December Investment Comments
The election season is almost over, with a few disputes remaining to be resolved along with several incomplete congressional elections. Control of the Senate is up in the air, with 50 Republicans and 48 Democrats seated and two runoff races in Georgia set for early January.
Voters opted for divided rule. Democrats picked up the White House and at least one Senate seat, and retained control over the House. Republicans added one governorship and several state legislatures, sharply narrowed Democrats’ majority in the House, and likely retained a slim majority in the Senate. Neither party has run the table; both parties will have to work together to accomplish anything. This setup increases the odds of cooperation, moderation, and stability, a rarity in these partisan times.
Investors frequently overstate the investment significance of Washington, D.C. Over the long term, the stock market has actually performed better under a Democratic administration than a Republican one. Divided rule, like we now appear to have, is thought to produce the best results for the stock market, but even this platitude is subject to some qualification. According to Dow Jones Market Data, the very best results have come from a Democratic president and a Congress controlled by Republicans or shared congressional power, i.e. what we appear to have, should Republicans retain at least one of the Georgia Senate seats.
Regardless of politics, the stock market is a function of corporate earnings which in turn are a function of economic growth. A government focused on economic growth rather than non-economic interests will foster a favorable environment for investors.
U.S. economic growth is rebounding following the near-shutdown induced by the COVID pandemic. Third quarter Gross Domestic Product rose at an annualized rate of 33.1%, recovering three-quarters of the second quarter’s decline. Further growth into the fourth quarter is likely, although regional restrictions resulting from rising COVID cases will probably temper growth. Overall, though, most indicators point to an economy that is still about 5% smaller than before the pandemic.
The unemployment rate fell to 6.9% in October from a high of 14.7% in the Spring. Retail sales remain strong, although cracks are starting to appear following the resurgence of COVID in October. Industrial production is returning as factories struggle to keep up with demand, especially following supply chain problems, as production restarted at an uneven pace. Shortages of many products have been reported, including toilet paper, cars, and even paint. Lower consumption of services like travel and dining out explains all the decline in the U.S. economy from pre-pandemic levels even as consumption of goods is at an all-time high.
The first thing we think of when we hear the word “shortages” is “inflation.” Shortages give pricing power to producers. However, inflation has been surprisingly tame, rising just 1.2% year-over-year in October, or 1.6% excluding the volatile food and energy sectors.
Europe experienced even stronger growth than the U.S. in the third quarter. It was hit harder by the pandemic in the spring and experienced an even sharper fall in output. A resurgence of the virus and accompanying economic shutdowns point to negative growth in the fourth quarter for Europe.
Due to greater experience with past viral outbreaks and cooperative citizens, the economic impact on Asia has been much more muted. China actually returned to year-over-year growth in the third quarter while many other Asian countries have experienced only moderate contractions.
All three major U.S. stock market indices reached new all-time highs in November. The primary catalyst has been success producing vaccines to prevent COVID-19. So far, two vaccines have shown 95% effectiveness without significant side effects. There are at least four other vaccine candidates under development by leading pharmaceuticals firms. The U.S. government has pre-bought 100 million doses from each firm, providing the six candidates with approximately $10 billion to fund research and development and to begin manufacturing product before even knowing whether their vaccines will be successful. However, having access to product right away upon approval leads experts to believe most Americans can look forward to receiving a vaccine within the next six months. The market has been encouraged, as should we all, to see light at the end of the tunnel.
Stock valuations are somewhat stretched as low interest rates and a flood of government money have pushed investors into stocks even as corporate earnings are down in many cases. Still, there are pockets of opportunity even though one must search harder than in the past to find them. We continue to believe the stock market can produce much better risk-adjusted returns than a 10-year Treasury bond still yielding less than 1%.
Scott D. Horsburgh, CFA