The Broad View
The stock market plunge that followed the coronavirus outbreak early this year was a heart-thumping reminder that bear markets can strike without warning. The past few months, however, have shown the flip side of that dynamic to be equally true: Forceful rallies can take hold just as swiftly and unexpectedly. It’s unclear how stocks will proceed from here, given that share prices have jumped despite a daunting economic overhang and still-unanswered medical questions. But at a minimum, the rally has underscored the risks involved in timing the market, as anyone who fled to the sidelines during the selloff missed the gains that ensued.
Looking forward, the most immediate issue may be the disconnect between the optimism in the market and the far more sobering economic backdrop. With the S&P 500 index rising more than 20% in the second quarter, the equity rebound is based on the notion that the worst financial damage has passed. Stocks have been galvanized in part by assertive monetary and fiscal policies. And as they have in the past, share prices may be anticipating an economic turn before a recovery becomes broadly visible.
Still, there are considerable risks that could cause equities to retreat anew. COVID-19 is uncharted territory, and a resurgent outbreak across parts of the U.S. has raised fear of a second wave that could undercut the fledgling recovery. Even if the pandemic is brought under control soon, the sheer magnitude of this year’s economic riptide could leave lingering financial or societal damage.
On a big-picture scale, the pandemic is likely to hasten some trends and hatch others, though which ones and by how much are yet to be determined. The digitization of daily life may accelerate as e-commerce and streaming video lure new adherents. The outlook is murkier for other parts of the business landscape, including the future of global supply chains and demand for commercial real estate.
The shape of the economic recovery is also up for debate. Three basic scenarios are: a V pattern with a quick drop and rapid bounce up, a U shape in which the economy drags for a while before rebounding and a W that entails a painful second leg down. Each has seemed both more and less likely at various points during the crisis.
But the near-term direction of the economy and share prices may be less important than how investors react to them. This year’s utter unpredictability has highlighted the risk of overreacting to external events with abrupt portfolio moves. Bear markets — and subsequent rallies — can occur with no advance notice, and history has often shown that the best strategy for long-term investors is to disregard the noise.
Considering the somber outlook a few months ago, U.S. economic indicators have been relatively upbeat. Unemployment has eased as regional lockdowns have lifted, and some furloughed employees have returned to work. Pent-up demand has aided retail sales and manufacturing activity.
The market has gotten an unmistakable boost from the massive U.S. policy response. The Federal Reserve expanded its balance sheet by a massive $3 trillion in three months, while fiscal stimulus has been larger and deployed far more quickly than during the 2008 financial crisis.
Looking ahead, the Fed has deployed only a portion of the money available from its emergency spending programs, giving it room to do more if conditions deteriorate. On a consumer level, a surge in the personal savings rate, due partly to housebound shoppers having fewer opportunities to spend, could aid growth in the near term.
In the long run, past economic upheaval has had the counterintuitive effect of hatching promising companies. Among others, McDonald’s, Starbucks, Apple and Facebook all started up during tough economic times.
Of course, the path of the coronavirus — and the government’s willingness to extend further stimulus — loom as big question marks. Barring a severe jump in cases, political leaders may shy away from restrictive lockdowns, given the social and economic costs. But vaccine development is typically slow, and it’s unclear how consumers might react if COVID-19 lingers.
An immediate issue is whether Congress will approve another aid package — specifically, the additional $600 a week in jobless benefits that are set to expire in July. Though the unemployment rate receded from 14.7% in April to 11.1% in June, it still tops the worst level of the 2008 financial crisis. If jobs are slow to return and income support falls off, the economic fallout that the initial stimulus was meant to deter may take hold anyway.
The foundation of the market rally also raises questions. Technology stocks have spearheaded the advance as sheltering in place has accentuated trends such as rising digital payments and telemedicine. But the market has become top-heavy. The five biggest businesses in the S&P 500, all tech companies, account for 22% of the index’s weighting, nearly double the concentration of six years earlier.
The U.S. presidential election adds another layer of complexity. Markets have climbed over much of the past four decades regardless of which party occupied the White House. However, market volatility has often risen during presidential election years.
In the bond market, returns were solid across sectors, including taxable and municipal securities, as yields remained low. As interest rates have fallen and credit spreads have widened, our fixed income investment team has moved to neutral duration and added credit.
Corporate bond valuations were expensive at the start of 2020 but became decidedly more attractive. Credit spreads — the extra yield that corporate bonds pay in comparison with U.S. Treasuries — widened sharply as the coronavirus set in, reaching levels not seen since the global financial crisis. As equities recovered, credit spreads tightened again, though they remain wide from the beginning of the year.
As for municipal bonds, the March selloff pushed valuations down and created significant value. Since then, the gradual reopening of local economies and tentative signs of improving jobless claims have boosted sentiment around the asset class. Our fixed income team believes there are pockets of compelling value despite recent gains. With interest rates expected to remain low and the possibility of higher tax rates in the future, munis offer an attractive source of tax-advantaged income.
As always, fixed income offers potential benefits, including income generation and capital preservation. This year has demonstrated the importance of bonds in providing diversification from the sometimes sharp swings in theequity market.