The upcoming election
By East Bay Financial Services
There hasn’t been much talk about this lately but there is an upcoming election (yes, a bit of sarcasm). Not surprisingly, there are a lot of prognostications taking place on how the markets will fare with several potential scenarios (Republican/Democrat as President, Republicans/ Democrats in charge of Senate/House).
Let’s make it clear that the outcome of any election can have an impact on tax policy, Social Security and therefore impact your financial plan. However, when it comes to the markets themselves, we would caution investors from making emotional decisions based on how they feel about the candidates and the party in power.
We provide this caution as historically making decisions solely based on party affiliation have led to suboptimal investment results. How so you ask? Exhibit 1 shows the growth of $10,000, from 1961-2019, investing when one particular party was president vs. investing through the entire period. As you can see, staying invested has far and away been the prudent strategy (source: Schwab Center for Financial Research with data provided by Morningstar, Ibbotson US Large Stock Index, past performance is not indicative of future results).
In fact, the average return of the S&P 500 for all presidential terms from 1929-2019 is an astounding 10.3% and there have only been four presidential terms with negative returns (1929-1932, 1937-1940, 2001-2004, 2005-2008; source: S&P).
But with Covid-19, a divided country politically, and a lot of social unrest, this time feels different to many. And we would agree, somewhat, this time is different. In fact, you could make the argument that the exact circumstances have always been different. We have been through World Wars, terrorist attacks, a dot-com crash and a few financial crises to name just a few significant events. While each of these events are important at the time, when you look at them over a longer time period in relation to the markets, the disciplined investor has done much better than the investor who thinks they can successfully time the market.
Keeping it in perspective, markets are made up of public companies that are required to make decisions that are in the best interest of their shareholders. Whether there is a currency crisis, a change in corporate tax policy, or a change in tariffs, to name a few examples, the leadership of these companies must adapt to their environment in order to build capital for their shareholders.
As we think about what happened in the third quarter of 2020, let’s remember that from February 19, 2020, through March 23, 2020, the S&P was down over 33% (source: Morningstar) in what is the fastest move from record high to bear market in history. Based on that nugget of information, it would have been hard imagining writing this next sentence. Amazingly, in August 2020, the S&P 500 hits its first new record since February 2020, in what is also the fastest recovery on record, just 126 trading days from peak to peak.
Exhibit 2 provides the 126-trading day reference with the next fastest recovery taking 310 trading days. How many prognosticators suggested this?
While the performance of the S&P is impressive, it also presents some challenges. For one, the S&P has become increasingly concentrated with a few stocks carrying more weight than others, both literally and figuratively. As of Sept. 30, the top 5 stocks in the S&P (Apple, Microsoft, Amazon, Facebook, Alphabet/Google) comprise over 22% of the index (source: iShares.com). This means the other 495 stocks comprise the other 78%. Exhibit 3 shows how the top 5 stocks have become a larger part of the S&P 500 over the years (spoiler alert: the NASDAQ is even more concentrated!).
What this simply means is that the more concentrated the index becomes, the more the returns of the overall index are driven by the largest companies. While this has worked for the S&P as of late, it can also work just as powerfully in the other direction. Just how impressive has the performance been of these top 5 stocks? Let’s simply just look at the performance of these top 5 stocks vs. all the other stocks in the S&P 500. Overall, as exhibit 4 shows, the S&P 500 from the beginning of 2020 through Aug. 31 returned 10%. Over the same time period, the top 5 stocks returned 49% while the remaining stocks in the index actually had a negative 3% return overall.
Source: S&P data, January 1, 2020 – August 31, 2020
As most investors hold a more globally diversified portfolio (including fixed income) and not just the S&P 500, it is likely, and expected that client portfolios have performed worse than the S&P on a year-to-date basis. The bottom line is using the S&P 500 as a benchmark comparison for a globally diversified portfolio is an inappropriate comparison.
Looking across the style and size spectrum, we have also done some work into value-oriented investments and found value stocks tended to correlate more with positive economic growth and inflation outlooks. Needless to say, that has not been the environment lately, so we have seen value suffer. It is a similar story for small companies, especially in cyclical sectors like real estate and financials.
International equities were also quite strong in the third quarter. Different from their US counterparts, international small cap stocks jumped 10.3%, beating developed large cap stocks, which went up by 4.8%, while emerging market stocks gained 9.6%.
The positive returns for developed international equities were generated in July and August as September brought concerns of a second wave of infections to Europe, which weighed negatively on returns. In looking at the European Union, EU leadership has been acting in a coordinated and impactful way, trying to limit the damages from the virus. Part of the plan called for the issuance of common debt by the European Commission.
Overall, the countries with large weightings in non-US developed indexes (Japan, UK, France, Switzerland, Germany, Canada) all underperformed the US broad market.
Another reason for positive international equity returns has been the declining dollar. The dollar experienced some ups and downs over the quarter, but overall ended the quarter lower versus where it started and has been declining since the dollar was peaking at the height of the virus in March 2020.
Can international stocks continue to post strong returns? We think it is certainly possible in an environment where there is a strong and coordinated policy response, a weaker dollar, and where valuations are relatively cheaper as compared to US stocks.
Emerging market stocks outperformed the US broad market during the third quarter as China, Taiwan, South Korea and India all outperformed the US (stocks in these countries represent over 70% of the MSCI Emerging Markets Index).
Global REITs, as represented by the Dow Jones Global Select REIT, generated a 7.1% return for the quarter. However, REITs continued to lag their equity counterparts, both for the quarter and on a year-to-date basis. The easy narrative to tell on REITs is that they are doing poorly for obvious reasons, whether that is because retail (and malls) are hurting (and it’s only gotten worse with the pandemic) or that employers/employees are going to stay virtual and that office space will bear the brunt of that decision. That is not the entire story though. For one, many leases are long-term in nature, so completely cutting your lease can be difficult. Similarly, in various surveys of large company CEOs, there seems to be an expectation that most employees will be returning to their office space once they are safely able to. Even mall owners are adapting. A recent article in the Wall Street Journal wrote about how Simon Properties, the largest mall owner in the US, is adapting by looking into the possibility of partnering with Amazon.com to use the empty department store space for distribution. Finally, REITs can include many different types of properties, some of which including cell towers, data centers, warehouses and storage facilities, which react differently to market conditions.
Global Fixed Income
Fixed income indexes were positive for the quarter with US corporate high yield leading the way with a 4.6% return, compared to the 3-Month US Treasury bill, which was flat.
Treasuries continue to be the asset of choice when concerns increase regarding the virus or the recovery from the virus. At the same time, with 3-month Treasury yields at 10 bps while 5-year Treasuries were 28 bps at quarter end, there is neither a lot of income nor capital appreciation expected from these fixed income assets. Treasuries showed little change overall for the quarter. In actuality, the market (based on the Fed’s guidance that they aren’t thinking about thinking about raising rates) is not pricing in any rate increases through 2023.
If we think about corporate bonds, we can still find higher yields vs. Treasuries while still focusing on investment grade bonds. An admitted challenge with this approach is that we are not the only investors looking for high-quality yield, and with investors purchasing large amounts of high-quality corporate bonds, spreads over Treasuries have dropped dramatically from their peaks this year and are towards the bottom of their 20-year ranges (source: JPMorgan Guide to the Markets as of September 30, 2020).
Municipal bonds had positive returns for the quarter and on a year-to-date basis even while state and local government budgets have been stressed as a results of decreased tax revenues, as impacted by the virus. It is important to remember that defaults in municipal bonds are quite rare for a variety of reasons, including the fact that governments can raise taxes to pay for shortfalls. It is important to remember that there is a large variety of bonds across the municipal bond landscape, with differences ranging from type (Government Obligation vs. revenue) to issuer (state, local govt, etc.) and that challenges in one municipality does not immediately equate to challenges across all municipal bonds.
Inflation continues to be a buzzword on the minds of investors. As a reminder, 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. Until recently, one of the Fed’s key objectives was to keep inflation at or below 2%, both to prevent inflation from getting to high and too low. However, in late August the Fed changed to having an “average” 2% inflation measure (what the Fed is calling inflation targeting), meaning inflation could rise above its 2% target without much concern from the Fed, leading to potential inflation uncertainty. Currently, whether you look at headline or core inflation, and whether you use CPI or PCE to measure inflation, the current results are all below the 2% target. However, if we were to see a quick acceleration in the economy from a vaccine, that could lead to higher inflation. With yields as low are they are across the fixed income landscape today, high and increasing inflation would be bad news for fixed income investors.
The Fed also announced they were going to focus on their other mandate, full employment. Since so many jobs have not returned since the depth of the recession, the Fed definitely has their work cut out for themselves.
From a global fixed income standpoint, changes in global government bond interest rates were mixed for the quarter. The UK, for example, saw yields increase across the curve while Germany experienced the opposite, with all maturities ending the quarter in negative territory.
As we discussed last quarter, in order to generate more return, investors need to assume more risk and in fixed income, that means either extending duration or lowering credit quality. These are all tradeoffs that have to be weighed very carefully before implementing them.
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.