The fastest, most economically destructive recession is now in investors’ rearview mirrors. CIO Larry Adam shares his perspective on the unfolding recovery.
This October marks 80 years since the opening of the Pennsylvania Turnpike, the United States’ first highway. Highways have been a critical driver of economic growth due to the connectivity, speed, and efficiency they provide. As Confucius so appropriately stated, “roads were made for journeys, not destinations.”
The last six months have undoubtedly been a challenging journey as the U.S. grapples with the COVID-19 outbreak. While we wish we could have bypassed the pandemic and its accompanying twists and turns, investors have learned that it is critical to focus on the road ahead rather than the rearview mirror. The virus understandably caused us to reroute our original 2020 outlook, but we are confident there is light at the end of this unwelcome COVID-19 tunnel. We may not have hit the last bump in the road just yet, so adhering to a disciplined investment strategy will be of the utmost importance if you wish to arrive at your destination, achieving all your goals and objectives.
The road to recovery has been under construction since real-time activity metrics bottomed in April, and the U.S. economy has improved from the severely depressed levels experienced during the shutdowns. Now, with the fastest and most economically destructive recession in modern history behind us, third quarter GDP is revving up to grow 25-30%—the best quarter of growth on record. Despite this, there are still many miles to go before the size of the economy returns to pre-COVID GDP levels (forecast of approximately -3% GDP for 2020, accelerating to about 2.7% in 2021). The recovery is unfolding in a K-shaped pattern, where different parts of the economy recover at dissimilar paces and magnitudes. This expectation is cemented by our assessment that the pandemic inherently favors certain sectors and industries more so than others, allowing certain companies (e.g., e-commerce, medicine, air freight) to enter the express lanes while forcing others (e.g., airlines, hospitality, leisure) to wait until the COVID-19 gridlock clears. Ultimately, a vaccine could alleviate this congestion and the lingering psychological impact of the virus, but even if a safe, effective candidate is approved by year end (80% - 90% probability) it would likely only be available for certain subsets of the population (e.g., medical professionals), with widespread distribution not occurring until mid-2021.
The pandemic’s prolonged impact makes it increasingly important for Congress to pass a Phase 4 fiscal stimulus deal that bridges the economy to more normal times. Jobless claims remain elevated, with much of the lost wages occurring in the lower income brackets. However, the recent bounce in economic data combined with Congressional leaders’ continuing resolution to fund the government through December 11 has resulted in a roadblock in negotiations, likely postponing a deal until after the election. In contrast, the Federal Reserve has performed ongoing maintenance to its already accommodative monetary policy in order to support Main Street, which includes holding short-term interest rates at zero through at least 2023.
The economic recovery may help the 10-year Treasury yield drift higher to ~1% by year end and 1.40% over the next 12 months, but upside movement will likely be constrained. With low inflation, central bank buying, and strong foreign demand, Treasury yields have no license to move significantly higher. In this low yield environment, we see a caution sign on the high-yield bond sector due to rising default risk and sector exposure, and instead encourage investors to follow the Fed’s path of purchasing investment-grade debt and municipal bonds. Emerging market bonds are becoming increasingly attractive as well, and our bias toward this sector is complemented by our expectation of further weakness in the dollar.
For equity investors, elevated valuations and a bifurcated market have led to questions regarding the vitality of the second strongest bull market in U.S. stock market history. However, valuations are attractive on a relative basis, and the equity market is supported by the ongoing economic recovery, low interest rates, optimism about the development of a vaccine and additional therapeutics, and a rebound in earnings growth in 2021. As such, our year end and 12-month price targets for the S&P 500 are 3,459 and 3,530 respectively. We favor U.S. equities over international equities, especially given our expectation for reduced speed ahead for Europe’s economic growth trajectory. In addition, despite their stark outperformance year-to-date, we prefer large-cap, growth-oriented sectors such as Technology, Consumer Discretionary, Communication Services, and Health Care. In fact, the (value-oriented sectors) road less traveled may be for a reason, as our preferred sectors have superior visibility for earnings growth. Case in point, Technology sector earnings will benefit from the building of the 5G highway, artificial intelligence, driverless cars, and a continuation of the work-from-home trend.
Other, more traditional value sectors such as Energy, have a cloudier outlook. Oil market fundamentals remain rather pedestrian, as the rebound in economic growth has not boosted demand for transportation fuels back to pre-pandemic levels. Numerous countries and U.S. states are still engaged in modified lockdowns, and the oil market needs to avoid a second-wave induced detour during the upcoming winter season as it would surely lead to intensified restrictions. OPEC discipline and a decline in U.S. production have offset a large portion of the reduction in demand, thus allowing oil dynamics to reach equilibrium. Accordingly, our price target for West Texas Intermediate (WTI) at year end is $40 per barrel (bbl) with potential to rise above $50/bbl over the next 12 months, contingent on stronger fuel demand globally.
While there are COVID-19 related risks to the market (vaccine setbacks, potential second wave), the outcome of the presidential race is at the forefront of investors’ minds. The polarized political environment was exacerbated by the COVID-19 outbreak, and with the election quickly approaching, voters are truly at a crossroads. For incumbent President Trump, a unique, virus-induced recession as well as high levels of unemployment have threatened his reelection efforts. However, a strong third quarter GDP report released just five days ahead of the election may provide him with the boost he needs. Former Vice President Biden currently has the edge, but this election cycle is likely to be unprecedented—from the debates to the final counting of results. Regardless of the outcome, we encourage investors to view the winner of the White House as only one factor in determining your asset allocation and sector positioning. The economy, earnings growth, Fed policy, and underlying secular trends combined create a more robust outlook. In fact, many generally accepted doctrines have proven to be inaccurate, such as Democrats being best for the economy (not always), the Energy sector performing best under Republicans (not recently), and tax hikes causing negative equity performance (not in the post-World War II era).
This year has taught us a number of lessons, and expecting the unexpected is certainly one of them. While we are aware of where the potential aforementioned potholes may lie, investors must take safety precautions as they advance toward their financial goals. Disciplined strategy and asset allocation parameters should serve as rumble strips, keeping a portfolio from drastically going off-course. In addition, an uncomfortable level of portfolio risk may be an opportune time to pull over and reassess the route ahead. Having your advisor serve as a co-pilot to help with directions is beneficial, but it is especially prudent when navigating the uncharted territory we find ourselves in today.
This upcoming quarter will move quickly – from the hopeful further reopening of the economy to Election Day and the holiday season that follows.
All expressions of opinion reflect the judgment of the Chief Investment Office and are subject to change. Investing involves risk including the possible loss of principal. Past performance may not be indicative of future results.