Third Quarter Market Overview
Domestic Equities: Domestic equities, as measured by the S&P 500, performed strongly over the third quarter, rising 8.9%. Large cap growth stocks continued to be the best performing cohort of the U.S. equity market led by the top five largest stocks in the index – Apple, Microsoft, Amazon, Facebook and Alphabet (Google). Despite the strong quarterly return number, volatility did emerge in September as the market became concerned about the valuation levels of some of these growth stocks and weaker than expected job growth numbers, which prompted a rotation into more defensive stocks. The volatility experienced in September could be foreshadowing for the fourth quarter as the market weighs the timing and efficacy of a vaccine for the coronavirus and the presidential election in November.
International Equities: Developed international equities, as measured by the MSCI EAFE Index, finished the quarter up 4.9% underperforming both the U.S. and emerging markets. Europe is facing an intense second wave of coronavirus infections while the United Kingdom and European Union struggle to make progress on a much-needed trade deal. Emerging market equities, as measured by the MSCI EM Index, rose 9.7% over the third quarter, led by developing Asian countries like China, Korea and Taiwan. The U.S. dollar weakened modestly over the third quarter, which further supported international equity returns.
Fixed Income: Fixed income markets, as measured by the Bloomberg Barclays U.S. Aggregate Index, rose 0.6% over the third quarter. The U.S. yield curve modestly steepened with the 5-year Treasury decreasing .03% to 0.31% and the 10-year Treasury rising .03% to 0.64%. Corporate bonds were a strong contributor to overall market performance, rising 1.33% over the quarter as measured by the Bloomberg Intermediate Corporate Bond Index. The Federal Reserve communicated that it has formally shifted its policy framework to view the inflation target as symmetrical around 2.0%, implying that it may let inflation run above that level to make up for previous shortfalls before raising the short-term federal funds rate.
Commodities: Commodities in general experienced a sharp rebound in the third quarter as economic activity continued to increase, rising 9.1% as measured by the Bloomberg Commodity Index. Lean hogs and silver were the standout performers in the index finishing the quarter up 30.8% and 25.0%, respectively. Oil prices were essentially unchanged from a quarter prior.
The ongoing battle against the COVID-19 pandemic continues to stress the drivers of global economies, societies and financial markets, causing unique challenges as well as opportunities for investors. On the one hand, financial markets continue to climb upwards, fueled by high expectations of additional fiscal stimulus, the discovery of COVID-19 vaccines and a continuing economic recovery. On the other hand, global cases continue rising, with over a million deaths worldwide and over 215,000 deaths in the U.S. alone. Even with the approval of a vaccine, many investors question the potential efficacy of any vaccine currently undergoing clinical trials and the ability to distribute these drugs efficiently when the time comes. From an economic standpoint, a prolonged recovery period adds further stress, with temporary layoffs becoming permanent and increased risk of even more bankruptcies and credit defaults.
However, we believe there is light at the end of the tunnel. There is growing consensus that the U.S. economy is past the worst, despite an elevated level of uncertainty that remains. GDP growth expectations for the third quarter currently range widely, with various Federal Reserve banks such as those in Atlanta, St. Louis and New York estimating that third quarter GDP growth could be anywhere from 14% to 35%. This would represent a significant improvement from the 31.4% decline during the second quarter. In addition, as third quarter earnings season kicks off, consensus estimates point toward recovering earnings growth compared to the previous quarter. Finally, even though November elections are underway and cause concern for many investors given the polarized political atmosphere, we continue to believe that investors who maintain focus beyond near-term election noise will be rewarded over the long term.
This Election Looks Nothing Like History, But it May Rhyme
The November election season continues the broad theme of 2020 — navigating through uncharted territory. With President Trump contracting COVID-19, which may impact the last stages of his campaign, and the unprecedented number of mail-in ballots we are already experiencing, this Presidential election may come with bouts of volatility before and after November 3, particularly if vote counts are contested. Many fear that Election Day may turn into election month, with the potential for civil unrest adding to the mounting social issues we have experienced this year. From an investment perspective, it is particularly important to focus on the long term. Elections have historically proven to serve as short-term noise in the market, however anxiety-inducing they may be.
We reiterate the importance of focusing on policies, not politics, and keeping one’s own beliefs and political affiliations from impacting portfolio decisions. Markets don’t adhere to political parties, and election-sensitive topics such as tax policy have historically proven to be just one of many factors that drive market movements over the long term. We continue to believe that the most significant catalyst for an economic recovery is tied to the ability to control the spread of the virus and the eventual approval of a vaccine. Voters’ views of Washington’s actions regarding COVID-19 may prove to be critical to their decisions at the voting booths (or mailbox as the case may be.)
Figure 1 below shows the average performance of the S&P 500 since 1928 before and after presidential elections. Even when considering the fact that each election cycle has proven unique for different reasons, historically, markets have generally exhibited weak returns around election time as uncertainty around the future of the nation’s leadership weighed heavily on markets. With the election occurring in the midst of a recession, President Trump faces an opportunity to make history once again; no president has ever been re-elected when an election occurs during a recession.
More importantly, regardless of the political party on the winning side, markets have historically experienced positive performance once a president is elected. Once clarity around the country’s leadership and potential policies has been established, the markets regain some sense of their previous equilibrium. If expectations that an economic recovery and the development of a vaccine are a question of “when” and not “if,” the path of markets post election may rhyme with the past.
FIGURE 1: AVERAGE S&P 500 PERFORMANCE AROUND PRESIDENTIAL ELECTIONS: 1928-2016
Source: T. Row Price; Bloomberg
Note: 1-year prior return for 1928 election excluded due to lack of available data; Prior to 1957, data sourced from Robert J. Shiller.
Much Is Riding on Third Quarter Earnings
In addition to underwriting the range of outcomes regarding elections, investors are forced to reckon with underwriting earnings growth as companies begin reporting third quarter earnings. As of the writing of this article, according to FactSet, the S&P 500 is expected to report a decline in earnings of 21% for the third quarter. That would represent the second-largest year-over-year earnings decline for the third quarter since 2009 if actual earnings reflect current estimates (although, over the past five years, actual earnings have exceeded estimates by 5.6% on average). The good news is that this would represent a significant bounce back over second quarter earnings which experienced a 32% decline. One of the challenges that remain is the lack of guidance companies are providing regarding earnings. Nearly one-third of S&P 500 companies are either withdrawing or not providing earnings guidance for 2020 or 2021 due to the ongoing uncertainty of future economic impact caused by COVID-19. This hesitance to offer earnings guidance is somewhat understandable given there was even more uncertainty during the second quarter, a period in which the S&P 500 rallied 20.5%. As shown in Figure 2, this market recovery has contributed to a significant divergence between forward earnings and price appreciation. With elevated prices of 21.9 forward price-earnings ratio (P/E) for the S&P 500 (compared to a 10-year average of 15.5P/E), investors may experience some turbulence if actual third quarter earnings fail to meet or exceed already high expectations, particularly as we head toward elections and economic fundamentals continue to remain slow to recover.
Figure 2: S&P 500 Change in Forward 12-Month Earnings per Share Versus Change in Price
Market Prices May Be Tied to the Fact that They are Not Tied to the Economy
As long as earnings keep pace, market prices may continue to grind higher despite the lagging economy. The uncomfortable reason behind this lies in understanding the differences between what now constitutes the market versus what drives the economy. The COVID-19 pandemic has made it very clear which sectors thus far have been winners and losers due to economic shutdowns and shelter-in-place mandates. Figure 3 compares the sectors that contribute to the U.S. economy to the composition of the country’s largest 1,000 companies by market cap. The largest components of U.S. markets are represented by the technology and healthcare sectors, which have been among the strongest performing sectors this year. In contrast, among the largest contributors to the economy are sectors such as real estate and construction and professional and technical services. For instance, year to date as of the end of the third quarter, the S&P 500 information technology sector has returned 29%. Retail real estate investment trusts have declined 41% for the same period, while the online retail sector has climbed over 60% as shoppers have shifted their buying habits due to shutdowns.
Figure 3: Market Value of Companies versus the Contribution to the Economy
Largest 1,000 U.S. companies; as of 9/15/20
As long as the pandemic continues to impact the reopening of economies, this dynamic between drivers of markets and contributors to the economy may persist, causing a heavier reliance on a smaller concentration of stocks such as large cap growth stocks (e.g., Facebook, Amazon, Netflix, Alphabet (Google), Microsoft) on leading the ongoing market rally.
Investors Should Continue to Focus on Their Long Game
There seems much to worry about as we enter the last quarter of 2020. Our ability to mitigate the spread of the virus remains limited, and elections are causing unsurprising anxiety around issues like COVID-19 policies, changes in tax laws and the path of foreign relations. We have experienced a multitude of societal and environmental challenges, and businesses and families continue to struggle through the current recession. However, we believe we are on the path to an eventual recovery and a return to some sense of normalcy, albeit with a revised version of what normalcy looks like. Overall, we maintain a cautious outlook in the near term for portfolios while maintaining consistency in rebalancing positions and exploiting the many opportunities that the current economic environment has presented. As we enter the last quarter of the year and think about the future that 2021 and beyond may hold, we look forward to opportunities to deploy available capital.