The first half of 2020 has been unprecedented with the global spread of the COVID-19 virus. The pandemic and the response of world leaders to contain the virus abruptly ended the longest economic expansion in U.S. history with the quickest and most severe deterioration in economic conditions in almost 75 years.
The ultimate financial impact of the health crisis remains uncertain, making it even more difficult to precisely predict where the economy will be in the next six months or a year from now. However, based on the facts we know today, the economy has the potential to return to its pre-coronavirus levels in the latter part of 2021 to early-2022.
Governments across the globe responded to the coronavirus by closing their borders, mandating social distancing policies and closures of non-essential businesses. In the U.S., more than 55 million Americans filed for unemployment benefits through early August while GDP in the second quarter fell -32.9 percent on an annualized basis, representing the worst quarterly decline in history and the third worst peak-to-trough decline behind the Great Depression and WWII mobilization.¹
The challenge of gauging where the economy may be headed in the future is further complicated by the government’s attempts to remove social restrictions and reopen the economy while new cases continue to rise in certain areas of the country.
Assessing the trajectory of the economy must start with an assessment of where we are with the virus. Given the escalation of new cases, the lack of a vaccine and the diverse range of policies and enforcement measures different states have instituted to curb the spread of the virus, it is difficult to predict where the economy might be in a month, six months or a year from now. Despite this continued period of uncertainty, we believe there are some recent developments that can provide us with a reason for optimism.
Antiviral drug Remdesivir showed positive results treating patients with COVID-19 and subsequently received emergency use authorization from the FDA. In addition, there are currently 165 COVID-19 vaccines in development, with 26 in clinical trials, 12 progressing to Phase Two and six entering the final Phase 3.² According to economic forecasting firm Good Judgement, there is an 80 percent chance that enough vaccine doses will be available for 25 million people between October 2020 and September 2021, with the odds of between October 2020 and March 2021 increasing significantly in recent weeks.³
Source: Good Judgement
In an effort to prevent a full-on collapse of the U.S. economy, Congress proactively passed the CARES Act providing a series of stimulus measures that far exceed those instituted in response to the 2008 financial crisis. Among the provisions included in the act are business loans that can convert to federal grants, tax credits and deductions to help businesses free up cash flow, expanded family medical leave and unemployment benefits, and direct payments of recovery rebates to qualifying taxpayers. At the time of this writing, Congress is in the process of negotiating a fourth round of stimulus in the $1 trillion dollar range.
Although there will be economic consequences of these stimulus measures far into the future, a lack of government intervention at this time would put the economy in far worse shape and a full recovery would take much longer to achieve.
The Federal Reserve Bank has responded to the COVID-19 pandemic by promising to do whatever is needed to get the economy back to stable footing. This hints at the possibility that we are entering a new monetary regime for which money supply will grow at a faster rate than in the past, and central banks will be willing to accept a higher level of inflation.
For perspective, at the end of 2018, the Fed initiated a broad review of the strategies, tools and communication practices it had been using to pursue its goals of maximum employment and stable prices. Despite almost a decade of overly accommodative monetary policy, the Fed found that economic growth after the financial crisis had been positive but sluggish, labor markets took more time to truly firm and allow wages to grow, and inflation had remained stubbornly below the Fed’s target.
Now, two years later, with COVID-19 sending shock waves through the economy and labor markets, we are at risk of a deflationary environment, defined as a general decline in the level of prices. This can be undesirable because it discourages consumer spending, a major driver of economic growth, and creates the expectation that prices will fall even lower at a later time. Deflation can also exacerbate the government’s debt and can be extremely difficult to reverse once it sets in.
The labor market started to deteriorate in March as the government forced the closure of nonessential businesses and instituted safer-at-home policies. In the subsequent months, as businesses laid off or furloughed workers, the U.S. unemployment rate escalated dramatically to 14.7 percent from its pre-pandemic 50-year record-low level of 3.5 percent.⁴ However, as the economy began to reopen and more people returned to work, the number of people filing for unemployed benefits began to decline. From May to July, the economy added a combined 9.3 million jobs, leaving the unemployment rate at 11.1 percent. ⁵ Just last week, unemployment filings were at the lowest level since the start of the pandemic.
While this data suggests that government stimulus may be helping to expedite a recovery, it is important to remember that the labor market is still struggling. The longer the virus continues to spread, the more time we will be subject to social distancing measures, and the greater the chance that temporary job losses will become permanent.
With roughly three months to go until the general election, the race is sure to heat up, and market volatility may pick up in August, as is typically the case in an election year.
Taking a broad view of the candidate’s platforms and setting aside the coronavirus and its economic implications, it is likely that a second term for Trump would look very similar to the past four years, marked by aggressive economic policy, a tough stance on trade, focus on keeping jobs in the U.S. and a continued tax-friendly environment. In comparison, Biden’s “Build Back Better” economic plan focuses on innovation and returning manufacturing to the U.S., as well as a repeal of the TCJA tax cuts for high-income earners and an increase of the corporate tax rates from 21 percent to 28 percent.
While Trump and Biden propose different paths forward and uncertainties over the election outcome could cause short-term market volatility, we do not believe there will be any draconian outcomes regardless of which candidate is elected. We live in challenging times with one of the most politically polarized climates, but, at the end of the day, we must have confidence in our democracy and the belief that both candidates will focus on getting the economy back to pre-coronavirus levels.
Amid all the current economic uncertainty, businesses and their employees have adapted quite well to the new normal. The rapid advancement and adoption of new technologies has made it easier for businesses and consumers to efficiently allocate their resources and even maintain productivity at their pre-pandemic levels. For example, there are several applications and services that make it easy for workers to collaborate remotely and work productively from their homes, telemedicine helps to connect consumers with their healthcare providers, drones and robots expand our reach, online shopping saves time for other activities, and 5G cellular service makes it faster and easier to communicate. Further technological advancements and faster adoption of these technologies will help to drive economic growth higher in the future.
The first half of 2020 represents one of the best examples of how challenging it can be to try and time the market.
Over a 33-day period, the S&P 500 declined by 34 percent, more than three times faster than all prior bear markets going back to the 1929 stock market crash.⁶ In March, there were four days of moves greater than positive or negative 9 percent. Since the market lows on March 23, the S&P 500 has risen more than 51 percent and is less than 1 percent below the all-time high reached in February.⁷
Our focus here, however, is what we can expect to happen in the future. After all, markets are forward-looking. Over the longer term, we believe stocks can continue to produce attractive returns. However, we recognize that gauging returns over the near term will be a challenge, due, in part, to uncertainty over where valuations will be the near term.
For example, valuations currently appear rather expensive based on the Forward P/E, which shows current stock prices relative to next 12 months expected earnings. With the recent rally in equity prices and the significant blow to corporate earnings from a weakened economy, the Forward P/E for the S&P 500 has risen to levels not seen since the dot-com bubble.
Source; JP Morgan
Part of the reason valuations are so high is the expected impact on corporate earnings. For perspective, Q2 earnings, which companies started to report on July 14, are expected to be -42 percent below estimates for the same time period before the onset of the virus, with full-year 2020 earnings expected to be -27 percent below pre-virus expectations.⁸ While consensus estimates recently showed marginal improvement, there is no way to sugar coat corporate earnings for the balance of 2020. Yet, given the extent of government stimulus, the historical precedent of quicker recoveries from event-driven recessions, and the expected recovery of some key data points as more parts of the economy reopen, we can look further into the future to predict what recovery in earnings may look like in 2021 and beyond.
It is also important to recognize that valuations are trending higher due to the performance of Facebook, Apple, Netflix, Google, Microsoft, Amazon, Netflix, and Tesla (FANGMANT), which account for 28.2 percent of the S&P 500. Further, the Forward P/E for these eight companies is currently 44.2. If we exclude these companies from S&P 500 for a moment, the Forward P/E is 18.5.⁹
With regard to valuations, stocks do look somewhat attractive relative to bond yields. The chart below shows the Equity Risk Premium comparing the forward earnings yield of the S&P 500. With interest rates expected to remain low, investors may be willing to bear some short-term volatility to outperform bonds over the long term.
Source: Top Down Charts
A better approach for gauging where equities could be headed requires a closer look at earnings, valuations and dividends.
If we assume markets will continue to look past the current economic uncertainties and their impact on 2020 earnings, we can focus on a recovery in 2021 and 2022 when consensus earnings are expected to return to normal. If we assume valuations decline modestly from 22.3 to 19.5 (a decline of 9 percent) and dividends remain level and consistent with their 25-year average of 2 percent, we would expect a return on the S&P 500 of -7 percent.
-7% S&P 500 Return = 0% Earnings Growth – 9% decline in valuations + 2% dividend
While this is an oversimplified analysis with many assumptions, it provides us with a benchmark to assess different scenarios and assign probabilities to determine what returns could look like in the future.
The availability of a vaccine will allow the government to lift restrictions and encourage the economy to more quickly return to normal. This, combined with continued and well-targeted government stimulus, may allow markets to look past weak Q2 corporate earnings and focus instead on 2021, when earnings may fully recover to pre-coronavirus levels. At that point, stimulus could start to ease and valuations could come down a bit but remain elevated given bond yields.
Under this scenario, we would expect earnings growth of 19.4 percent, a decline in valuations by roughly 10 percent and dividends to remain at current levels, resulting in a net return of 11.4 percent.
11.4% S&P 500 Return = 19.4% Earnings Growth – 10% decline in valuations + 2% dividend
If there is no material progress on a COVID-19 vaccine and new cases continues to rise across the country, states will be unable to reopen fully and the virus will continue to weigh on consumer and business confidence. Even with continued stimulus measures from the federal government, certain industries will feel a significant impact and be forced to close, which will stall full employment and prolong any chance of a recovery. Currently, 2021 earnings estimates prove to be overly optimistic, and only recover half of current consensus estimates.
Under this scenario, we would expect earnings to improve only half of what is currently expected, resulting in -10.8 percent decline, with valuations declining 10 percent from current levels, dividends remaining steady at 2.0 percent with equities returning -18.8 percent.
-18.8% S&P 500 Return = -10.8% Earnings Growth – 10% decline in valuations + 2% dividend
Assuming that no material progress is made on a vaccine and all other virus-mitigation measures prove futile, it is possible that a second wave of new coronavirus cases in the Fall will prevent the economy from reopening, wiping away any signs of recovery from recent weeks. If we also assume that corporate earnings grow at a linear rate and take five years to fully recover, earnings growth would be 33 percent below the current 2021 expectations.
A faltering recovery will create concerns as to whether policymakers can do enough to spark the economy longer term, despite extraordinary stimulus from the Fed to keep interest rates low, causing valuations to decline by -19.4 percent. With significant challenges ahead and continued uncertainty, companies would need to cut their dividends in half, resulting in an expected return for the S&P 500 of -49.1 percent.
-49.1% S&P 500 Return = -33% Earnings Growth – 19.4% decline in valuations + 1% dividend
We believe the scenario analysis above takes a rational approach to gauging where returns could be over the next 12 months using reasonable assumptions on corporate earnings, valuations, and dividends under different scenarios. However, in each scenario we assume that valuations will move at least somewhat towards their long-term average. While that will happen at some point, the amount of monetary stimulus from the Fed and the low interest rate environment can keep valuations abnormally high for an extended period. If we further assume that valuations remain at current levels but all other inputs of the scenario analysis remain the same, the weighted average expected return moves to positive 4.5 percent with the optimistic scenario resulting in a return of 21.4 percent.
Finally, it should be noted that the analysis above uses the S&P 500, which is meant to provide a general gauge of the broader market. In reality, some segments of the market are thriving during COVID-19 due to shifts in consumer behavior and business’s quick response to adapt. Consequently, we have repositioned our discretionary portfolios to capture this theme, placing a greater emphasis on innovative technologies and companies with competitive advantages. On balance, the equity exposure in our discretionary portfolios remain slightly defensive compared to where it was prior to the onset of the virus. Furthermore, we view a market pullback as an attractive opportunity to add exposure long term.
As central banks across the globe maintain extremely accommodative monetary policy, government bond yields have declined materially. The 10-year treasury, which started the year at 1.53 percent, is now 0.65 percent, slightly above the all-time low. Moreover, there are currently $15 trillion worth of bonds across the world with negative yields.
Bonds will always be a component of a well-diversified portfolio given their attributes of price stability and cash-flow production. However, in the current environment, bonds are less likely to add much value in the near term. Taking into consideration the record low rates and flatness of the yield curve, we recommend investors focus on shorter-term maturities that can provide a competitive yield relative to longer term bonds as well as greater flexibility should interest rates move. Moreover, given that we are likely at the early stages of a new economic expansion with substantial support from the Fed, we have also added exposure to credit, which we feel can add value above conventional treasuries.
How quickly the economy can recover from the COVID-19 pandemic will depend on our ability to contain, treat and prevent this virus from spreading further. Only after we reach that point, can restrictions be lifted and the economy be free to recover. Given the historic precedent of quick recoveries following previous event-driven recessions and the current level of stimulus across the globe, we can expect a quick rebound. However, if the first part of 2020 is any indication of the rest of the year, there will be additional challenges to consider along the way. As always, we will continue to monitor conditions closely and keep you informed as conditions change.
About the Author: Joseph Karl, CFA, is chief investment strategist with Provenance Wealth Advisors (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs, and a registered representative with Raymond James Financial Services. For more information, call (954) 712-8888 or email email@example.com.
Provenance Wealth Advisors, 515 E. Las Olas Blvd., Ft. Lauderdale, FL 33301 (954) 712-8888.
Joseph Karl, CFA, is a registered representative of and offers securities through Raymond James Financial Services, Inc., Member FINRA/SIPC. Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors and Accountants. PWA is not a registered broker/dealer and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc., and Provenance Wealth Advisors.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of the advisors of PWA and not necessarily those of Raymond James. You should discuss any legal matters with the appropriate professional. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investments mentioned may not be suitable for all investors.
The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor’s results will vary.
Every investor’s situation is unique, and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected.
There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices generally rise. Past performance may not be indicative of future results. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. The above hypothetical examples are for illustration purposes only. Actual results will vary. Future performance cannot be guaranteed, and investment yields will fluctuate with market conditions. Diversification does not ensure a profit or guarantee against a loss.