We’re in the midst of the greatest economic contraction in modern history: Oil prices fell into negative territory, the United States lost over 30 million jobs since mid-March,¹ companies are pulling earnings guidance, and beneath it all, the lingering sense that a second wave of COVID-19 could take place soon.
On the other hand, global central banks are continuing to engage in the most expansive monetary policy response of our time, and governments worldwide are blowing out their fiscal deficits to levels that are typical of wartime. How should investors navigate the depths of market uncertainty and manage upside/downside risks in the months ahead? Here’s one way to look at it.
If we were in the midst of a baseball game, we’re probably only in the second inning—and it’s still far from certain how it’ll end. With that as a caveat, we present five key investment themes—a playbook of sorts—that frame our thinking and help us navigate uncertain markets.
Largest week-on-week dips in economic indicators are likely a thing of the past, but expect more turbulence ahead
We’re expecting risk assets to retrace some of their recent gains, although we don’t expect the market to hit new lows. From an investment perspective, we believe caution is still warranted; this doesn’t feel like the time to make huge bets about which way the equity markets will go. That said, it makes sense for investors with a longer investment horizon to gradually add risk back to their portfolios.
Most high-frequency indicators that we’re monitoring suggest the worst of the economic fallout ended in mid-April; that is, it’ll likely continue to worsen, but at a slower pace. Despite this, we continue to have several concerns. There’s still pronounced uncertainty about how the COVID-19 virus could evolve. Specifically, we can’t discount the possibility of another outbreak in the autumn or winter, which could lead to another round of shutdowns. In addition, with oil prices at current levels, we find it difficult to dismiss the possibility of credit events materializing, even with support from the U.S. Federal Reserve (Fed).
Although nearly a fifth of companies that have handed in their quarterly earnings met expectations,² dividend cuts and reductions in share buybacks remain concerning. Meanwhile, daily moves in the S&P 500 Index continue to be led by large-cap companies, and the index has yet to break through key technical levels²—history suggests another drawdown is likely before we see a sustainable recovery in stock prices. That said, we don’t expect markets to retest recent lows.
Finally, the upcoming U.S. election will no doubt have an effect on market sentiment, as will the evolving rhetoric regarding U.S.-China relations, which will have important implications for global supply chains going forward.
We can’t discount the possibility of another outbreak in the autumn or winter, which could lead to another round of shutdowns.
Any rebound will be uneven across economies, sectors, and markets
Industrial, consumption, and traffic data from China provides an imperfect but valuable road map to understanding what’s likely to happen when an economy emerges from a lockdown. From what we’ve seen, the key takeaway is that even as the supply side of the economy reopens for business, confidence channels will slow the return to discretionary consumer spending quite substantially. From an investment perspective, this suggests the manufacturing/construction sector will likely outperform the consumer discretionary sector in the near term.
On a macro level, it also means that we’re more likely to see a recovery in corporate earnings before we see a broader economic rebound. Based on data from previous recessions, we know that corporate earnings—on average—take 27 months to recover the lowest point it’ll hit during the contraction. The equivalent recovery period for economic growth, by comparison, is 58 months.³ For this reason, we have a more optimistic view of the equity markets in the medium term than the economic environment.
It’s worth noting that the current contraction is services led and will likely incur a substantially larger number of job losses than traditional manufacturing-led recessions. Whereas it’s often mentioned that services make up two-thirds of the U.S. economy in terms of monetary value, the sector accounts for 86% of the U.S. job market.⁴ We expect the U.S. unemployment rate to rise to near 20% in the next two months; while a significant amount of the job losses will be unwound as the economy reopens, not all positions will be recouped.
The services-led nature of this contraction also implies that most job losses will come from lower-paid positions. Of the 701,000 jobs lost in March, nearly 60% were from the food services industry, where the median annual income is just under $24,000.⁴
That said, although we’re likely to see the largest job losses in modern history in absolute terms, the top 20 industries that have shed the most number of jobs make up a smaller percent of total income (14%) than what the headline numbers suggest.⁵ This is, however, a double-edged sword: While it limits the aggregate impact on growth, it remains particularly painful for a significant and important segment of the population.
A near-term deflation ahead; front-end yields can touch zero
We see a variety of deflationary forces ahead and expect outright month-over-month deflation in April and May. It also must be said that the decline in oil prices is profoundly deflationary and is likely to weigh on year-over-year comparisons through to April 2021. Continued U.S. dollar strength will also have a deflationary effect in the United States.
We don’t think the Fed is overly concerned about near-term price pressures—it’s more focused on preventing a credit crisis. We believe the U.S. central bank will seek to pin down the front end of the curve and may engage in yield curve control, a policy move that could, if it happens, push short-term rates to zero.
"Gold, we believe, can do well in such an environment—the precious metal can serve as a hedge against volatility in the short term and inflation in the longer term."
Fiscal packages are powerful and (longer-term) inflationary
As much as near-term deflationary pressures are important, we believe it makes sense to add to inflation protection from a longer-term perspective. While it may be too early to conclude if fiscal packages announced so far will be sufficient to revive economic growth, there can be no doubt about the size and scale of these measures.
Few would disagree that monetary policy’s effectiveness at supporting growth and inflation has weakened post-1995; in contrast, the effectiveness of fiscal policies has probably strengthened. Research suggests that at this point, every dollar of U.S. government spending could contribute as much as $4 to U.S. GDP four years down the road.⁶ In other words, today’s fiscal spending could well translate into inflationary pressure in three to five years.
What does this mean from a market perspective? Gold, we believe, can do well in such an environment—the precious metal can serve as a hedge against volatility in the short term and inflation in the longer term. Crucially, the typical negative correlation between the U.S. dollar and gold has broken down as a result of their safe haven status, meaning we’re likely to see strong and persistent investment demand from both investors and central banks.
Own what the Fed owns … but beware some central bank pushback
In our view, owning what the Fed owns could be this decade’s equivalent of “not fighting the Fed”—a prominent investment mantra within the investment circles in the aftermath of the global financial crisis.
The Fed has begun dipping into the high-yield (HY) market (slowly) by saying it may purchase “fallen angels,” which were rated investment grade (IG) pre-COVID-19, but were subsequently downgraded. Our base case expectation is that the Fed won’t need to step into the HY market more aggressively. Indeed, we believe the Fed will want the market to understand that its role isn’t to support “zombie” companies. There is therefore scope for some near-term market disappointment as Fed Chair Jerome Powell begins to delineate what he is and isn’t willing to do.
Against this backdrop, it’s perhaps easy to understand why we have a preference for U.S. corporate credit over U.S. Treasuries. That said, a caveat remains—the possibility of cascading credit events, however, remote it might seem at the moment.
1 Bloomberg, as of May 1, 2020. 2 FactSet, as of April 24, 2020. 3 National Bureau of Economic Research, Fundstrat, April 24, 2020. 4 Bureau of Labor Statistics, April 3, 2020. 5 Fundstrat, April 24, 2020. 6 “Aggregate Effects of Budget Stimulus: Evidence from the Large Fiscal Expansions Database,” Peterson Institute for International Economics, July 2019.
Views are those of the author(s) and are subject to change. No forecasts are guaranteed. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. Past performance does not guarantee future results.
The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. The U.S. Dollar Index tracks the value of the United States dollar relative to a basket of six major foreign currencies. It is not possible to invest directly in an index.
A fallen angel refers to corporate bonds that originally received investment-grade (IG) rating, but had their credit rating reduced to non-IG rating as their issuers' financial health deteriorated.
The term "zombie companies" is commonly used to describe businesses that earn just enough to keep their operations going, but aren't able to pay off their debt. It's also used to describe companies that cannot exist without external assistance, for example, a bailout.