Waving the summer goodbye

At the end of August, the tech sector was flying high, the expiration of the expanded unemployment benefits from the CARES Act had not yet hit economic data, and investors were hopeful that a vaccine was just around the corner. September, however, was an entirely different story.

In short

• While we certainly would not proclaim victory from the economic destruction resulting from the March and April lockdowns, there has been continued improvement in economic data since May.
• Risk assets performed well in July and August, but were pressured lower in September as investors took gains off the table in anticipation of volatility ahead of the election.
• Another wave of Covid-19 cases, a potential Blue Wave, and a second wave of deteriorating economic data are all on the horizon for investors between now and the end of 2020.

After the first two quarters of the year brought us all that Covid-19 could offer from an investment perspective, the third quarter was all about the recovering global economy, and a sense of optimism that the recovery could be sustained.

The global economy has now likely moved out of recession, and the massive monetary and fiscal stimuli are acting as clear tailwinds for a recovery. Notable improvement which has resulted in an upgrade of our expectations are narrowing bond spreads, the stabilizing European economy, and the red hot housing market. However, even as we are cautious as it relates to the sustainability of outsized job gains, we are comforted by the Fed’s commitment to low rates, at least in the near term, and we are optimistic that earnings growth will increase as we move into 2021.

In reviewing the data that underlies this assessment, we first focus on business sentiment, as measured by the ISM Manufacturing and Non-Manufacturing indexes – both of which have been steadily rising over the course of the summer. On the manufacturing side, these steady increases culminated in a recent high of 56 in August, but the September reading fell back a bit to 55.4. Relative declines occurred in new orders and production, while employment held steady and export orders accelerated. Services’ business owners continue to be buoyed by reopening and consistently improving demand, as the ISM Non-Manufacturing index moved up to 57.8 in September, a better than expected reading after a strong 56.9 print in August. The increase was attributable to business activity, new orders, and employment, while pricing pressure eased incrementally.

As for the Conference Board’s Leading Economic Index, it too continued to move higher, but remains in negative territory for the six month period ending in August of 2020, posting a -4.7% decline, or -9.3% annualized. This compares with a flat reading for the six month period ending in February of 2020, and is hardly surprising given the -31.7% decline in second quarter GDP. Weighing on the measure in the most recent release was deceleration in new orders for capital goods, residential construction, consumer confidence, and financial conditions – all indicating that the hangover from the expiration of the CARES Act could continue to weigh on the economy over the next couple of months.

Of course, a lot of attention is paid to consumer confidence, especially after a recession that was driven by plummeting consumer demand. Consumer confidence is notoriously fickle, and is therefore difficult to utilize for forecasting on a month by month basis. Instead, averaging out the recent trend is the way to go, and when using that approach, it puts us back to late 2016 levels. More recently, while things were dire in the eyes of consumers during the height of the pandemic lockdown, things have stabilized, and consumers appear more optimistic. What could create a downshift in confidence is economic pressure resulting from the lack of an additional fiscal stimulus package, or a contested election, and that in turn could create lower expectations for the economic rebound in the first half of 2021.

Confidence isn’t just for consumers of course – the ISM readings have indicated that businesses have become more optimistic as well, and that is certainly borne out by the CEO confidence readings. The major benefit from increasing confidence in the C-suite would be in hiring, but instead, we have started to see larger companies initiating layoffs in their businesses following changes to the way many industries are operating. Historically, an increase in CEO confidence comes 3 to 6 months before the gains in the stock market, and 6 to 9 months ahead of meaningful economic benefit. However, given the compressed timeline on which we have been operating, this sharp rebound in confidence could translate into spending faster than in previous cycles.

Employment, for its part, has been a bright spot in this recovery over the past few months. While expectations were for U-3 unemployment to potentially remain in double digits through the end of the year, it hit 7.9% for the month of September, better than expected despite a slowing rate of non-farm payroll growth. What is important to point out for future consumption, however, is that the labor force participation rate has fallen dramatically, and has been slow to catch up. This phenomenon is reversing the positive trend experienced over the last several years of a growing workforce, and could impair the economy from returning to previous consumer spending levels.

As for the markets, at the beginning of 2020, the biggest source of potential disruption was expected to be the November elections here in the United States, and so it was not surprising to see a bearish shift as campaigning began in earnest. In addition, while the odds were high through much of August that another fiscal stimulus package would be passed to continue the good work of the CARES Act, it became clear, particularly after the death of Supreme Court Justice Ruth Bader Ginsburg, that it would prove to be much more difficult than anticipated. Despite the big swings in September, the strong gains from July and August still propelled the equity markets higher for the quarter. U.S. and emerging market equities, commodities, and high yield bonds all performed well, while investment grade bonds – led by Treasuries – and real estate were laggards for the period. Finding a place to hide during periods of volatility will become increasingly difficult, as low yields on both cash and high quality fixed income create a challenge for equity investors looking to insulate their portfolios, or potentially just to rebalance back to their desired long term allocations. This lack of alternatives to long only equity is likely to continue to support stock prices, particularly in the first half of 2021.

In focus: The next wave

Weathering the storm in September was challenging, especially for investors looking to anchor in a safe port ahead of what is likely to be a difficult period for risk assets in the U.S. With stocks performing so well in July and August, investors were faced with the decision to continue with their winners, or potentially reallocate ahead of two significant risks that lay ahead: the U.S. elections, and the likely re-acceleration of Covid-19 cases.

The two source of concern intersected, of course, when President Trump and several of his inner circle were diagnosed with Covid-19, forcing the cancellation of the second Presidential debate and creating a firestorm in Washington D.C. around preventative measures taken (or not taken) by the Administration. It has also created an even more charged environment for the confirmation hearings for Amy Coney Barrett, who has been tapped to succeed former Justice Ruth Bader Ginsburg on the Supreme Court, with Democrats now citing health concerns as part of their justification for delaying the hearings.

Even without the diagnosis, however, the next wave of Covid-19 cases is on the horizon. The winter months will limit the options for outdoor activities, and after so many months of social distancing, working from home, and remote learning, it is difficult to know how strong the appetite will be for the type of social distancing that we experienced in March and April. Government mandates, if they are to occur, are likely to be more localized and based on infection rates, and will vary widely. Ahead of a vaccine, the promising news is that therapeutics and a more consistent standard of care appear to be helping to lower the mortality rate, but the availability of those treatments still varies widely.

Another wave creating uncertainty in the minds of investors is the potential Blue Wave, which would result if former Vice President Joe Biden wins the White House and the Democrats take the Senate. While it is yet unclear exactly what the economic repercussions of such an outcome would be, the prevailing sentiment is that it would likely lead to higher taxes, for wealthy individuals, corporations, or both. Deregulation, too, could be rolled back, particularly in environmentally impactful industries. Stimulus, however, could be the same or greater in such a scenario, but the implementation of such stimulus would differ.

Our final wave, and one that gets less attention and bears worth watching is the second wave of economic disruption. The timing of stimulus, the impact on consumer behavior of accelerating Covid-19 cases, and a reaction to the election could all lead to a near term softening in the U.S. economy, and it is this wave that is the hardest to predict.

What we’re watching

With just weeks to go before the November elections, tensions are running high, and investors are waiting to see how it will all turn out.

While the polls are showing former Vice President Joe Biden with an advantage over President Donald Trump, there is little doubt that investors are skeptical after the outcome of the 2016 contest, which was expected to go in Hillary Clinton’s favor. Many are harkening back to the contested Gore vs. Bush election and the challenge of the hanging chads to determine what the impact might be. Of course, the environment is even more polarized, and with a massive increase expected in mail-in voting, the threat of a delay is higher, which would result in market volatility. However, stocks typically perform better out of an election – even if it takes a little bit longer for a final decision to be made.