Quarterly Market Digest - 3Q2020
by Keith A. Rhodus on Oct 7, 2020
QUARTERLY MARKET DIGEST
Client Letter | 3Q20 Market Review
The U.S. stock market rally remained intact to start 3Q20 as July and August both produced positive market returns. The path of least resistance was higher for stocks as central bank stimulus supported the economy and created a liquidity tailwind. Big Tech, which includes popular names such as Apple, Amazon, Facebook, Google, and Microsoft, carried the stock market higher. The S&P 500 and Nasdaq both reached all-time highs in late August. From a sector perspective, Financials (low interest rates, loan losses), Real Estate (tenant rent deferrals, uncertainty created by the work-from-home trend), and Energy (falling gas demand, weak oil prices) each trailed the broad market.
2Q20 earnings resilience was a key driver of the August stock market rally as companies beat estimates at a high rate. Overly pessimistic Wall Street estimates, monetary and fiscal stimulus support, and aggressive cost cutting measures drove the strong earnings beat rate. Improving sequential demand during May and June was a common theme on earnings calls. However, company management teams were still very cautious and uncertainty remained high for the second half of 2020.
U.S. credit markets mostly followed the equity market’s lead. High-yield corporate debt and municipals outperformed investment grade corporate debt and U.S. treasuries. With interest rates near historic lows, savers continue to bear the brunt of the Federal Reserve’s stimulus policies. Yield starved investors face difficult decisions related to the tradeoffs between higher credit risk and higher yields.
Positive Investor Sentiment & Negative Real Yields Support Strong Stock Market Performance
Monetary stimulus continues to materially impact stock market dynamics. Central bank asset purchases are keeping interest rates low and tightening corporate bond spreads. The result is a stimulus induced stock market rally willing to overlook the fragile economy, rising coronavirus cases, and expensive stock market valuations.
While stimulus measures are credited with protecting the economy, they can distort stock markets. Movement in real yields, which represent the interest rate earned after accounting for inflation, is a prime example. Figure 1 (on the following page) shows the dramatic decline in real yields this year. At the end of 3Q20, real yields for 5YR, 10YR, and 30YR U.S. treasuries were all negative. This means an investor could expect to earn a negative yield, after accounting for inflation, by holding these U.S. treasury maturities.
Negative real yields are forcing investors to search for positive returns elsewhere. Higher growth assets, such as big tech stocks and emerging market stocks, are relatively more attractive. Gold is a popular inflation hedge and an attractive asset to store value because investors are sacrificing lower yields to diversify and protect their portfolios. Lower interest rates also tend to support higher equity valuations. With interest rates expected to remain low for an extended period of time, this is giving investors the comfort to purchase expensive stocks. The risk to this investment thesis occurs if real yields rise (e.g. become less negative) and bonds become slightly more attractive.
September 2020 Market Sell Off Shakes Investors
Global stock markets were broadly lower in September. The most talked about theme was big tech’s weakness. The group traded lower after months of pushing the U.S. stock market higher. There was no clear catalyst for the sell off, but common concerns revolved around an overcrowded tech trade and stretched stock valuations.
A second, but less discussed catalyst, was movement in the real yield curve. Figure 1 shows how real yields ticked higher from August into September. The small tick up caused investors to question whether it still makes sense to purchase growth stocks at whatever price.
Coronavirus Resurgence & Stalling Recovery
The coronavirus pandemic and a stalling economic recovery were at the forefront of investors’ minds throughout 3Q20. The U.S. faced an uptick in coronavirus infections in July and August. Multiple European countries, including the United Kingdom, France, and Spain, experienced a late summer resurgence, while Latin America struggled to combat the coronavirus pandemic.
Vaccine progress and positive clinical trials kept investors optimistic, which allowed markets to overlook the uptick in coronavirus infections. However, high-frequency data suggests the economic recovery is stalling. Figure 2 charts the year-over-year decline in restaurant reservations made via OpenTable and passenger throughput at TSA checkpoints. Public transit ridership remains weak as well. Sporadic pauses and rollbacks of reopening plans, consumer behavior changes, declining stimulus, and falling pent-up demand from initial shutdowns were each cited as factors leading to the economic deceleration.
Political Risk Creates Stock Market Risk
Markets continue to expect Congress to pass a fifth stimulus package. However, it became apparent in late 3Q20 that Congress’ stimulus negotiations were going nowhere. The two sides remain far apart on multiple issues, including the total size of the package, aid for state and local governments, and liability protections for reopening businesses. Distractions created by mail-in ballots and a Supreme Court vacancy complicate the path to a bipartisan compromise ahead of the election. Congress’ inability to pass additional fiscal stimulus could put the U.S. economic recovery at risk. Federal Reserve Chairman Powell previously cautioned Congress against pulling back fiscal stimulus.
There is also a growing unease around the upcoming 2020 presidential election. Markets are concerned about a prolonged period of uncertainty if the election results are delayed or contested. The result could be a volatility surge in the weeks surrounding the November 3rd election. If market volatility does increase, it is important to remain rational and remember stock markets primarily trade on future earnings projections and company fundamentals.
4Q20 Investment Outlook
As the stock market enters the final quarter of 2020, there are numerous risks to be cognizant about. The 2020 presidential election, a stalling economic recovery, and rising coronavirus infections each present headwinds. In addition, the U.S.’s consumer financial health is at risk. Enhanced unemployment benefits lapsed on July 31st as Congress struggles to pass additional fiscal stimulus. The labor market is also showing signs of strain. Disney, United Airlines, Shell, and Allstate Insurance each recently announced job layoffs. In addition, rent, mortgage, and other loan deferrals are expected to come due at some point.
All these risks could (and likely will) cause market volatility to increase. However, it is important to remember, investors who focus on short term movements are only observing the variability of the portfolio, not the returns. Do not let the volatility impact your long-term financial goals. The current news cycle will continue to change rapidly, and we will be watching things closely. Onward and upward!
Important Disclosures: Clare Market Investments, LLC is a Registered Investment Advisor. This material is for informational purposes only. It is not intended as and should not be used to provide investment advice and is not an offer to sell a security or a recommendation to buy a security. This summary is based exclusively on an analysis of general market conditions and does not speak to the suitability of any specific proposed securities transaction or investment strategy. Judgement or recommendations found in this report may differ materially from what may be presented in a long-term investment plan and are subject to change at any time. This report’s authors will not advise you as to any changes in figures or views found in this report. Investors should consult with their investment advisor to determine the appropriate investment strategy and investment vehicle. Investment decisions should be made based on the investor’s specific financial needs and objectives, goals, time horizon and risk tolerance. Except for the historical information contained in this report, certain matters are forward-looking statements or projections that are dependent upon risks and uncertainties, including but not limited to such factors and considerations such as general market volatility, global economic risk, geopolitical risk, currency risk and other country-specific factors, fiscal and monetary policy, the level of interest rates, security-specific risks, and historical market segment or sector performance relationships as they relate to the business and economic cycle. See claremarket.com for additional information and disclosures. © 2020 Clare Market Investments, LLC
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