August Investment Comments

“If you see that kind of disconnect, it doesn’t go on indefinitely.  Those normally will get reconciled, and this will too.”

These were the words of Federal Reserve Board Bank of Dallas President Robert Kaplan when interviewed by CNBC on July 13th.  He was referring to the disconnect between the financial markets, with an upbeat view of the future, and the performance of the economy, which remains under stress.  The question for investors, of course, is will the markets move towards the economy or the economy towards the markets?

The stresses in the economy are easy to see.  First quarter U.S. GDP decreased 5%, understating the sharp drop of activity starting in March as states instituted stay-at-home orders to slow the rapid spread of COVID-19.  The Federal Reserve of Atlanta’s GDPNow estimate for the second quarter calls for a 35% decrease, a breathtaking decline, but up from an early June estimate of a 55% drop.  States began to reopen their economies in May, leading to a meaningful jump in activity that contributed to closing the 20% gap.

After shedding 21 million workers in March and April, May and June saw employers add 7.5 million jobs as states reopened their economies.  The unemployment rate in June registered 11.1%, down from 14.7% in April.  New weekly jobless claims, after soaring to almost 6.9 million in the final week of March, have declined to 1.3 million in mid-July.  This is good news only in a relative sense as this latest tally represents the 17th straight week claims have exceeded the previous weekly record of 695,000 recorded in 1982.

Further, in recent weeks the jump in daily infections of COVID-19 in states that had reopened their economies appears to be slowing the recovery.  California, Texas, and Arizona have seen the biggest jumps and have responded with various directives to get the virus under control.  Governor Gavin Newsom in California has reinstituted closure restrictions for parts of the state that cover 80% of the population and resemble the tough shutdown steps taken in March.  Most other states are seeing increasing positive COVID-19 cases as economic activity increases.

It is no surprise that travel and hospitality have been hard hit, but only now are we beginning to see the impact of the sharp falloff in activity.  Delta Airlines recorded a $5.7 billion loss in the second quarter and for the third quarter will utilize only 25% of last year’s capacity.  United Airlines has sent mandatory 60-day furlough notices under federal labor rules to 36,000 of its employees, 45% of its 80,000 U.S. workforce.  The company has been covering staff costs with Federal aid that runs out October 1st and does not anticipate taking further support to pay workers without revenue generating activity.

Contrasting this tough economic environment is the resiliency of the financial markets.  After falling 35% in March, the S&P 500 gained 20.5% during the second quarter, its best quarterly return since the fourth quarter of 1998, and has registered a modest 3.1% loss for the first half of 2020.  Even though analysts project second quarter earnings to fall approximately 45%, the market appears to be betting on the rapid development and deployment of a COVID-19 vaccine to return the economy to pre-pandemic normalcy.  Because 185 S&P 500 companies have pulled or limited their guidance, analyst projections are wider than normal, but the current view is that 2021 will return to 2019’s level of profitability, implying a 2021 S&P 500 P/E ratio of 19.0.

The financial markets further appear to assume The Federal Reserve and U.S. Government will continue to provide unprecedented support to workers and businesses that will carry the economy through the COVID-19 pandemic.  After pumping $3.0 trillion of liquidity into the economy to date, Mr. Kaplin and other Fed officials continue to reiterate that the Fed will do whatever is necessary to provide additional liquidity and hold interest rates steady for the foreseeable future.  The 10-Year Treasury has been rangebound at roughly 0.5%-0.7%, far below the 2%+ level earlier in the year.  If analysts are right about 2021, equities do not appear expensive with interest rates this low.

But what if the market is wrong and a vaccine is not forthcoming until mid-2021 or later?  In this case it would be illogical for corporate earnings to grow to pre-pandemic levels.  Up to now the U.S. Government’s fiscal support has been substantial enough to slow what would have been jarring restructurings of major parts of the economy, particularly travel, hospitality, and various service industries.  Just like the Fed, it is likely the U.S. government will continue to provide additional fiscal support, but probably not on the scale of the $3.3 trillion committed to date.  Even in the face of all this support more than 30 U.S. companies with liabilities exceeding $1.0 billion have filed for Chapter 11 bankruptcy since the start of January, including household names Macy’s and Hertz.

So, what should an investor believe:  the market or her eyes?  The answer is probably somewhere in the middle, with the markets and economy likely moving toward each other.  In the second quarter, JP Morgan, Citigroup, and Wells Fargo reserved a combined $28 billion for anticipated loan losses as government mandated consumer and business deferral payment programs come to an end.  Per JP Morgan’s CEO, James Dimon, “This is not a normal recession.  The recessionary part of this you’re going to see down the road.”  Not surprisingly, bank shares declined on the news to adjust for this bleaker outlook.

Does this mean investing now is foolish as the market is set to fall?  There is risk, but, as always, stock selection is key.  We note that shares of firms exposed to remote work, cloud software, and other tech trends have vastly outperformed in 2020.  Technology now makes up a 28% weight of the S&P 500, up from about 21% in late 2016.  The recently created Communications Services sector, which includes Facebook (FB), Alphabet (GOOG), and Netflix (NFLX), has increased to 11% from about 3%.  Large tech companies are attractive given their robust growth and strong balance sheets, but their valuations have been bid up.  Economically sensitive sectors have seen declines, particularly Consumer Discretionary, Industrials, and Financial Services, but there are strong businesses here that can be purchased at much more reasonable prices.

Daniel J. Boyle, CFA