Spring forward, fall back?

August was a stellar month for the equity markets, as the momentum from July carried stocks higher even as the global pandemic remains a clear and present threat. With September came some skittishness, however – what will the rest of autumn bring?

In short

• Globally, data releases continue to support the narrative that the global economy remains intact, with both manufacturing and the consumer showing clear signs of life.
• Equity investors threw caution to the wind and poured money into stocks during the month of August, driving gains that were some of the best in decades.
• Market participants saw visions of the dot com bust as the month of September started off rocky for the summer’s high flying tech winners. While calls for a value rotation have started once again in earnest, market leadership often shifts slowly.

With provisions of the CARES Act expiring at the end of July, and no clear resolution in sight from Capitol Hill, it appeared as if August could be a tough month for risk assets at the outset.

However, while the fiscal stimulus may have been winding down, the Fed made it clear that a very accommodative monetary policy stance is here to stay. During the Fed’s annual Jackson Hole meetings, which were held virtually this year, Fed Chairman Jerome Powell outlined the Fed’s new approach to its dual mandate of inflation management and maximum employment. Instead of managing “deviations” in these two metrics, the Fed will focus instead on “shortfalls”, implying that the threat of deflation is greater in the Fed’s eyes than above target inflation. This shift was hardly surprising, given the lack of correlation between low unemployment and inflation over the last decade, and the decision to let inflation “run hot” had been all but assumed prior to the meetings. While this certainly points to interest rates remaining lower for longer, it also points to the potential for higher inflation longer term, which could finally steepen the yield curve.

As for the U.S. economy, if there is a dip down following the expiration of the CARES Act, it isn’t yet showing up in manufacturing data. U.S. manufacturing PMI rose to 56 in August, from 54.2 in July. This was higher than the consensus expectation for a 54.8 print, and was led by a meaningful increase in new orders, with a modest improvement in employment, although that sub-index remains in contractionary territory. This is consistent with strength experienced outside of the U.S. as well, as Chinese manufacturing data continues to rebound, with the Caixin PMI rising to 53.1 in August from 52.8 in July, a better-than-expected result. Specifically, both output and new orders crested levels not seen since early 2011.

In addition, July U.S. existing home sales rose +24.7% month-over-month, continuing the trend of hot housing data that has proved a surprise bright spot over the last three months. Unlike the last recession, which saw supply balloon, supply actually fell by -21.1% on a year-over-year basis, as prices rose nationally by +8.5%. This diminished supply and the existence of strong demand point to a likely continuation of the strong permits and housing starts numbers released during the month, as entrants into new markets, driven by Covid-19 or low rates, or a combination of the two, create the need for more supply – and fast.

Buoying this housing demand is a strengthening U.S. labor market. Non-farm payrolls increased 1.37 million for the month of August, and the unemployment rate fell to 8.4% from 10.2% in July. The U-6 unemployment rate, which is always higher than the headline rate as it includes part-time and discouraged workers, also fell to 14.2%. While the increase in payrolls and the decline in the U-3 rate were encouraging, government hires of Census workers accounted for +344k of the gains, and there is evidence that a second round of layoffs in non-hospitality businesses is likely on the horizon as companies reassess the “new normal” of the U.S. economy. However, the magnitude of these job losses is unlikely to create a significant spike in unemployment, but rather could slow the improvement over the next several months.

Perhaps the only measure really reflecting the expiration of enhanced unemployment benefits and eviction protections is consumer confidence. The Conference Board’s Consumer Confidence index fell to 84.8 for the month of August, down from 91.7, and the lowest print in six years. This is sharply lower than the expected increase to 93, and is attributable to a sharp decline in the assessment of consumers’ current situation. Retail sales, for their part, continue to moderate, with July’s increase up +1.2% over June, and a +2.7% increase year-over-year. Despite the modest gain, nine of 13 retail sectors were higher on the month, with apparel posting an outsized +5.7% increase. To be fair, even with this uptick in activity, the sector remains well below its 2019 activity level.

In what has become a typical pattern, however, equity investors shrugged off the potential for a step back in the U.S. economy following the end of some of the stimulative measures put in place, and piled into global risk assets. Stocks across the board posted sizable gains, led by large cap U.S. equities. Emerging markets stocks, which were coming off a strong July, cooled somewhat as the slide in the dollar decelerated. Bonds, for their part, are running in place as central banks globally are focused on maintaining the current low rate environment; even corporate bonds spreads have improved over the past month, reflecting the reality that returns in the near term are likely to remain muted. Outside of long only equity and fixed income, a renewed interest in commodities on the back of incrementally higher inflation has created strong moves in areas such as gold over the past month. The inflation trade is one to watch closely; investors will remember the rush into gold and TIPS post-financial crisis, and the global economy went on to deliver below trend inflation for another decade.

In focus: tech wreck 2.0

Entering into September, investors were flying high after a tremendous summer in the equity markets. Valuations were the last thing on the average investor’s mind, as the companies which had weathered the low growth environment of 2018 and 2019 were also faring relatively well during this period of global pandemic. Benefiting from the thematic tailwind that was the shift to working and learning from home, large U.S. growth companies also earned the love of investors for all of that cash they have been “hoarding” on their balance sheets over the last several years. And while names like Apple and Facebook get a lot of attention, the most significant appreciation had been in smaller, rising companies such as Zoom, Teladoc, and Docusign, not to mention the super-charged ascent of Tesla.

Then, all of the sudden, the music stopped. So what caused investors to shy away from growth stocks in the first few trading days of the month? While it would make a lot of sense to cite those lofty valuations, valuations were likely a contributing factor, rather than the main driver. Nor was it fundamentals – in fact, all of the major technology and communication services (think media, social and otherwise) save Disney have been fairly well insulated, and thus have continued to deliver consistent results relative to the broader market.

Instead, it appeared to be a realization that the summer might have been just a little too good, and that perhaps, some of the performance that one would expect from these companies had been pulled ahead. Mix in some evidence of some institutional option activity, two mega cap company stock splits (Apple and Tesla), upcoming elections, and an improvement in economic data pointing to the potential for cyclical outperformance, and one has all the ingredients for a correction cocktail.

What did not occur, however, is a dot com era meltdown. While growth bears – or colloquially, value investors – have called the current rally unsustainable in its similarities to first few years of this century, the landscape in the technology sector is far different. Mature companies generating growing earnings and cash flows, mega cap tech will continue to be an important part of diversified portfolio. The overconcentration in these stocks could create pain in the market weighted indexes, but a rotation to other, less loved sectors would point to the conclusion that investors believe an economic rebound is on the horizon – which should help to push all parts of the market higher in the longer term.

What we’re watching

Politics is now firmly in focus. With the conventions in the rearview mirror, all eyes are now on Washington, and how U.S. politicians have handled the recent crisis.

With additional fiscal stimulus all but dead until after the November elections, voters will have plenty to think about over the next two months. While economic data has been improving, especially in areas such as the housing market, there are some signs that the pace of improvement could sputter, especially as the northern states move into their traditional cold and flu season, creating challenges in differentiating Covid-19 infections from other illnesses. This heightened sense of uncertainty is likely to lead to greater volatility in the equity markets, some of which we have already experienced, and navigating these several storms could prove tricky over the coming weeks.