Market Commentary - August 2020

Monthly Update

It was another amazing month for markets and one in which took the S&P 500 and NASDAQ to fresh all-time highs[1]. A combination of recovery hopes, a very easy Federal Reserve, and good old fashioned stock splits drove the performance where the S&P 500 was higher by 7% and the NASDAQ by 9.6%[2]. Even the underperforming Russell 2000 joined the party with a 5.5% gain[3].

We also saw a rebound in long term interest rates[4]. As the Federal Reserve has pinned short term rates near zero, longer term rates are the only thing left that can be moved by the markets and they did so in August. This was mostly in response to the Fed saying they will tolerate higher inflation above their 2% target to offset a period of time below that[5]. They refer to this concept as either ‘inflation symmetry’ or ‘inflation averaging.’ Either way, the Fed is telling us they want higher inflation.

The global economy continues to rebound in Q3 from the obviously difficult Q2. The pace and sustainability though in coming quarters remains the big question as it will likely take some more time before we exit the recovery and enter the expansion.

In the months ahead we’ll hear more information on the phase 3 trials of different vaccine trials and we’re optimistic we’ll get good news. It will still likely be a 2021 event before we are mass inoculated but the pace at which drug companies are trying to find effective ones is quite amazing.

The Stock Market

In what hearkened back to the technology driven stock market in the late 1990’s, we saw announcements from both Apple and Tesla where they announced their decisions to split their stocks in order to lower the per share price but in conjunction with an offsetting rise in shares outstanding. The general goal on the part of companies in doing this is to allow individual investors the opportunity to buy at a reduced per share price. There is no resulting change though in the value of the company just as there is no difference between a $5 bill and 5 singles. This said, just as it did in the late 1990’s, it stoked market speculation and short covering and both stocks had sharp rallies.

Stocks are now expensive priced at 27 times earnings as of this writing and 21 times the 2021 estimate of about $165 which equals the record level of earnings seen in 2019[6]. Valuations don’t mean anything for stock market performance in the short term but the higher they are, the more future return has been pulled forward.

The Federal Reserve

The continued sharp increase in money supply, by 25% year over year as measured by M2, engineered by the Federal Reserve and US government, has been a major support for asset prices along with the Fed’s policy of keeping rates near zero for likely years to come[7]. This has been a big help in expanding P/E multiples.

Noteworthy in August was the annual Jackson Hole central bank get together, remotely this year, where Jay Powell laid out the Federal Reserve’s plan to have inflation average out to their target of 2%. He didn’t specify over what time frame or to what extent they will allow inflation to be above 2% but the point is they want higher inflation.

I’m of the belief that it is nonsensical as the last thing the consumer needs is a higher cost of living and the last thing an over indebted economy can stand is higher interest rates. Instead, the Fed has their own econometric models and reasons and they made it clear what they are striving for. The same can be said for what the Bank of Japan and European Central Bank have been trying to attain for years but to no avail. The Fed is conducting the same policies but hoping for a different result.

Interest Rates

August was an interesting month with respect to market driven interest rates. The 10 yr yield jumped by 18 bps to close over .70%[8]. For perspective it was 1.15% in February but got as low as .51% in early August[9]. Also of note, inflation expectations in the TIPS market continued higher and now sit to match the highest level since May 2019[10]. I believe we will be seeing higher inflation in the coming quarters and in 2021 because supply chains have been very disrupted by Covid. The fiscal stimulus helping the demand side has been strong and an eventual successful vaccine will further increase that demand. The Federal Reserve should be careful what they wish for.

The rise in rates also led to selling in corporate credit as both investment grade and high yield indices traded lower[11]. This though comes after an amazing rally in prior months helped by the Fed’s decision to purchase corporate bonds, most of which have been investment grade, including Apple to name a credit.

The US Dollar

Another noteworthy move in markets was that of the US dollar and that was lower again. The euro heavy dollar index closed down for a 5^th straight month and is at the lowest level since 2018[12]. This index is down 7% since the February close and I attribute the weakness to both the extraordinary easing by the Fed and also due to the exploding debts and deficits being taken on by the US government, recently of course to help the economy in our world of Covid[13].

While a weaker US dollar can help the earnings of multinationals that export goods and services, it will raise the cost of imports and thus can be inflationary. This rise in costs could pressure profit margins and if passed on to the consumer could lead to higher prices and less spending. Also, foreigners own a large amount of US assets and they won’t be happy with a weaker dollar but on the other hand, it will make future purchases of US assets that much cheaper.

The Economy

The economy was a mixed bag in August as growth continues to bounce as businesses further reopen but the labor market, as measured by initial jobless claims, remains a challenge. Initial jobless claims averaged 1mm a week in the month and this as the extra $600 per week that unemployment provided to recipients expired[14]. That though will likely be extended by Congress, if they can come to an agreement, in coming weeks but at a reduced level. The extraordinary amount of government transfers since Covid has actually offset the reduction in wages and salaries. A slowdown in that pace should now be expected.

Economies overseas also continued to recover but the timing of when the world gets back to its pre-Covid economic pace will still take time. Asian countries likely will be getting there first for the sole reason that they were impacted much less and didn’t shut their economies down to the extent that the US and Europe did.

Conclusion

I seem to get this question every week, how can the stock market be doing so well when the economy is still so challenged? My answer has been that we’ve seen many times in history where economic growth and the stock market disconnect where one gets ahead of the other. This is certainly one of those times and dramatically impacted by Fed policy but at some point the differential needs to be reconciled. When that is though remains to be seen and how it will happen of course is too.

Either way, it is vital that investors have a plan that suits their short term liquidity needs over the coming 24-36 months. Knowing this is covered can help cushion the balance of one’s portfolio against what I believe will be a continued choppy time for both the economy and markets. This is hopefully a once in a lifetime experience, and not in a good way, that doesn’t just solve itself in a few months. Please do not hesitate to reach out at any time with questions or for any discussion on the economy and markets.

Disclaimer