Monthly Update
After 5 months of gains following the tough February and March, a stock market pullback began on September 3rd led by the biggest winners this year, big cap tech. The S&P 500 ended the month down 3.9%, the NASDAQ by 5.2%, and the small cap Russell 2000 by 3.5%[1]. I wish I could say there was a clear catalyst, but there wasn’t. Maybe the market was just ready for a breather after its recent sprint. We did have continued concerns with the pace of the Covid spread, along with the end of the warmer weather, upcoming cooler weather, and what that would mean for the virus when people go back inside again. We saw no fiscal package deal out of Congress, which meant that the added unemployment benefits that expired on August 1st still have not been extended. Or, just maybe, the valuations of some stocks that have led the bull run just got to levels that turned off investors.
Unlike in previous market downdrafts, bonds were no offset. US Treasuries, in particular, were a port in the volatility but saw no price gains of note. Rather, they held steady as the 10 yr yield started the month at .71% and ended the month at .69%[2]. According to the Bloomberg Barclays high yield and investment grade indices, both high yield and investment grade credit traded lower in the month.[3]
The global economy continued to recover, but in fits and starts. China is open to the point where movie theaters are 90% of pre-Covid attendance and domestic travel has seen a sharp rebound. Trip.com, the largest Asian online travel agency, said in its earnings call late in the month that they expect more than 600mm trips to be made in the 8 day Golden Week starting in early October. On the other hand, some European countries like the UK and Spain are reinitiating some Covid-driven restrictions, because of rising case counts. The US economy is expected to rebound by 34% in Q3 according to the Atlanta Fed, but only after a 31.4% q/o/q annualized decline in Q2.[4]
The months ahead are potentially filled with especially important market moving news and events. Of course, we have the election on November 3rd, optimistically positive news on the progress of a Covid vaccine, and Q3 earnings results. In particular, Pfizer is expected to release results of its phase 3 trials in late October or early November[5].
The Stock Market
As stated, after an amazing run the big cap tech stocks finally had a pullback of note. To list the extent of the declines of the biggest and well known ones, Facebook fell 10.7%m, Apple by 10.3%, Amazon by 8.8%, Microsoft by 6.7%, and Alphabet/Google by 10%[6]. With these five companies making up almost 25% of the S&P 500, it’s tough to offset that in the short term[7].
Perspective, though, is always important. The August rally took the S&P 500 above the previous high in February, pre-Covid. The rally has been incredible in light of the upside down world we’re in. We can thank the resilience of the tech stocks and the Federal Reserve for that rally.
International stocks were also weak in September, but some outperformed the US, as the Euro STOXX 600 index was down just 1.5%, while the Japanese Nikkei was up by .2% and the South Korean Kospi was flat[8]. On the flip side, the Shanghai composite was weaker by 5.2%, but is still up on the year by 5.5%[9].
When trying to figure out the direction of the market from here, valuation should always be a big picture overlay. Right now, the S&P 500 is trading at 20 times 2021 earnings estimate[10]. That is rich, as while interest rates are very low, they are so because growth is also low.
The Federal Reserve
I mentioned in the August letter that Jay Powell, in his virtual Jackson Hole speech, laid out the Fed’s strategy of targeting a 2% inflation rate over time. ‘Over time’ means that they want it to average 2%, but over some undefined time frame. In the September FOMC meeting, the Fed statement, and in Powell’s press conference, we got no greater clarity on what this new inflation targeting regime will actually look like. As I said last month, I don’t believe wanting higher inflation is a good idea, 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.
Bonds
The brilliance of the longstanding and conventional 60/40 asset allocation between stocks and bonds over the years has been seen in great risk adjusted returns. That during times of turbulence for stocks, bonds rallied to an extent that mitigated the overall portfolio pain. The help of a 40 yr bull market in bonds has been the incredible ballast and generator of good returns, regardless of what stocks did. The question before the house, then, is what happens from here, when the starting point of interest rates is now so low. While yields can still go lower, a 10 yr yield of .68% is already so close to zero that most of the rate decline is already in. Thus, we should start looking at the fixed income side as more to help preserve existing capital, rather than a means of enlarging it.
All other areas of credit also took a breather along with stocks, particular corporate credit with both high yield and investment grade under pressure. The latter have been a big beneficiary of Fed buying while the former has ridden the coattails. Though now the issue with high yield is that default rates are rising while credit spreads remain tight. That is a more precarious situation for those looking for opportunities on the long side.
The US Dollar
Along with the equity market pullback, the dollar rallied for the 1st time since March, as carry trades were unwound and the dollar was a flight to safety. The euro heavy dollar index was higher by 1.9% after a combined 7% drop in the prior five months[11]. Looking forward, I continue to believe that the rising debts and deficits (both trade and budget) will be a headwind for the US dollar, along with the Fed’s zero rate policy and QE program, where they are buying $80b of US Treasuries and $40b of mortgage backed securities each month, that has taken their balance sheet to $7 Trillion[12].
As I stated in the August letter, a weaker dollar will help the earnings of multinationals that export goods and services, but it will raise the cost of imports, and thus can be inflationary. It will reduce the purchasing power of our consumer spending dependent economy, as companies try to offset higher import costs with higher prices passed on to consumers.
The Economy
An economy that declines about 30% q/o/q and then recovers by a like amount in the following quarter is still around 10% below its peak. Thus, even after a strong Q3 economic rebound, the US economy will still need more time to get back to the Q4 GDP level that was its peak. Hopefully, that full recovery can take place sometime in 2021 and then an expansion can resume. The effectiveness of a vaccine will certainly drive the timeline.
With respect to US consumer spending, very generous government transfer payments where consumers got more money than what was lost via the decline in wages and salaries helped to drive consumer spending to above pre-Covid levels. Housing has been a particular bright spot, as the desire to live in the suburbs from the cities, the need for more space and taking advantage of historically low mortgage rates have all combined to lift activity. On the manufacturing side, the need to rebuild inventories has given a boost to factory activity. The big question is, what happens now that the summer is over, the weather gets colder, and we head back inside again? Once more, the results of the vaccine trials are so key here.
Conclusion
Whether the market correction in September is the beginning of something more, or just a needed rest, will likely be determined in the short term by the election results in early November (that’s if we get a result on election night), Q3 earnings results, and the vaccine news that we should start getting within the next month or two.
Whatever the outcomes of the above, 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. Please do not hesitate to reach out at any time with questions or for any discussion on the economy and markets.
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