The year 2020 has been among the most disconcerting in market and economic history. We began the second quarter in the midst of unprecedented market and economic dislocation, facing a wide range of financial and economic possibilities, all equally likely to occur. We encouraged investors to hold steady through what most of us thought would be a very rough period. Then stocks surprised us with one of the best 10-week periods on record.
The entire path of February, March, April, May, and June – from the onset of the pandemic to the depths of a market rout to a resounding recovery – was a testament to maintaining a strategic investment policy. Achieving any tactical advantage was extremely problematic during this period. The triumph of discipline through chaos and uncertainty was beneficial to Pitcairn clients who, as always, were guided by their long-term investment policies.
The exceptional equity rally has been largely predicated on investors looking beyond COVID-19 into 2021 and 2022 and making more positive inferences, particularly as increased knowledge of the virus led to lower fatality rates, shorter hospital stays, and higher hopes for a vaccine.
Other drivers added fuel to the rally. Initially, I didn’t give much credence to the role of day traders, but there is anecdotal evidence that younger gamblers who can’t visit casinos or bet on sports are turning to the stock market. We have seen speculation from US day traders and Asian day traders, based on overnight action. That is not a comforting scenario for those of us who remember 1999.
However, I think by far the more powerful driver is that investors are bowing to the adage, Don’t fight the Fed, which contends that stocks will rise as long as the Fed is supportive. Clearly, the Federal Reserve’s rapid response in mid to late March contributed to the significant recovery. Institutional investors see the Fed pumping liquidity into this market, they see no threat of inflation, and they expect little to no return potential or diversification from other major asset classes. The bottom line: large investors believe there is no alternative to equities (TINA).
What Will Keep the Rally Going?
I shy away from decrying an upward moving market because rising portfolio values spawn all kinds of good economic outcomes. However, if you had told me in February that over the next six months, a pandemic would shut down the global economy and the US would see widespread protests and social unrest, I would have said equities would now be down 15%-20%. Instead, US equities are about even year-to-date, raising some questions about the sustainability of the current rally. We want to be sure capital markets don’t get ahead of themselves.
S&P 500 cumulative earnings have risen to $142 from a low of $139, but are still far below January/February when earnings were about $175. Though, we expect US GDP to be up about 24% next quarter and another 6%-7% in the fourth quarter, it will probably be late 2021 or 2022 before aggregate earnings recover to their December 2019 level. That’s the nature of economic slowdowns. In 2008, it took over three years to get back to peak earnings. Meanwhile, stock prices have approached their previous highs, pushing forward price-to-earnings ratios (which were 22x as of mid-July, compared to the 25-year average of 16.4x) toward a less comfortable level.
The market has pulled a good deal of future positive news into current stock prices. Investors may not be fully appreciating the economic dislocation in the US and the world, and, furthermore, seem to be placing a premium on corporate earnings that remain uncertain. To the extent that the news isn’t as positive as the market thinks it will be, we could see prices pull back.
Though it seems likely that stocks have already delivered most of their return for 2020, markets trade on relative good and bad and on surprises, positive or negative. Stocks could rise further if any of the following occur: a measure of calm in US politics (albeit unlikely), continued improvement in economic data (employment, spending, manufacturing), or declining infection trends in populous states in the south and west. Congress is currently debating an additional stimulus package that would help consumers who are still without work due to the virus. A quick passage of a substantial program would certainly buoy markets and sentiment at least in the short term.
I stand by my belief that this is not a year to make big execution calls one way or the other – there’s just too much risk in that. The right strategy is to follow your policy. That has always been our best advice, but especially in times like these.
Fed Policy and Rising US Debt Are Likely to Have Longest Lasting Effect
While I am acutely aware of the many variables in play - the pandemic, the election, global trade, geopolitics - as a contrarian and a long-term investor, I ask myself what will have the most significant and longest-term effect on capital markets? I believe the pivotal driver is the Federal Reserve’s extreme monetary policies, the substantial debt resulting from government stimulus spending, and how these do or do not resolve themselves. (See Chart A: US Federal Reserve’s Balance Sheet and Chart B: Fiscal Policy.)
It’s been 49 years since President Nixon took the US off the Gold Standard (ending the Bretton Woods Agreement on August 15, 1971). That is a seminal event in US economic history. To describe the change in household budget terms, the US went from managing its finances with a debit card to using a virtually unlimited credit card. Ending the gold standard provided many positives for the economy, but at this juncture, we have to think about long-term consequences. In 1971, the US had about $398 billion in outstanding Treasuries. Since just March 15th of this year, we have added about $3 trillion in debt. No doubt, we are borrowing from our children and future productivity. Will the rest of the world at some point require the US to pay a higher return on its paper? Are we hamstringing future GDP growth?
Opinions on these questions are mixed. Some say all will be fine, that whether or not there is some level of inflation, the dollar’s integrity will remain the world’s standard no matter how much money the Fed prints. Others say this debt is a hole we won’t be able to climb out of and as we print more and more to satisfy the debt, the dollar will fall and the US standard of living will suffer greatly. I believe the answer is somewhere in between those extremes.
No single dollar of credit card spending makes someone a bad credit; it’s a confluence of factors. The same is true of sovereign nations, with the added complexity of relative valuation – how a country’s debt compares to alternative stores of value, such as other currencies. Today’s US debt level appears excessive, but still presents a better story than many other countries. When distress hits, investors around the world have always run to US Treasuries and the US dollar. Flows into US government bonds increased in the second quarter according to data tracked by Morningstar Direct.
As the strongest growth engine ever produced by global capitalism, the US should be able to carry more debt than other economies. In some countries, central bank balance sheets are already at 100% of GDP, while the US debt-to-GDP ratio is not yet at 50% (though it may get close if Congress passes another stimulus bill). When operating properly, the US economic engine should be able to rationalize even the current high debt in the eyes of global investors.
Pandemic Remains Greatest Unknown for Economic Recovery
While the equity recovery has been rapid and robust, economic recovery will likely be more challenging. GDP growth could be a V with a sharp, steady recovery, or a W, with more than one up and down phase. Regional virus outbreaks may slow or reverse reopening progress, although I don’t believe a return to full shutdown is likely. The upcoming release of second-quarter GDP is expected to show an estimated decline of about 34.3%. Third-quarter GDP is projected to be up 24%.
Outside of the US, Asia seems to have weathered the pandemic a bit better than the rest of the world, so GDP recovery in China appears V-shaped. Conversely, Latin America is struggling. As much promise as Latin American countries exhibit, their infrastructure and health care systems are not well developed, which means COVID-19 is hitting them hard.
Interestingly, Europe has bounced back well. Supported by central bank stimulus and also partly due to the region not experiencing a second wave of the virus (at least not yet), Europe’s recovery seems ahead of the US.
Changing Currency Trends May Spark Outperformance in Non-US Stocks
In the financial industry, early can be synonymous with wrong, and I have been an advocate for global equities for several years now. Still, I believe there is opportunity in non-US and emerging market stocks. Over the last four years, Fed policy and the strong dollar have made this a tough asset class, but a regime change on currency values and shifting perspectives on central bank policy may force an inflection point. US dollar cycles average 8 to 10 years in length, and we are in year 12 of a strong cycle. So it certainly seems to be time for a change. Combined with major Fed action, this spells opportunity for non-US and emerging market equities.
Turn Down the Volume on the Ugly Election Season
In the next month or so, the election will probably overtake COVID-19 as the biggest brick in the wall of worry. Most recent polls predict a Democratic sweep. Polls have been wrong before, but given the level of voter dissatisfaction, economic losses, and social unrest, voters may seek change.
Markets generally prefer a division of power rather than a president and Congress of the same party. However, as we well know, this year is unlike any other. There is some feeling that the public is so tired of the strident political discord that a wholesale change may actually improve investor sentiment even if there is no division of power. On the other hand, expectations that a Biden administration could raise corporate taxes bode poorly for stocks. What seems certain is that this will be a very nasty political season, and I encourage all investors to look beyond it. An election happening four months from now should not be a meaningful factor in the decision making for anyone with a 40- or 50-year investment horizon.
Pitcairn Stays Strategic Amid Uncertainty
Though we stress the importance of not being buffeted by fear, euphoria, or politics, that does not mean Pitcairn portfolios are static. The managers in your portfolio actively take advantage of changes in their particular market segments to best position for opportunities, lock in gains, and move away from risk.
This quarter, we have been nimbly and strategically harvesting tax losses, as well as making other tax moves for the benefit of our clients. Tax alpha in overlay portfolios has been outstanding because of the diligent, persistent, and daily nature of the process.
We also continuously monitor the evolution of the various asset classes to analyze how they have changed. What an asset class represents today may be different than 10 years ago. Recognizing this helps ensure that we are recommending the right asset allocation relative to an investment policy statement.
Given the call for caution in the equity markets, we are also working to be sure portfolios are being adequately compensated for risk and that we are optimizing risk/return relationships. We typically do that through ample diversification. However, in the current environment, we find that fixed income and other traditional sources of diversification have not been as effective as they were in the past. For example, US bonds have become more closely correlated to stocks due to Fed policy and other factors. Consequently, the biggest change to our allocation outlook is the potential inclusion of hard assets such as gold or other metals to augment existing exposure in commodities. We are also looking at ways to upgrade the implantation of specific investment areas, such as the addition of private real estate, in order to achieve appropriate diversification.
Investment Policy Statements Exist for a Reason
The current environment is exactly the kind of market where investors make costly mistakes. In 1999, people wanted tech stocks no matter how expensive they were and in 2008, investors vehemently shunned stocks in favor of cash. Wrong moves at both ends of the spectrum. Investment Policy Statements exist for a reason, and 2020 is without question a time for discipline against a backdrop of chaos.
COVID-19 and the election will be important drivers for the next three to six months, but that time period is irrelevant for people investing for 50 years or more. We have unwavering confidence in the long-term integrity of investment policies that we construct.
Step Back to Focus on Family, Community and Personal Well-Being
As Pitcairn continues our Voices in Leadership Series, I recently reconnected with Meir Statman who is a renowned behavioral finance expert and the Glenn Klimek Professor of Finance at Santa Clara University. Meir and I touched on a number of topics that really resonated with me given the difficult days our country is facing. We talked about investing, but more importantly, we talked about well-being, which encompasses more than our finances.
Meir said that in 2020, a year of such tremendous change and uncertainty, we should worry less about our portfolios, which will be fine as long as we have managers doing the work they are supposed to do. Instead, he suggests that we should focus on what makes life meaningful for us. Take care of our families, spend time with our kids, or do something for a neighbor who needs help.
Markets push us to take action, but Meir’s experience in human behavior tells us that taking time to step away from our emotions and engage our cognition leads to more successful outcomes. That echoes what we always tell our clients. Don’t overreact to external conditions. Focus on what is within your control. Rely on your Investment Policy Statement and keep you focus on the long term.