Quarterly Market & Economic Perspective – Q3 2020

There has been much talk about the upcoming election.  Not surprisingly, there are a lot of prognostications taking place on how the markets will fare with several potential scenarios (Republican/Democrat as President, Republicans/Democrats in charge of the Senate/House). ​

Let’s make it clear that the outcome of any election can have an impact on tax policy, social security, and many other factors, and can therefore impact your financial plan. However, when it comes to the markets, we would caution investors from making emotional decisions based on how they feel about the candidates and the party in power. We provide this caution as history shows, making decisions solely based on party affiliation has led to suboptimal investment results. “How so?” you ask. 

Exhibit 1 shows the growth of $10,000, from 1961-2019, investing only when each one party was president vs. investing throughout the entire period. As you can see, staying invested has far and away been the prudent strategy. 
 
In fact, the average return of the S&P 500 for all presidential terms from 1929-2019 is an astounding 10.3% and there have only been four presidential terms with negative returns (1929-1932, 1937-1940, 2001-2004, 2005, ­2008; source: S&P). 
 
Exhibit 1

But with Covid-19, a divided country politically, and social unrest, this time feels different to many. We would agree somewhat that this time is different. In fact, you could make the argument that the exact circumstances have always been different. We have been through World Wars, terrorist attacks, a dot-com crash, and a few financial crises to name just a few significant events. 

While each of these events are important at the time, when you look at them over a longer time period in relation to the markets, the disciplined investor has done much better than the investor who thinks they can successfully time the market. 

Keeping it in perspective, markets are made up of public companies that are required to make decisions that are in the best interest of their shareholders. Whether there is a currency crisis, a change in corporate tax policy, or a change in tariffs to name a few examples, the leadership of these companies must adapt to their environment to build capital for their shareholders. 

U.S. Equity

As we think about what happened in Q3 2020, let’s remember that from February 19, 2020, through March 23, 2020, the S&P was down over 33% (source: Morningstar) in what is the fastest move from a record high to bear market in history. Based on that nugget of information, it would have been hard imagining writing this next sentence. Amazingly, in August 2020, the S&P 500 hit its first new record since February 2020, in what is also the fastest recovery on record, just 126 trading days from peak to peak. 
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Exhibit 2

Exhibit 2 provides the 126-trading day reference with the next fastest recovery taking 310 trading days. How many prognosticators suggested this?

While the performance of the S&P is impressive, it also presents some challenges. For one, the S&P has become increasingly concentrated with a few stocks carrying more weight than others, both literally and figuratively. As of September 30, the top 5 stocks in the S&P (Apple, Microsoft, Amazon, Facebook, Alphabet/Google) comprise over 22% of the index (source: iShares.com). This means the other 495 stocks comprise the other 78%. Exhibit 3 shows how the top 5 stocks have become a larger part of the S&P 500 over the years (spoiler alert: the NASDAQ is even more concentrated!).

​Exhibit 3

What this simply means is that the more concentrated the index becomes, the more the returns of the overall index are driven by the largest companies. While this has worked for the S&P as of late, it can also work just as powerfully in the other direction. Just how impressive has the performance been of these top 5 stocks? Let’s simply just look at the performance of these top 5 stocks vs. all the other stocks in the S&P 500. Overall, as exhibit 4 shows, the S&P 500 from the beginning of 2020 through August 31 returned 10%. Over the same period, the top 5 stocks returned 49% while the remaining stocks in the index had a negative 3% return overall. ​

Exhibit 4

As most investors hold a more globally diversified portfolio (including fixed income) and not just the S&P 500, it is likely, and expected, that investors have performed worse than the S&P on a year-to-date basis. The bottom line is using the S&P 500 as a benchmark comparison for a globally diversified portfolio is an inappropriate comparison.

Looking across the style and size spectrum, we have also done some work in value-oriented investments and found value stocks tended to correlate more with positive economic growth and inflation outlooks. This has not been the environment lately, so we have seen value suffer. It is a similar story for small companies, especially in cyclical sectors like real estate and financials.

Global Fixed-Income

Fixed-income indexes were positive for the quarter with US corporate high yield leading the way with a 4.6% return, compared to the 3 Month US Treasury bill, which was flat. 

Treasuries continue to be the bond asset of choice when concerns increase regarding the virus or the recovery from the virus. At the same time, with 3-month Treasury yields at 10 bps and 5-year Treasuries at 28 bps at quarter-end, there is neither a lot of income nor capital appreciation expected from these fixed-income assets. Treasuries showed little change overall for the quarter. The market (based on the Fed’s guidance that they aren’t thinking about raising rates) is not pricing in any rate increases through 2023. 

If we think about corporate bonds, we can still find higher yields vs. Treasuries while still focusing on investment-grade bonds. An admitted challenge with this approach is that we are not the only investors looking for high-quality yield, and with investors purchasing large amounts of high-quality corporate bonds, spreads over Treasuries have dropped dramatically from their peaks this year and are towards the bottom of their 20-year ranges (source: JPMorgan Guide to the Markets as of September 30, 2020). 

Municipal bonds had positive returns for the quarter and on a year-to-date basis even while state and local government budgets have been stressed due to the virus’s impact on tax revenues. It is important to remember, however, that defaults in municipal bonds are quite rare for a variety of reasons, including the fact that governments can raise taxes to pay for shortfalls. It is also important to remember that there is a large variety of bonds across the municipal bond landscape, with differences ranging from type (Government Obligation vs. revenue) to issuer (state, local govt, etc.), and that challenges in one municipality do not immediately equate to challenges across all municipal bonds. 

Inflation continues to be a buzzword on the minds of investors. As a reminder, inflation is simply defined as a general increase in prices and a decrease in the purchasing power of money. For bond investors, the higher the expected rate of inflation, the higher yields will rise across the yield curve as investors demand more compensation. Until recently, one of the Fed’s key objectives was to keep inflation at or below 2%, both to prevent inflation from getting too high and too low. However, in late August the Fed changed to having an “average” 2% inflation measure (what the Fed is calling inflation targeting), meaning inflation could rise above its 2% target without much concern from the Fed, leading to potential inflation uncertainty. Currently, whether you look at headline or core inflation, and whether you use CPI or PCE to measure inflation, the current results are all below the 2% target. However, if we were to see a quick acceleration in the economy from a vaccine, that could lead to higher inflation. With yields as low are they are across the fixed-income landscape today, high and increasing inflation would be bad news for fixed-income investors in the short term. The rise in yields due to higher future inflation adjustments should compensate that in the long run. 

The Fed also announced they were going to focus on their other mandate, full employment. Since so many jobs have not returned since the depth of the recession, the Fed has their work cut out for itself. 

From a global fixed-income standpoint, changes in global government bond interest rates were mixed for the quarter. The UK, for example, saw yields increase across the curve while Germany experienced the opposite, with all maturities ending the quarter in negative territory. 

As we discussed last quarter, to generate more return, investors need to assume more risk and in fixed-income, which means either extending duration or lowering credit quality. There are many tradeoffs that must be weighed very carefully before implementing either strategy. 

We continue to view fixed-income as a method of reducing overall portfolio risk (as measured by standard deviation), given that equities are expected to have much higher volatility. Our portfolio’s focus will continue to be on high-quality bonds with an emphasis on short to intermediate duration government and corporate bonds, where default risk has historically been relatively low. For some investors, muni bonds are attractive for their tax-free income. 

As always, please reach out to your advisor if you have any questions about your personalized Investment Plan.