Resurging returns

While government policies related to Covid-19 were initially focused on safety and flattening the curve, the race to reopen in order to accelerate spending and get the global economy back on its feet is facing a major test as U.S. cases rise at a rapid pace.

In short

• Evidence of an economic recovery continued to mount in June, but early indications in July of the need for increased caution could slow this progress.
• Risk was back with a vengeance in the second quarter, as investors eschewed Treasuries and the U.S. dollar in favor of corporate credit and stocks globally.
• While a massive infusion of monetary and fiscal stimulus to insulate the global economy from the Covid-19 demand shock should boost economic growth into next year, investors appear content sticking with their winners – even if the landscape has changed.

With states reopening, consumers spending, and businesses looking forward to increasing demand, the V-shaped recovery in the equity markets is finally getting some support from the economy.

While most economists have been cautious about calling this comeback sustainable, the data improvement points squarely to the conclusion that not all of the activity lost during the shutdowns in April and May is gone forever. Given the nature of the shock, and the relative stability of the U.S. economy as 2019 closed, the rapid decline and subsequent improvement are not necessarily surprising. Overall, sentiment data is leading the charge higher, with hard data coming in behind it to provide some credibility. The monetary stimulus experienced globally remains the foundation for capital markets, while a continuation of fiscal stimulus is necessary for economic growth to take hold. A big question that remains is how the landscape of employment in the U.S. has been permanently changed, and how long elevated unemployment will persist. In addition, with cases of Covid-19 once again on the rise, there is likely to be some slowing of economic data improvement, as pent up demand wanes, and virus fears create greater caution.

For the time being, June data built on the improvement we experienced in May. The U.S. ISM manufacturing index rose to 52.6 in June, up markedly from 34.1 in May, and above expectations for a 49.5 print. Production, new orders, prices, and employment all rose significantly month-over-month, indicating a strong move towards expansion. The ISM non-manufacturing index also came in better-than-expected for June at 57.1, up from 45.4 in May.

Consensus had been for a 50 print, and the increase marks the biggest jump since tracking began in 1997. This is consistent with increased credit card spending and confidence data, pointing to a quickly reemerging U.S. consumer.

The increase in the leading economic indicators index can be attributed to these improvements in PMIs, as well as the gains in the stock market, but also in consumer related inputs like retail sales and housing. U.S. retail sales for May smashed expectations, increasing +17.7% month-over-month, well over the consensus estimate of +8%, and much improved from April’s -16.4% decline. Ex-food, sales were still up +16.8%, led by a +188% gain in clothing and accessories, followed up by other retail (sporting goods/hobby/instruments/books) which saw a sales increase of +88.2%.

The housing market, too, is heating up. The recovery has been buoyed by low rates, a release of pent up demand, and an improvement in confidence. Homebuilder sentiment rose significantly by 21 points to 58 in June, well above the low of 30 in April. The assessment of the strength of current conditions and expectations for the next six months were both meaningfully higher, reflecting the enthusiasm of buyers evidenced by the mortgage applications numbers over the last several weeks.

Consumer confidence is on the rise as well, with the Conference Board’s measure of consumer confidence blowing past expectations in June for its largest increase since 2011. The index rose to 98.1 from 85.9 in May, much better than the estimate of 90.5. The expectations component of the survey continued to drive the measure higher, as consumers believe that the economy is likely to improve from where it is today over the next year.

So why has the consumer become so confident? With the reopening of the economy, hiring has picked up again, and the strengthening of the employment backdrop is driving this optimism. Non-farm payrolls surpassed expectations for the month of June with a gain of 4.8 million jobs. The U3 unemployment rate fell to 11.1%, down from what was reportedly an artificially low 13.3% in May. In addition, May’s report was revised upward by almost +200k, evidence that a combination of reopening, improved consumer confidence, and the PPP program led to rehiring in hard hit industries like hospitality and construction.

As it relates to capital markets, it was certainly a tale of two quarters thus far in 2020. While there was virtually nowhere to hide in the first quarter, investors who hung tight and held on to their riskier positions were rewarded with a tremendous rebound in the second quarter. The rebound was most pronounced in U.S. stocks, with growth once again outperforming value – even with a few weeks of value “rotation” buried in the results – and small and mid-cap stocks outperforming large cap names. Outside of the U.S. the trends were similar, but the returns were not quite as strong. The credit markets, too, performed very well in the quarter, buoyed by the Fed’s generosity as evidenced by its programs to buy debt in the secondary market, which extended even to corporate bonds. Short to intermediate term Treasuries were essentially flat for the quarter. Overall, investors who stayed invested in a diversified portfolio benefited in the quarter, while investors who eliminated risk in favor of safe havens at the height of the crisis experienced muted results. Looking ahead, pressure on the U.S. dollar could allow for a shift in market leadership; a smoother return to post-Covid 19 life could also allow international and emerging markets economies to recovery faster than the U.S., which seems to be moving in the wrong direction as it relates to grappling with the global pandemic.

In focus: more of the same?

Taking a step back and thinking about the first six months of 2020, one could say that a lot of what we took for granted, especially in developed economies, has been altered. The threat of infection by a virus, for which the transmission mechanism remains unclear, was on very few pundits’ list of concerns coming out of 2019. The availability of basic consumer goods, the ability to walk into a store and purchase an item at will, and even the accessibility of schools were no longer a given for people in affected countries, and in some places, these disruptions are still present. Many who had ventured into an office every day have now settled into a life of working from home – or is it living at work? – which has implications for city life and office space which may take years to play out fully. Our social circles are smaller, people are flying much less, and families are spending time and money on our homes.

Yet, in the markets, it has seemed like more of the same. Initially, there was significant investor interest in what were termed “stay-at-home” thematic investments. The cautious tone of social distancing and a home centered existence pushed these stocks higher, whether it was digital content, food, or networking tools. Then, as reopening took off, there were investors clamoring to add hospitality and airline names, along with energy and industrials stocks – all of which would benefit from an accelerating and perhaps even above trend economy into the second half of 2020 and through 2021.

Whether you classify this move as a pure rotation to value, or just the fulfillment of every single investment professional shouting from the rooftops for the last decade to “buy the dip”, it has come and gone quickly. What’s left in its wake are U.S. equity markets in which breadth is quickly slipping away, as investors concentrate their capital in stocks that can survive and thrive in a low growth, low interest rate environment. For despite all of the stimulus poured into the global economy in the last 4 months, when searching for a return to normal, one needs look no further than the S&P 500, where valuations are rising precipitously for certain names, while many of the stocks in the index remain well off their highs. The concentration in these names is perceived by investors as a “safer” play, given their past success. However, this phenomenon could yield risks as well, particularly if a return to “normal” looks a bit different than our recent past.

What we’re watching: the election cycle is just beginning – and the potential second phase of Covid-19 looms large.

Whether you define what’s happening in Florida, Texas, California, Arizona, and other states as a second wave of Covid-19 or not, the reality is that the U.S. is only modestly closer to the finish line, which likely requires a very effective standard of care, robust testing, and perhaps even a vaccine. The response of both the federal government and state and local authorities now seems likely to have a meaningful impact on the upcoming elections, and with schools slated to reopen in late August and early September, and campaigning likely to be in full swing, one should be prepared for a turbulent several months.