This series of articles is designed to help investors filter the noise in today’s markets to improve understanding and investment decisions

After a broad-based rally in markets this spring, markets have become narrow and more defensive again. A handful of the biggest, defensive tech stocks have led the market for the past few weeks (Exhibit One), and 10-Year Treasury yields have fallen again (as Treasury bond prices rise).

This change in mood reflects growing investor caution about the pace of economic recovery as the coronavirus shows signs of spreading again, as well as uncertainty about the outcome of the US Presidential election in November.

We’ll cover the latest on the virus perspective today, and we’ll turn to the elections in a separate commentary shortly.

SUMMARY MESSAGES

  • Earnings season has so far confirmed our expectations about the path to recovery, with visibility for most companies extremely limited.
  • Early economic data was encouraging, highlighting the strength of pent-up demand. It has leveled off with the spread of the virus on re-opening. We expect calls for social distancing and wearing masks to increase—enabling measured re-opening—but don’t expect major lockdowns.
  • Key parts of the stimulus package expire in the coming weeks. We expect further stimulus support, but political brinksmanship could create near-term volatility in markets.
  • We believe the best opportunity for long-term investors is not in today’s obvious beneficiaries, but in smaller stocks and higher quality companies that benefit from recovery.

INSIGHTS MIDWAY THROUGH EARNINGS SEASON

Corporate earnings reports for the June quarter are coming in as expectedessentially confirming the two things the market already reflects in current stock prices: that 1) companies driving the digital economy or providing core essentials benefit from uncertainty in the pandemic and 2) visibility for most other companies, who are struggling to recover, is extremely limited.

Importantly, there is investment opportunity in both areas, although it is skewed to the second category in our view. The challenge is not to chase “what is currently working” nor to take chances on “cheap stocks”; instead, it is to find opportunities offering better risk/reward over time. This is the art and discipline of buying at low prices, and selling at higher prices, rather than the other way around.

As we discussed here, we are comfortable with our exposure to 1) what we believe are the higher quality investments leveraged to tomorrow’s recovery, rather than to today’s quarantine, and 2) the more conservative investments we’ve made to help clients play defense until recovery unfolds.

THE PATH TO RECOVERY

As we’ve highlighted here and here, we expect a choppy path toward economic recovery, perhaps forming a “W-shaped” path. The June quarter will likely represent the deepest pain, but the pace in the coming year will be determined by government support, productivity of the health system, and individual behavior until a vaccine is found.

 

EARLY ECONOMIC DATA HIGHLIGHTS PENT-UP DEMAND

After historic stimulus, the initial rebound in May and early June was encouraging, prompting some optimism that the recovery might be rapid (V-shaped). Credit markets stabilized, over half the businesses that closed had re-opened[1], employment began to grow, and consumer spending ramped across key sectors like dining, clothing, gas, and furniture.

Notably, spending was higher in states with declining COVID infections, but it was still positive in states where it was increasing. Whether it could be sustained was an open question, but the good news to us was that this showed clear signs of pent-up demand: Consumer spending thus far appears highly proportional to effective control of the virus.

 

CHALLENGES TO RE-OPENING, AND BEWARE CONGRESSIONAL SPARRING OVER STIMULUS

With reports of the virus spreading again as certain states re-open, it comes as little surprise then that economic activity is starting to level off. Jobless claims have stabilized around a very high 1.3 million per week[2], after falling reassuringly since April. Consumer traffic into restaurants is down since mid-June, after notable improvement[3].

In earnings reports, the large banks increased reserves against losses substantially, expecting further challenges ahead. They also reported historically high cash balances in checking accounts, showing deep concern about the future among consumers and businesses.

Stimulus from the CARES Act begins to expire over the next few months, arguably putting parts of the recovery at risk.

  • One of the most significant is the $116 billion offered in weekly unemployment benefits for displaced workers, with support ending the last week of July. Unemployment had improved from over 14% to now 11% but is still extremely elevated.
  • Likewise, relief on payments on mortgages, student loans, and rent through federally insured programs will sunset; with delinquencies running much higher than prior to the downturn[4].

Brinkmanship politics could bring volatility to markets. We expect Congress to announce additional stimulus, but reaching agreement between a divided House and Senate could stoke tensions and fears. The Trump administration has called for additional stimulus, but capped at $1 trillion, while the House has approved relief totaling $3.5 trillion, with significant Senate opposition.

 

THE VIRUS WILL INFLUENCE MARKETS FOR MUCH OF THIS YEAR

The markets are watching infection rates and deaths as economies re-open. Number of cases is on the rise after states have re-opened, although the increase in death rates is more moderate (Exhibit Two).

If the rise in infections continues, we expect state and local governments to continue to moderate activity—through various mandates on social distancing and wearing masks—but do not anticipate heavy lock-downs. Various studies show a lag of about four weeks between mandates and infection rates, so it may be August or September before the markets see confirming evidence whether the virus is under control or not.

A vaccine is of course the wildcard (Exhibit Three shows the latest pipeline), but we continue to think that won’t be available until at least the spring. Many companies and organizations are working hard to develop one, and the pace of development has been encouraging to the markets.

 

BOTTOM LINE

As economies re-open—and they must—there will be surprises, both positive and negative. Current earnings season is highlighting what the markets have expected (the dramatic impact of the shutdown), and companies and investors alike are grappling with what the coming year looks like. The next big challenge will be if, when, and what type of additional stimulus laws will be passed, as well as how to balance economic activity while containing the spread of the virus. Ultimately, we continue to believe the severest part of the recession has happened and that companies with better balance sheets and cash flow generation will be best positioned to drive returns during the recovery.

 

Exhibit One: Recent Stock Performance

Exhibit Two: Status of Coronavirus Outbreak

Exhibit 3: Coronavirus Vaccine Tracker
At July 16, 2020

Source: New York Times

[1] According to Homebase, provider of scheduling and hiring software

[2] This is down from 6.9 million weekly filings at its peak in April, but well ahead of the prior weekly record of 695,000 in 1982, according to industry sources.

[3] According to Open Table reports.

[4] The Mortgage Bankers Association indicated on July 7 that 8.4% of loan balances, owed by an estimated 4.2 million homeowners, were in forbearance. It has been trending downward gradually as economies re-opened. The New York Federal Reserve Bank notes that delinquencies on student debt was 11% for 1Q20, but could be another 9% higher in the current environment.