The COVID-19 pandemic caused the fastest market collapse on record during the first quarter of 2020, and we are in the midst of the worst economic contraction since World War II. However, since late March, we have also witnessed the fastest market recovery in history, with the S&P 500 only around 8% away from its all-time high at the close of the second quarter on June 30th. We remain concerned that despite green shoots of an economic recovery the recent market rally leaves little room for error, and we remain wary of potential volatility over the next few months as the gap between economic expectations and current market prices remains wide.
The State of the Pandemic
While most of us remain sheltered in place and are coping with our “new normal” as we continue to face the COVID-19 pandemic, we should acknowledge the likely scenario that our day-to-day lives in the U.S. will continue to be heavily impacted by the pandemic for the rest of the year. School openings in the fall are uncertain, and states that have reopened are seeing new spikes of cases as we face what appears to be the worst weeks of the virus yet nationally. This surge in infections is causing some areas to delay further reopening or even to order the closing of businesses that have already been allowed to reopen.
One bit of good news is that vaccine development appears to be progressing. There are currently nearly 180 vaccines in development, with 20 of them having entered human testing. While we are just beginning to see results from the first drug trials, this is an encouraging sign that the original 12- to 18-month timeline that was estimated early in the pandemic may prove right, despite being several times faster than the successful development of any vaccine previously.
While the vaccine may still be close to a year away, treatment options that could shorten the severity of the disease or decrease morbidity are beginning to surface. Research is ongoing both on existing drugs that may be effective against COVID-19 and on potential new medications, and existing drugs like Remdesivir and Dexamethasone look to be promising candidates.
Medical advancements on the horizon give some reason for optimism but the fact remains that currently, our best available tools for controlling the spread of the virus remain wearing masks, practicing social distancing and following strict hygiene practices.
Americans Are Staying Home, And The Economy Is Feeling The Impact
The mask-wearing, social distancing and continued stay-at-home orders, unfortunately, come with a high economic cost, as they require closing or reducing the capacity of nonessential businesses and limiting the kinds of travel and gatherings that are typically heavy drivers of the economy, particularly during our summer months.
Most Americans are sticking close to home, whether by choice or as a result of stay-at-home orders, foregoing their usual leisure activities and skipping summer travel. Businesses remain closed, many permanently, and the ones that can operate are often running at decreased capacity due to things like occupancy restrictions to allow for social distancing and reduced demand. All of this has contributed to an estimated drop in second-quarter GDP that looks to be the worst since WWII. See Figure 1.
FIGURE 1: U.S. REAL GDP CHANGE: ACTUAL VS Q2 2020 ESTIMATES
For many Americans, the choice to enjoy a night out or a summer vacation has as much to do with the economic strain of unemployment as it does with stay-at-home orders. After a recovery in May as businesses in many parts of the country began to reopen, jobless numbers have stabilized, indicating that many of the unemployment claims were from people who were temporarily laid off after the initial stay-at-home orders had been put into place. Most of the jobs recovered in May were the result of the economy reopening, which means that if the virus continues to spread as it has in recent weeks, people could be out of work again if newly reopened businesses are forced to shut down. See Figure 2.
FIGURE 2: JOBS INCREASED AND REDUCED IN MAY 2020
And Yet Somehow, The Markets Rally On
Despite the concerning economic indicators, elevated unemployment and business shutdowns, the markets are largely at pre-pandemic levels. In fact, the S&P 500 is within around 8% of the all-time high as of June 30th and is currently trending upward. See Figure 3.
This surprisingly rapid recovery is mainly due to markets being buoyed by federal stimulus programs implemented in the wake of the initial stay-at-home orders. While the direct payments to individuals and increased unemployment benefits may have been the most visible efforts, the full force of the stimulus involved an unprecedented combined effort of both fiscal and monetary policy. The CARES (Coronavirus Aid, Relief, and Economic Security) Act alone totaled more than $2.2 trillion.
FIGURE 3: S&P 500 INDEX PRICES: JUNE 2019-2020
But overall, the most impactful catalyst for the strong market performance is the U.S. Federal Reserve (Fed). As a response to the COVID-19 pandemic, the Fed has implemented a record number of stimulus measures the likes of which we have never seen before. Specifically, the Fed has done three critical but costly things. See Figure 4. First, it has provided liquidity to ensure that despite volatility, markets are still able to function reasonably well. Second, it has backstopped credit markets to provide support to sectors important for an economic recovery by buying an unlimited amount of government bonds and even went so far as to extend its purchases to investment-grade corporate bonds as well as high yield instruments. Lastly, it has cut rates again to nearly zero to increase investor confidence and keep borrowing costs low. Notably, the programs focused on backstopping the credit markets were announced on March 23rd, which perhaps not coincidentally marked the bottom of the recent market sell-off, and the market hasn’t looked back since.
FIGURE 4: FEDERAL RESERVE STIMULUS PROGRAMS
So Why The Disconnect?
The first thing to note about the apparent disconnect between the economic fundamentals and the markets is that it may not be as pronounced as it seems at first glance. While aggregate market performance has improved, until quite recently it has been boosted in large part by a relatively limited number of technology stocks (Apple, Amazon, Alphabet (formerly Google), Facebook, Microsoft and Netflix). But those that believe that the current market performance is evidence of a new bull market point to the fact that positive market performance has been spreading to more than just the large-cap tech names. Since the March market bottom, small-cap value stocks, which have been out of favor for the last several years, have finally been outperforming large-cap growth stocks. If a recovery in parts of the market such as small-cap stocks proves sustainable, this may provide further evidence that the broader recovery may be underway, since it is small businesses (public and private) that are likely to be impacted more by the pandemic and, according to the Small Business Administration, account for 44% of U.S. Gross Domestic Product (GDP).
Given that markets are forward-looking, it seems clear that they have looked past the near-term horizon to better days of an eventual economic recovery and a return of business and earnings growth. The pandemic, as harrowing as it has been for all of us, is an acute event, so the question is not whether the economy recovers but when. Businesses reopening in many parts of the country in May gave some reason for this optimism, as we appeared to be beginning to return to some sort of normality, and many of those unemployed in March returned to work. The question now is whether we can wrestle back control from the virus to avoid another round of strict stay-at-home measures and stave off another significant market correction. As recently as July 13th, California Governor Newsom announced that all indoor operations at restaurants, museums, zoos, movie theaters and wineries and all operations at bars must stop, with additional closures required in counties on the state watch list. Other states are also announcing at least partial reversals of their reopening measures. If we are faced with a second wave of infections, or indeed a further resurgence of what is still the first wave, it will become apparent quite quickly whether the recent market rebound was a mirage or has staying power.
This swift and significant market recovery has surprised many investors because it is difficult to reconcile with the harsh reality we face with concerns for personal health and safety, ongoing civil unrest and high unemployment. We remain optimistic about the economic recovery, and therefore we continue to stay the course and maintain current allocations. However, we do expect more volatility as the markets’ steep and swift recovery over the past several months now leaves little room for error. In portfolios, we remain conservatively positioned with a slight underweight to equities after our initial rebalancing, because we believe there remain sufficient risks that could weigh on markets over the next several months, whether from a resurgence of additional viral outbreaks, the upcoming election and potential changes to tax policy, or geopolitical risks which have been pushed aside during the pandemic. We are staying consistent with our game plan; rebalancing portfolios, reassessing all our strategies to ensure that we can capture the benefits of the economic recovery through our portfolio exposures, and, lastly, looking for new opportunities during volatile times that we believe will be well-positioned as we come out of this recession.