By East Bay Financial Services
If the first quarter of 2020 was a quarter unlike we had seen before, we can agree the second quarter was equally dizzying. Before we get into what occurred and what it means for investors, we want to express that we sincerely hope everyone is safe and well. From cancelled graduations and summer vacations to working from home, we all have had to adjust in some ways; but rather than focus on the negative changes, we prefer to focus on the positives like more time to spend with family or time to start a new hobby.
If we think about the markets and economy as a puzzle that was in scattered pieces from a sharp decline in the first quarter, the second quarter was spent trying to start to put those pieces back together. Not surprisingly, there have been fits and starts.
If we think back to April, we saw unemployment jump to 14.7%, the highest level recorded since the Bureau of Labor Statistics (BLS) started recording the data in 1948 (if not for a misclassification issue in April and May, the reported unemployment rate would have been 19.7% and 16.3% respectively). What made this increase so surprising was the speed with which it happened; in February 2020 the unemployment rate was the lowest it had been in 50 years (3.5%). In April we experienced something we probably never thought we would - negative oil prices. While some of this was a technicality stemming from how oil trades on futures markets, it was emblematic of both a stalled global economy and a glut of oil with nowhere to store it.
Fast forward to May and we had another first-time experience, the Fed began purchasing ETFs that invest in corporate bonds as a way to rapidly provide stability for credit markets. While we aren’t buyers of specific products simply because of this, Fed buying certainly supported some of our corporate bond positions. As they say, don’t fight the Fed. Despite the uncertainty and instability, we saw stocks rise on headlines a vaccine may be coming sooner than originally expected. Unemployment eased slightly to 13.3% in May.
Optimism continued in June as more economies opened across the globe. It was also in June that the National Bureau of Economic Research (NBER) officially declared that a recession started in February 2020, ending the longest expansion on record. Stocks rose and fell throughout the month based on updated coronavirus data.
What does all this mean for investors? Richmond Fed President Thomas Barkin said it best when he explained his economic outlook: “We took the elevator down, but we're going to need to take the stairs back up."
Economists have come up with a variety of shapes (see Exhibit 1) that an economic recovery might take, each of which are highly dependent on the uncertain path the virus takes. Of course, any treatments or vaccines that come about will have an almost immediate impact to the trajectory taken.
Overall, we continue to believe the depth and duration of the economic crisis will be determined by the depth and duration of the health crisis. While we see economies opening across the globe, it is happening for different sectors and different countries at varying paces and we must remember the global pandemic is still with us. At the same time, we would not recommend making changes to your portfolio allocation based on market prognostications, and we should continue to look for rebalancing opportunities as markets fluctuate.
Why are the markets going up when the economic statistics seem so gloomy?
This was the most common question asked by clients throughout the quarter as there was an apparent disconnect between economic data and market results. The reality is the market and economy are normally disconnected, though it may not always be this obvious.
If we think about the disconnect, it’s really important to remember the speed in which the global economy shut down and how abruptly and sharply markets fell. From there, global monetary and fiscal aid provided almost immediate stability and support for markets.
It is also important to remember that many economic statistics, like unemployment for example, are backward looking while the markets are really a forward-looking mechanism. If you think about any individual stock, its current value is based on the present value of its expected future earnings, not its past earnings. Anecdotally, it is suggested the markets are looking out six months ahead of where we are today. With that in mind, it is typical for markets to improve before a recession has ended, reflecting future optimism.
We understand it can sometimes be uncomfortable to invest in times of higher volatility and uncertainty. Investors will often express a desire to go to cash until a point in which markets “stabilize.” However, how will we know when markets stabilize? We know there won’t be a headline telling us when this happens. On the contrary, we do know that it is during these times of uncertainty when the possibility for higher equity returns exist and there is no way for us to achieve them if we are not invested.
We saw stocks surge in the second quarter as the U.S. government and Fed provided enormous amounts of aid, combined with optimism surrounding a broad opening of the economy; though it has not been nor is expected to be a smooth ride going forward. For the quarter, large cap value stocks increased by 14.3%, the lowest return of the U.S. indices we track while the small cap growth index jumped by over 30%. Even with these large returns, most equity benchmarks are still in negative territory on a year to date basis with only the large cap growth index showing positive returns over that time period.
Another popular large cap index, the S&P 500, rose by 20.5% over the quarter but has still fallen -3.1% year to date though the end of June month. A significant part of what has been driving the index, at least more recently, has been the fact that the top five largest stocks in the index account for 20% of the market cap, representing the highest concentration in more than 30 years (see Exhibit 2). This is important because it tells us the higher the level of concentration goes, the more the S&P 500 returns are driven by these five stocks and the less benefit that exists from the diversification of the other 495 stocks in the index, assuming a capitalization-weighted investment in this index.
As of July 2, these 5 stocks and their respective weights were Microsoft (6.05%), Apple (5.73%), Amazon (4.68%), Facebook (2.17%), Alphabet Class A (1.71%), totaling 20.34%. A similar level of concentration exists at the sector level as four of the eleven S&P sectors (information technology, health care, consumer discretionary, and communication services) represent almost 64% of the total index (source: www.spglobal.com).
Exhibit 2 Source: Compustat, Goldman Sachs Global Investment Research, data as of 4/30/2020.
Like U.S. equities, international stocks had a pretty stellar second quarter while they also remained negative on a year to date basis.
Like the Fed, the European Central Bank has taken aggressive actions to stabilize their economies through their own bond buying program and stimulus efforts. As has been the case within the EU and ECB, there is concern that certain countries are better prepared to handle Covid-19 and the amount of aid each country will need will vary, putting added stress to their union.
Like the different states in the United States, the different countries that comprise international equities have had varying experiences and results from Covid-19. Countries like New Zealand and Germany, which have done a relatively good job of flattening the curve and bringing their economies online more quickly, were countries with some of the best performing stocks, gaining 27.0% and 26.8% respectively (source: MSCI). At the same time, the UK, which has been often criticized for their handling of the coronavirus, grew by only 8.8%.
In the emerging markets index, the weight of companies domiciled in China has now grown to be just over 40% of the index and is actually larger than the weight of the next largest four countries combined (Taiwan, 12.3%; South Korea, 11.6%; India, 8.0%; Brazil, 5.1%) (source: MSCI). For the second quarter, China’s underperformance negatively impacted the overall emerging index (15.2% vs. 18.1%).
International equities remain undervalued relative to both historical averages and current U.S. valuations. Investors should also keep in mind the return of international equities can be driven by the dollar’s relative strength or weakness versus foreign currencies (the Wall Street Journal Dollar Index ended the quarter lower/weaker). Overall, most developed and emerging market currencies appreciated versus the dollar over the quarter.
While U.S. equities have broadly outperformed non-U.S. equities over the last five to ten years, the handling of the coronavirus, which will be a driver of how quickly economies get up to speed, could be a catalyst for international equities to begin to outperform U.S. equities again.
Global REITs, as represented by the Dow Jones Global Select REIT, were one of the lower performers for the quarter, earning 9.5%. Non-U.S. REITs performed slightly better (10.0%) vs. their U.S. counterparts (9.1%). Overall, it is important to remember that there are many different types of REITs, some of which may be more/less impacted by social distancing today and variations in potentially diminished demand going forward. For example, hotels are negatively impacted in the short run while retail (some temporary closings may become permanent) and office space (more people work from home) may experience longer term challenges. At the same time, cell towers and self-storage REITS appear to be less impacted by the virus in both the short term and long term.
Source: Morningstar, Bloomberg Barclays and ICE BoA ML benchmarks shown, past performance is not indicative of future results
Global Fixed Income
Fixed income indices were broadly positive for the quarter with intermediate corporate bonds leading the way. Let’s look at how fixed income indices fared.
Treasuries are generally seen as the best hedge for equities, as their returns have historically been negatively correlated. Unfortunately for shorter term Treasuries, money market funds and CD’s, with yields near zero there is little expected from either a capital appreciation or income standpoint. Intermediate Treasuries, while low, have some yield advantage over short-term Treasuries.
As we know in fixed income, the best indicator for future fixed income returns are current yields to maturity. Therefore, someone who invests in a 10-year Treasury today can only expect to receive 0.66% in return over the next ten years. With that in mind, if investors are interested in increasing their return and with the expectation the Fed is going to keep rates lower for longer, the options are to increase duration or decrease credit quality. Our preferred approach is to keep duration shorter vs. the Bloomberg Barclays U.S. Aggregate Index, the main U.S. fixed income benchmark, and to allocate towards high quality corporate securities.
Municipal bonds are another type of credit, usually held by tax sensitive investors. Some positive characteristics of munis are their extensive diversification across issuers along with the incredibly low default rates. The low default rates stem in part from the fact that under federal bankruptcy law today, states are not permitted to file for bankruptcy, which lends them to carry a balanced budget and be generally fiscally conservative.
For local governments, the idea of defaulting is full of longer-term implications as the issuer would likely have tremendous difficulties being able to borrow again (and if they could borrow, it would be at a relatively higher rate). Even with that backdrop, the obvious question becomes whether we will see increased defaults as local governments deal with decreased collections (e.g. less sales tax collection if people aren’t spending money) and stressed budgets. Before defaulting, issuers have other levers they can pull, such as increasing taxes or cutting services, neither of which are attractive in their own right. Fortunately, many issuers seemed to have learned valuable lessons from the financial crisis of 2008-2009 and entered this crisis in a better position. We try to mitigate risk by focusing on higher quality bonds, similar to our preference in all bond categories.
Finally, we can’t talk about fixed income without mentioning inflation. Inflation is simply defined as a general increase in prices and decrease in the purchasing power of money. For bond investors, the higher the expected rate of inflation, the higher yields will rise across the yield curve as investors demand more compensation. One of the Fed’s key objectives is to keep inflation around 2%, both to prevent inflation from getting to high and too low. Whether you look at headline or core inflation, and whether you use CPI or PCE to measure inflation, the current results are well below the 2% target.
In the short term, one could make the argument that with high unemployment and diminished spending, deflation is more of a concern vs. inflation.
In the long term, there is tremendous variation among fixed income strategists about whether all the stimulus will lead to inflation. The way we think about it is that printing money by itself doesn’t cause inflation. Instead, inflation requires spending and investment to reach the point where the economy overheats, sending prices and wages up. Therefore, we do not see a reason to alter portfolios due to a particular inflation outlook. We do suggest considering the risk of inflation for investors with low allocations to “growth” oriented assets such as equities or real estate.
We continue to view fixed income as a method of reducing overall portfolio volatility, given that equities are expected to have much higher volatility. Our portfolio’s focus will continue to be on high quality bonds with an emphasis on short to intermediate duration government and corporate bonds, where default risk has historically been relatively low. For some investors, muni bonds are attractive for their tax-free income.
East Bay Financial Services, LLC, a Registered Investment Advisory firm, supplies investment research services under contract to Four Ponds Financial Planning, LLC. Review East Bay disclosures.