Second Quarter Recap and Key Market Drivers

When COVID-19 first appeared on our shores, many analysts expected the impact to be akin to a natural disaster such as a hurricane or earthquake. Under this scenario, any lost production would be recovered quickly over subsequent quarters. When the situation intensified and led to a virtual lockdown of the global economy in March and April, focus shifted towards the longer-term damage on specific industries and sectors of the economy.

Better than expected economic data in May and June increased confidence that the lockdown-induced decline bottomed in April. Various purchasing managers and consumer sentiment surveys and statistics from housing, durable goods orders, employment, and consumer spending helped confirm the sharp equity rally. By the end of second quarter, global equities and other risk-based assets had retraced a good portion of their first-quarter losses. This sharp rebound was a function of aggressive fiscal, monetary, and social policies, and hope the economy would fully reopen in the third quarter.

The stimulus checks, enhanced unemployment benefits, and business loans provided at the beginning of the crisis were meant to replace lost income and keep businesses solvent during the lockdown. Even though the jury is still out on the effectiveness of these initiatives, many are calling for another large fiscal package. However, there are concerns that the enhanced benefits may be disincentivizing individuals from returning to work. As such, it will likely take a notable deterioration in the equity markets or economic statistics to spur Congress to act.

As we head into third quarter, there are a few byproducts of the COVID-19 crisis that bear watching:

Trade. China’s perceived lack of transparency about the virus appears to have broken the fragile trade détente between the U.S. and China. Towards the end of the second quarter, trade frictions extended to Europe as the U.S. threatened retaliatory tariffs if Europe imposes a digital tax on U.S. technology companies.

U.S. elections. Recent events have widened Joe Biden’s lead over President Trump in the polls, increasing the probability of Democrats winning control of the Senate in the fall. History has shown no discernible difference in long-term equity market performance among the parties. That said, the rising probability of a Democratic sweep can be viewed as another near-term headwind for markets, given the strong advance seen in the second quarter.

Unemployment. The potential loss of state and local government jobs due to dramatic budget cuts could further slow the economic recovery unless Congress passes a substantial fiscal aid package.

Inflation. Concerns exist around the inflationary implications of the unprecedented expansion of monetary policy. But as of now, there is no indication of inflationary pressures. The global economy remains far from producing and consuming at full capacity.

Our Perspective

Equity Markets

 
  • One of the primary criticisms of the equity market advance was that it wasn’t broad enough to be sustained. A few companies in a limited number of sectors dominated the rebound. Technology, health care, and certain consumer discretionary companies should continue to benefit from the shift to working from home, the search for treatments and vaccines, and the continued rise of online shopping.
  • Energy and energy capital expenditures could have a weak recovery, given the 35% year-to-date decrease in oil prices.
  • Certain subsectors of the real estate market could face challenges through the end of the year. The need for rent abatements due to business and office closures could impact malls and commercial real estate.
Bond Markets
  • The fixed income markets saw minimal movement in longer-term rates over the quarter. However, the Treasury yield curve did steepen slightly as shorter-term rates declined with the aggressive Fed ease.
  • The Fed’s unprecedented purchases of lower-rated and sometimes below-investment-grade securities buoyed the U.S. high-yield markets.
  • Emerging market debt received a boost from the early reopening of Asian economies and the recovery in energy prices from the deep declines at the beginning of the quarter.

Monetary Policies/Currencies
  • The unprecedented expansion of monetary policy had little to do with decreasing the already low fed funds rate, but more with ensuring liquidity to the markets and preventing the seizures experienced during the financial crisis of 2008-2009.
  • The Fed’s aggressive policy and commitment to maintaining rates at existing levels for the foreseeable future have allowed multiples on projected earnings to expand. In other words, investors should be willing to pay more for corporate earnings, given the relatively weak returns from competing asset classes such as fixed income and cash.

What This Means for Investors

The May/June economic rebound could merely be a sign of pent-up demand exploding out of the gate as the economy reopened, not a sustained recovery. The willingness of consumers to fully re-engage remains to be seen, given the continued pandemic conditions. Investors should be wary of a recurrence of virus infections and the longer-term economic damage caused by the lockdown.

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