far from typical. In typical cycles, economic weakness usually follows a period of great excess (a Boom) fueling a downturn. Healing is fostered through economic tools and stimulus. In this cycle, a non-economic development (the virus), and the subsequent economic shut-down, caused the recession. Stimulus was applied, fast and focused, with magnitude and speed unprecedented in recent memory. Thus far, the swift actions of the Federal Reserve and Congress may have circumvented one of the most devastating default cycles in modern history.
While economic stimulus can, and some would say must, bridge the gap to recovery, the root cause has to be repaired for healing to fully take shape. Even then, secular forces currently underway are likely to change our behavior, and our economy, sustainably.
The Virus: A Science-Based Solution Appears Imminent
There are more than 170 research teams around the world attempting to develop a vaccine, nine of which are in critical Phase 3 trials. For perspective, historical approval rates for vaccines in Phase 3 trials is over 80%.1 Results from two trials, Moderna and Pfizer, are expected before year end, and possibly as soon as this month.
Pfizer’s trial has enrolled 44,000 volunteers. The initial analysis will occur by late October with data on safety by the third week of November. If preliminary results indicate the vaccine can work safely, Pfizer could request an Emergency Use Authorization (“EUA”) from the FDA by late November.
Moderna has enrolled 30,000 people in its study. The initial analysis will occur in early November with data on safety by late November. Moderna may have reached the thresholds necessary to seek an EUA from the FDA as soon as December. If the vaccine doesn’t demonstrate sufficient efficacy in the first interim analysis, a second analysis is expected in December shifting an FDA decision on EUA to late January or early February.
Given these developments, and the number of candidates in Phase 3 trials, the likelihood we have an announcement in the near term regarding a safe and effective vaccine is reasonably high. While distribution may take some time, we can’t underestimate what a science-driven solution will do for business confidence and investor sentiment.
The Cycle: Early Stages of Recovery are Often the Most Profitable
A typical cycle plays out in four stages as investors move from Despair to Hope to Growth to Optimism. In the current cycle, the initial (Hope) phase, which is often associated with the highest returns, played out with unusual speed. In this stage, earnings often remain depressed and multiples investors are willing to pay for those earnings start to expand. The divergence between corporate winners and losers we witnessed from Spring into Fall was the widest we’ve seen. Earnings estimate dispersion reached a new record high in the second quarter. The winners, comprising 34% of S&P 500 companies, reported higher revenue growth than pre-COVID estimates.9 Many of the losers continue to languish.
As we look to 2021, the foundation to shift from Hope to Growth is taking shape. Following a vaccine, earnings for a broader base of companies are expected to recover. Perhaps the most important question when we turn the COVID risk-corner is what is the pace of the recovery?
The consumer broadly has remained steady despite the high level of job loss as massive economic stimulus built a financial bridge to recovery. Since the recession start, real disposable personal income is up about $3 trillion, approximately 15% of GDP, even as wages decline. 2 March to June saw the largest increase in money supply in 75 years, up approximately 70%, with current levels still running about twice the rate pre-COVID.3
Interestingly, much of this capital has been saved. As a signal of economic health and potential pent-up demand, these savings are noteworthy. From pre-recession savings rates of around 7%, savings peaked at 34% in the Spring, and have since fallen to still elevated levels at close to 14%. Should additional stimulus include direct payments to U.S. citizens, we could see another large capital injection into the economy in early 2021. An available vaccine could unleash pent-up demand fueling a strong economic and earnings recovery next year.
Corporations are raising capital with yields at record lows, shoring up balance sheets and positioning for new investment and capital spending as the economy recovers. Productivity is soaring. The second quarter of 2020 saw the largest jump in productivity in 50 years.6
As we peel back the hood and look inside our economy, the number of companies operating at scale with astounding revenue growth and significantly lower fixed costs is accelerating. This includes technology companies, but the base is expanding to domestic and multi-national companies across industries embracing the power of e- commerce, online business models, and digital transformation through payments, logistics, content streaming, and more. This is a super-cycle playing out virtually every day in the economy and markets.
As shared by Blackrock CIO, Rick Rieder, “It’s about an economic era of productivity at scale, the likes of which history has never seen before, accelerated by the Covid-virus present and future reality.”
Employment may only moderately improve in this modern, productivity-rich economy. Therefore, continued stimulus and low rates may keep this economic cycle moving briskly ahead. The growth of services and technology drives efficiencies through all parts of the business model fueling more stable cash flow generation, with potentially less reliance on leverage, which may lead to a more stable business cycle.
There is much hand-wringing over the burgeoning size of our public debt, now at 126% of U.S. GDP. Will we inflate, grow, or tax our way out? Blackrock makes a strong case that the secular shift in the composition our economy provides runway for smart, targeted fiscal policy to generate robust nominal GDP growth over time, mitigating the potential negative impacts of large, single-year deficits like 2020.
The Election: Profits Matter More Than Politics
As the election draws near, political angst is palpable. For voters, it’s personal and the outcome clearly matters. For capital markets however, performance rarely dives or thrives based solely on who’s in the Oval Office. In the past 23 election years, 74% of the time the S&P 500 has ended the year in positive territory.4 In the six periods when the market ended lower, larger forces were at play. Over the past 75 years, through Democratic and Republican administrations, the S&P 500 has averaged an annual return of about 11%.4
Potential Biden policies have garnered much attention and analysis. Will higher tax policy short-circuit growth? In the near term, it’s unlikely. Detailed earnings analysis makes a strong case that tax-driven headwinds will be largely offset by reduced trade uncertainty and higher expected stimulus under a Democratic-led government, particularly over the next twelve months.
A contested election is a near-term risk and could drive asset price volatility. Yet it should be short-lived. On the other hand, a decisive win by either party would remove a major near-term uncertainty and be positive for sentiment. Should a blue wave transpire, we may see capital gains harvesting by high income earners into year- end as they seek to rebalance portfolios ahead of potential higher future taxes.
History has shown over many decades that profits matter much more to the capital markets than politics. As political power shifts driving potential policy changes, the capital markets are quick to price in expectations once the outcome becomes clear. Should the market move lower in the weeks around the election, an opportunity to buy high-quality companies on sale may unfold.
It’s All Relative: The Premium Paid to Own Equities Is Attractive
In investing, most decisions are relative. Investors match investments to their timeline and goals. Within those parameters, they seek assets that will achieve the highest risk-adjusted returns. Much of the decision process is comparative.
Consider our current environment in which the yield on the 10-year U.S. Treasury is 0.83%.5 With even modest inflation of 1%, in the absence of additional interest rate declines (pretty difficult when you’re near the floor), you are likely to lose money as the value of your investment, when adjusted for inflation, turns negative. And you are locking in this return for ten years.
In this real scenario today, investors are highly motivated to seek other assets providing higher potential returns.
Rational investors will demand a premium to invest in higher-risk assets. For U.S. stocks, this premium is measured using the earnings yield on the S&P 500. The earnings yield is simply calculated by dividing earnings over price and is also known as the equity risk premium.
The long-term historical equity risk premium for the S&P 500 is 3.0 to 3.5%.6 Today’s equity risk premium is closer to 4.8%.7 What does this mean? It’s a valuation-driven calculation of the comparable yield on equities vs. a risk- free Treasury bond. Rather than a predictor of absolute returns, this measure is widely used by professional investors to assess compensation for risk-taking. In short, we believe you are getting paid an above average premium for taking risk. Since 1951, the last time the ratio of S&P 500 yields to Treasury yields was at such a high level, equities delivered nineteen times outperformance over Treasuries.8
There is little evidence of imminent inflation. Wages continue to decline with unemployment levels still high. The Federal Reserve has been clear. They will hold the short-term Federal Funds rate at the current level of zero until labor market conditions are consistent with full employment (implying an unemployment rate of 4.1%) and inflation has risen to 2%, and is on track to moderately exceed 2% for some time. Of voting Fed governors, the median assessment of participants is a zero short rate until 2023. Rates are important in the pricing of stocks. Discounting future earnings at lower rates implies higher value today.
While inflation is down, it is not out. Over time, sharp increases in money supply put directly in the hands of consumers who will spend it can be inflationary. However, we expect these increases to be gradual and the Fed to remain anchored by its dual mandate of maximum employment and stable prices.
Portfolio Positioning: Be Selective
What does this all mean for portfolio positioning? Above all else, be selective. This is not an environment in which a rising tide lifts all boats. There is wide divergence between winners and losers within and across asset classes, sectors, and regions. We continue to favor high-quality, secular growth companies with durable cash flows, but not at any price. Valuation is important as earnings disappointments, or a modest move higher in long-term interest rates, could affect the price investors are willing to pay for these growth stocks.
Interestingly, technology stocks have exhibited both growth and defensive characteristics, the former due to superior fundamentals and strong secular trends, and the latter due to balance sheet strength, strong free cash flow generation, and improving margins. Much of the year-to-date outperformance in domestic technology stocks has been earnings driven, and not aided by relative multiple expansion. Secular trends accelerated by the COVID- crisis favor some of the strongest innovation and growth in the following sectors: digital transformation, cloud- enabled software, digital payments, e-commerce, online entertainment, 5G, and genomics and precision medicine.
As the economy recovers, particularly once supported by an effective vaccine, the earnings of high-quality cyclicals and mid-to-smaller capitalization companies are likely to follow. We are finding attractive opportunities in both. As the recovery progresses, long-term interest rates may gradually adjust higher providing a further lift for the share prices of some cyclical value stocks.
Fixed income is challenging. Real yields on Treasuries (Fed Funds minus the core inflation rate) are currently negative. There are opportunities in some areas of credit. We prefer to keep maturities shorter and have found other ways to hedge risk. Negative real yields, a declining U.S. dollar, and the prospect of inflation have supported the strong performance of gold this year. We continue to like gold as a risk management tool and portfolio hedge.
The decline in U.S. interest rates across the yield curve coupled with massive fiscal stimulus increasing money supply has started to weaken the U.S. dollar. This could favor non-U.S. stocks where valuations are attractive. While still overweight the U.S., we have increased exposure to companies in both developed and emerging economies. We also continue to like companies who screen well for sustainability using environmental, social, and governance screens (“ESG”). Many ESG companies exhibited strong defensive characteristics in the recent equity market downturn.
Near-term volatility may remain high as we navigate election and stimulus uncertainty, awaiting a safe and effective vaccine. Yet, as we zoom out and look ahead, we recognize the complexion of our economy is shifting with strong companies thriving, business models adjusting, and new companies launching, accelerated by Covid.
As we enter 2021, election uncertainty should be resolved with a new President in place. More stimulus is likely until an effective vaccine can be widely disseminated. The Federal Reserve has been clear -- continued low interest rates and additional quantitative support will be provided as needed. Corporate profits for many companies should improve relative to depressed 2020 levels.
We are still early in this new cycle when some of the best equity returns may have yet to be realized.
Footnotes:
1 American Council on Science and Health.
2 Jeff Gundlach, Doubleline Capital Thought Leadership, 9/8/2020.
3 Money supply refers to M1 & M2. Jeremy Siegel, Behind the Markets, 10/16/2020.
4 Raymond James Equity Research, 3 Myths About Voting and Market Volatility
5 Data as of 10/20/2020.
6 Jeremy Siegel, The Future For Investors & Behind the Markets.
7 Data as of 10/21/2020; earnings reflect Refinitiv consensus earnings estimate for the S&P 500 of $166.36 for 2021.
8 Alkeon Capital Management.
9 J.P. Morgan.
Any opinions are those of Financial Advisors Catherine Trinder-Miller and Theresa N. Benson, CDFA and not necessarily those of Raymond James. The information contained in this article does not purport to be a complete description of the securities, markets, or developments referred to in this material. The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete. It is not a statement of all available data necessary for making an investment decision and does not constitute a recommendation. All opinions are as of this date and are subject to change without notice.
Past performance may not be indicative of future results. Investing involves risk and you may incur a profit or loss regardless of strategy selected.
The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses, which would reduce returns.