The US economy has rebounded significantly in the 3rd quarter (Q3), although the bounce owes itself to the historic 2nd quarter trough and the equally historic monetary and fiscal policy response. The degree to which the recovery can continue is uncertain both in amplitude and sustainability as election year posturing has put another round of pandemic relief legislation in doubt, at least prior to the election. Record amounts of fiscal stimulus have begun to run out for those hit hardest by the pandemic, as the future remains uncertain for several industries which rely inherently on even modest amounts of human congregation. Initial claims for unemployment insurance continue to be over 750,000 people per week, a pace greater than at any time during the Great Recession of 2008.
Our leaders have the unenviable and difficult choices of picking winning and losers, in terms of bailout considerations, while “act of god” caveats are being used to further stray from free market fundamentals. We are all now witness to the realities of the tsunami of spending made possible when there is a bipartisan or public will to do so, and both sides of the aisle are likely dreaming up fresh ways to expand the widening budget deficit. The US dollar has been the gauge used to judge policy on efficiency of capital allocation, and this quarter’s weakness has given a taste of what could happen when markets whiff the indefinite opening of monetary and fiscal spigots. The US dollar’s fall has gone a long way in boosting asset prices during the quarter, while historically low interest rates and pent-up consumers flush with cash also helped inflation measures rebound from the lockdown low. Market-based measures of inflation, or the difference between nominal yields and real (inflation-adjusted) yields had started to perk up before reversing course along with risk assets in September.
Real annualized Gross Domestic Product (GDP) in the 2nd quarter was revised 1.5% higher for the final estimate from the Bureau of Economic Analysis, but at -31.4%, remained the worst quarterly drop on record and signals a recession after the -5.0% drop from Q1. The Atlanta Fed GDPNow estimate is currently expecting a rebound expansion of 32% for Q3, as close to a “V-shaped” recovery as one will ever see. The official unemployment rate has fallen to 7.9% from the 14.7% reached in April, and while it has been a quick fall from the high, the still unemployed may be in for a long slog without a widely available and effective vaccine.
Measures of business activity such as the IHS Market Purchasing Managers’ Index (PMI) have continued to show improvement, although the pace of the expansion slowed slightly according to the most recent preliminary flash release for September. The Services sector experienced a greater expansion than the manufacturing sector in September, driven by the strongest growth in new business in 18 months. IHS Markit noted that expansion in August, which was the fastest since early 2019, was uneven and concentrated in business services and technology while consumer-facing services continue to face headwinds from the pandemic and upcoming election uncertainty. These headwinds popped up again in the most recent survey, weighing on business optimism in the year ahead. Companies also reported raising their selling prices at the fastest pace in two years, passing increased costs onto customers.
It was a strong quarter for US large-cap equity markets, with the broad US indices ending Q3 with high single-digit percentage returns. A steady decline to close the quarter nearly halved the gains experienced through the first two-thirds of the quarter, as election uncertainty and a feared delay of a new fiscal relief package became reality. The year-to-date leading Technology sector started to fall steeply from recent all-time highs at the beginning of September, though still managed solid gains during the quarter. It was the largest companies in Consumer Discretionary which powered a cyclical resurgence to outperformance, edging out the smaller Industrial and Basic Materials sectors. Performance in the Energy sector continued to be abysmal, however, with high dividend yields unable to attract investors into the challenging environment of waning global oil demand. The Financial sector looked ready to outperform thanks to the Federal Reserve’s insistence on spurring inflation, thus leading to potentially higher longer-term interest rates and a better environment for the Finance sector. However, that market view was short-lived, and the Financial sector continues to bewilder investors and remain relatively flat. The Real Estate sector achieved modest gains during the quarter despite obvious pandemic related uncertainty in several sub-sectors including Retail, Hospitality, and Commercial Mortgage Real Estate Investment Trusts. The broad S&P 500 Index remains trading near 20x forecasted 2021 earnings, which increased nearly 2% during the quarter, to $164.30.
Small-cap US equities continued to underperform during the quarter, likely struggling with added pandemic related costs without the benefit of scale achieved by the major players, but also due to a relative overweight to the underperforming Financial versus the high-flying Technology sector. This sector weighting dynamic is equally true about International Developed Market equities, which also underperformed large-cap US equities after starting to outperform early in the quarter. Fears of a second wave of COVID-19 and associated renewed lockdown in Europe weighed on international equities near the end of the period.
Emerging Markets performed well, outperforming US and Developed International. Emerging Markets continue to have an outsized benefit from the flood of global central bank liquidity and a more seamless and earlier recovery from the heart of the pandemic shutdown. Global trade has been depressed, however, and will have to rebound for the move in Emerging Markets to be sustained. The trade dispute between the US and China has become no clearer, and the antagonistic rhetoric has not abated and is currently focused on privacy/national security concerns regarding the popular China-based app TikTok. The broader trade dispute has largely been in a holding pattern, and will likely be so until after the election, while US officials remain confident that China is living up to the Phase 1 agreement.
Longer-term interest rates ended the quarter near where they started, though the quarter end change masks the intra-period swings of the significant declines in July and the reflation bounce in August. The pullback in risk assets in September led to US Treasury demand, driving the US 10-Year Treasury Note yield back to 0.65%. Shorter-term yields slipped further on a relative basis, as the 2-Year Treasury Note slipped from 0.17% to 0.12%. These low yields continued to push investors out on the risk spectrum and into corporate bonds, decreasing the yield spread between corporate bonds and similar maturity Treasury bonds. Active buying by the Federal Reserve in secondary markets boosted investor confidence to seek those attractive yields in sub-investment grade, high yield corporate bonds despite defaults continuing to stack up. Fitch has reported 42 global corporate defaults in its rated portfolio through the end of August, which is the most since 2009, a year which the ratings agency expects 2020 to surpass when it’s all said and done.
Along with transportation and retail, the oil commodities space is where these defaults have started to pile up. Oil prices have stabilized during Q3, near $40 per barrel for the West Texas Intermediate crude oil benchmark; this is due to much lower production output from OPEC and North American producers. Demand is still forecast to be weak into 2021 due to the pandemic, and many companies in the space are finding it difficult to manage. Other commodities have seen a notable spike during the quarter. A spike above $2,000 per ounce for Gold has boosted mining stocks thanks to monetary policy reducing interest rates, thus reducing the drag related to physical storage costs. COVID19 related closings of lumber mills, persistent demand for new home supply, and speculative positioning combined to spike lumber prices over 3x from the April low, with lumber reaching an all-time high of $928.50 per thousand board feet in September before retreating to the mid-$600s.
Markets are likely to continue to be volatile and prone to excess positioning, on both the upside and downside, as monetary and fiscal policies fuel speculative risk taking and at times the reverse. The 3rd quarter has been a microcosm of the pronounced swings we are likely to see, and while risk assets have pulled back from recent all-time highs, optimism runs high despite the uncertain future of accelerated technological disruption and the apparent pull-back from decades of globalization. We know that the only constant is change and though 2020 has so far been full of surprises, we may only be getting started. For instance, at this writing news has just been released that President Trump and the First Lady have contracted COVID-19.
Our mission remains protecting our clients against such market turbulence, with a disciplined, emotionless investment approach guided by our principles of Passion, Integrity, Vision, and Care.
Thank you for the opportunity to be of service and we hope that everyone stays healthy and positive in these trying times. Keep in mind, this is not a destination, it’s a transition.
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