Economic Review Fall 2020
We will join the chorus and state the obvious. Unless you survived the flu epidemic of 1918, 2020 is a year unlike any experienced in our lifetime. The U.S. economy suffered its steepest downturn on record due to the COVID-19 pandemic when Q2 GDP plummeted at a 31.4% annualized rate, following a Q1 decline of 5%. Consumer spending plunged 33% during the second quarter.1 Except for government spending, other economic sectors shrank drastically as well.
The good news, such as it is, is that despite the speed and severity of the downturn, the economy bottomed in April and began to turn up in May with the partial reopening of the economy. The rebound has extended through the Summer and GDP is estimated to have bounced back in excess of 25% in the third quarter. Employment, which cratered in early Spring, has recovered well ahead of expectations with over half of the jobs lost now regained. The unemployment rate which peaked at 14.7% in April was expected to sit at 8.4% in December 2020. It has already declined to 7.9%.2
Before we get carried away, there were still well over 10 million fewer people working in September than in February. There are 6.5 million job openings in the U.S., an excellent number by the way, but more than 13 million people looking for work. Back in February, jobs openings exceeded job seekers by over a million.3 Some sectors, such as residential construction, are in the midst of a V-shaped recovery. Manufacturing and capital spending are also showing signs of life as technology prospers. Unfortunately, labor intensive industries including hospitality and travel continue to struggle.
The Federal Reserve revised its economic outlook in mid-September and upgraded its forecast for 2020 U.S. GDP to decline by 3.7% from a prior estimate of a sharper 5% contraction. The rapidity of the U.S. turnaround has been due in large part to massive government support. Between fiscal stimulus passed by Congress and lending facilities instituted by the Fed, an estimated $4 trillion was committed to revive the economy.
Many of these Federal Programs have now lapsed. Another round of stimulus, however, was thought to be forthcoming and deemed necessary by Federal Reserve Chief Powell to keep the recovery on track. With supplemental unemployment benefits curtailed and additional aid to states and municipalities now on hold, there is concern that the Fed may have been overly optimistic in changing its outlook. Furthermore, the recent surge in new Coronavirus cases is also an issue. Worries are mounting that long-term “scarring” of the economy will be inevitable due to the shuttering of so many small businesses.
Financial markets, however, continue to look past the pandemic and remained buoyant in the third quarter. COVID-19 treatments continue to improve, and several vaccines are already in Phase 3 testing, although widespread distribution of a successful vaccine is unlikely before the spring of 2021. U.S. stocks as measured by the S&P 500 Index turned positive in the third quarter and have posted a gain of 5.6% as of 09/30/20, an astonishing achievement after the first quarter’s 20% shellacking. However, smaller capitalization shares remain mired in the red at quarter-end as were international stocks. Fixed income markets have also generated solid results (the Bloomberg Barclays US Aggregate has advanced 6.8% as of 09/30/20) due to the dramatic fall in interest rates.4
Given the pandemic-induced 25% collapse in 2020 earnings, U.S. stocks now seem expensive. Even anticipating a solid 34% for 2021 earnings recovery to $164 per share, stocks still appear fully valued, trading at 21.4x Washington Trust’s estimate.5 In our view, the Federal Reserve deserves much of the credit for the stock market’s surge to record levels.
Not only did the Fed lower the overnight interest rate to the zero lower bound and resumed quantitative easing back in March, it has provided guidance suggesting the rate will remain anchored there potentially into 2023 or beyond. Furthermore, the Fed which has a dual mandate of ensuring price stability and full employment, has put inflation fighting on the back burner and declared the priority of restoring lost jobs. To that end, the Fed has altered its approach in assessing inflationary conditions and will use inflation “averaging” rather than a single point in time to determine policy. Using this method, the Fed will allow the economy to run “hot” before taking action to bring down the inflation rate.
If stocks appear rich, Fed policy has sent bond prices soaring. As of September 30th, a 10-year Treasury note and a 30-year Treasury bond yielded just 0.68% and 1.46%, respectively. However, expansionary Fed policy has revived both inflation and inflationary expectations. A 10-year market derived inflation forecast stood at 1.64% per year.6 This implies that bond yields adjusted for inflation are negative across the yield curve. Government bonds are viewed as a safe investment but if this inflation forecast pans out, an investor purchasing a bond today will suffer an economic loss over the life of the investment.
Another consideration for investors is, of course, the pending Presidential election. The Trump Administration is generally viewed as pro-business and investor friendly. The stock market has performed well under its watch. Biden and the Democrats are proposing tax hikes and re-regulation, but the market continues to rise even as they solidify their lead in the polls. While sector leadership may be affected by the Presidential Election’s outcome, our conclusion is to focus on the fundamentals of the economy and earnings and, without fail, on the Fed in trying to assess the direction of the broad market.
At this juncture, we continue to favor equities over bonds given the meager returns available in the fixed income market. However, some caution is warranted and paring back equity exposure to maintain alignment with portfolio objectives is the sensible course. Pre-election rallies can, of course, result in post-election pullbacks. We also anticipate a potential shift in leadership, but time will tell. In the fixed income market, we believe a modest further steepening of the yield curve may provide a better entry point, and some exposure to credit risk is necessary to generate a positive real return.
The views expressed here are those of Washington Trust Wealth Management and are subject to change based on market and other conditions. Investment recommendations and opinions expressed in these reports may change without prior notice. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. Investing entails risk, including the possible loss of principal. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions.
Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments, including floating rate bonds, involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. Past performance does not guarantee future results. The S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock-market performance. In addition, the S&P 500 Index cannot be invested in directly and does not reflect any fees, expenses or sales charges. Further, such index includes 400 industrial firms, 40 financial stocks, 40 utilities and 20 transportation stocks. The information we provide does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. Please consult with your Portfolio Manager, Financial Counselor, attorney or tax professional regarding your specific investment, legal or tax situation.
1 U.S. Bureau of Economic Analysis
2 U.S. Bureau of Labor Statistics 2 U.S. Bureau of Labor Statistics
5 Washington Trust Wealth Management