Major US equity indexes showed resilience in the second quarter of 2020, propelled higher by an unprecedented policy response from the US Government and the Federal Reserve to combat the economic downturn brought on by the COVID-19 pandemic.
In a remarkable reversal, the fastest 30% drawdown in the history of global equities in the first quarter was followed by the largest 50-day advance in market history in the second quarter.
The S&P 500, as of June 30, 2020, was down a mere 4% on the year with advances led by large-cap technology stocks benefiting from work-from-home digital transformation, social media, data storage, and online shopping, to name a few.
Below, our article explores what transpired in Q2.
Unprecedented Policy Response
The US economy experienced a historic slowdown at the beginning of Q2 with, at one point, 95% of Americans under stay-at-home orders. The fiscal and monetary response however was equally extraordinary.
The US Federal Reserve cut interest rates to zero, announced unlimited quantitative easing, and committed to buy investment grade and high yield corporate bonds. The government’s fiscal stimulus response was also significant and included forgivable loans to small businesses and unemployment benefits equal to wage income for the median worker who lost their job.
The price tag on this fiscal response at the time of publication is around $2.5 trillion with further funding anticipated.
Economic Growth and Unemployment
The markets were initially rocked by the April unemployment rate, which came in at 14.7%— equating to the loss of all jobs created since the financial crisis. However, many of these job losses were temporary and the markets have cheered subsequent reports; both May and June came in better than expected and showed significant re-hiring bringing the unemployment rate down to 11.1% as of June 2020.
Gross domestic product (GDP) is expected to take a significant hit for Q2. The Congressional Budget Office (CBO) expects a decline of 12% from the previous quarter, however the expectation is for GDP to rebound in the latter half of 2020. According to the Fed, pre-pandemic levels of US GDP aren’t likely until 2022.
The CBO is looking for a $3.7 trillion add to the national debt this year before factoring in a phase four stimulus package. This includes the cost of the fiscal stimulus supplied thus far plus impacts of the economic shutdown on federal revenues.
This would bring the total federal debt to the highest levels since World War II placing it in excess of 100% of GDP by year-end. This is no doubt a daunting figure, however, it’s being funded at historically low-yield levels.
Another COVID-19 Wave
In the latter part of Q2, a second wave of COVID-19 spread in several Southern states including Texas, Florida, California, and Arizona. While this has the potential to slow the re-opening in some areas, there seems to be little appetite for the full lockdown measures implemented in March 2020, and thus far the market has shaken it off.
Some headway in COVID-19 vaccine development has supported the markets during Q2; pharmaceutical companies such as Pfizer and Johnson & Johnson have announced promising advances. Medical professionals predict a vaccine will become widely available in 2021.
The belief that the US Congress will extend additional fiscal support for households and firms is also supporting the markets; around the world both fiscal and monetary policy is expected to remain highly accommodative.
US Federal Elections
The US presidential election is a wild card for the markets heading into the second half of 2020. President Trump has slipped in the polls and is down by as much as 14% in national polls at the time of publication.
A critical development will also be the outcome in the Senate. The results of the election could potentially lead to lawmakers proposing changes to current individual and corporate taxes.
US-China Trade War
Relations between Washington D.C. and Beijing have deteriorated in recent months putting more uncertainty around supply chains.
The change in Beijing’s national security law constraining Hong Kong’s autonomy has further threatened the already fragile phase one trade deal between the two countries.
This friction, paired with elevated rhetoric around COVID-19 and the race to develop a vaccine, is creating heightened tensions.
Longer-term Impacts of the Pandemic
Low Interest Rates
The global economy has taken a significant hit from the pandemic and major central banks globally have brought interest rates to zero or lower. Economic spare capacity should keep inflation tame for some time which means central banks will keep rates low.
Recent comments from Chair of the Federal Reserve Jerome Powell even indicate it would be inclined to let inflation overheat some before raising rates. In a recent speech, he said the Federal Reserve isn’t even, “thinking about thinking about raising rates.”
Globalization was already receding before COVID-19 with the rise of the US/China trade war. The virus is accelerating the anti-globalization trend.
Global supply chains are being unwound and the pandemic has created pressure for domestic production of essential goods such as medical supplies and vital technologies.
Increased Government Debt
The lockdowns are leading to the largest rise in government debt levels since World War II and high levels of government support for certain industries.
Eventually, the political debate will turn and focus on how to pay for the lockdown support measures and address the inequalities that have been worsened by the pandemic.
Pressure on Profit Margins
The following factors could put pressure on profit margins in the future:
- Slower trend economic growth
- Less efficient capital allocation
- Just-in-case inventory management, as opposed to just-in-time
- Higher taxes
- Higher labor costs
One potential offset is the increased use of technology encouraged by the lockdowns will generate cost savings and productivity improvements.
To curtail recessionary tides and improve market liquidity, the Federal Reserve expanded its balance sheet dramatically over Q2 to a new high of $7.2 trillion from $4.2 trillion at the end of February.
Asset purchases and anticipated usage of the Federal Reserve’s credit facilities are estimated to bring the balance up to $10.3 trillion by the end of 2020, over 13% of GDP.
For context, the same level of stimulus implemented since March took nearly three years to achieve after the 2008 financial crisis. This support has been successful in tightening credit spreads for investment grade and high yield corporates. Many issuers, companies hit hard by the pandemic, have been able to shore up liquidity at attractive rates to attempt to bridge their business to the other side of the crisis.
Looking forward, economic weakness may further accelerate ratings downgrades and fallen angel activity. A fallen angel in the investing world is a bond that was initially given an investment grade rating but has since been reduced to junk bond status. As a result, volatility may tick up in fixed income markets despite aggressive action by the Federal Reserve.
It is no surprise that Q2 earnings are expected to be dismal. However, thus far, the broader market is attempting to look through the current economic situation to an economic rebound and better earnings into 2021.
The markets will likely continue to be volatile as investors digest continued data around:
- Additional waves of COVID-19
- Further deterioration in US-China relations
- News of progress on treatments or vaccines
- Additional fiscal support for individuals and households
- Ongoing federal support in the credit markets
In the meantime, it’s important to diversify and structure portfolios in anticipation of turbulence.
While the instinct to take abrupt action during bouts of volatility can be strong, it can significantly damage long-term investment results. For long-term investors, the decision to make thoughtful rebalancing decisions can enhance longer-term outcomes.
It’s a challenging time for investors, but the economy and the markets have a lengthy track record for tackling crisis—and coming out stronger on the other side.
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