One of the under-appreciated joys of growing up in America’s Heartland was long drives down winding roads. Vacations, sporting events, drives to the lake and trips to see the grandparents were just a few of the getaways that only later in life I’ve grown to appreciate for their monotony. Hours on the road meant plenty of time for mindless escapes like counting license plates and turning clouds into animals. Watching the upcoming bend in the road was a particular favorite of the Couden family as a game of “Who can guess what is around the corner?” was a common occurrence.
Given the historically volatile first half of 2020, many people are asking themselves what lies around the corner for their investments. The sharpest bear market in history, followed by the sharpest rally in history, has more than a few investors scratching their heads. For those who have been following our weekly market updates (click here to see the videos), you will be familiar with several of our key concerns and opportunities. We have previously stated that the unprecedented retrenchment in economic activity caused by the pandemic will keep market volatility elevated. However, we also noted most of the shutdown is self-inflicted, not structural, and prone to snapping back once social distancing guidelines are lifted (see In The Throes, The Road Back, Resilient, or Delusional? here).
At BakerAvenue, we maintain analytical independence from pre-written market narratives. We remove preconceived biases from the equation and defer to our analytical output. Ultimately, our views are only as optimistic or pessimistic as our technical, fundamental and macro market analyses indicate. Our disciplines exited June in better shape than May (and May was better than April, in aggregate). Accordingly, our positioning turned more optimistic as the weeks rolled by. In short, we are turning the corner on better footing. Our interpretation of what’s around that corner will continue to be defined by the output from our disciplines.
Let’s start with the macro backdrop. Over the past several weeks, investor focus has rightfully shifted from infection to economic trajectory (they are clearly linked). Upside surprises on incoming economic data (e.g. June’s ISM manufacturing index unexpectedly jumped to an expansionary 52.6 from contractionary 43.1 in May) continue to support the narrative of a recovery in activity and related optimism in financial markets. However, surging COVID-19 cases raise the question of whether improvement has been achieved through premature easing of restrictions.
We stated previously that, as the world’s economies open back up, cases will tick higher. However, the market is most focused on hospitalization and mortality rates and the trends there are, so far at least, less bad. While the resurgence debate may affect the trajectory of the recovery, we doubt it will directionally alter the way forward. Simply, there is a high hurdle to re-engage in full shutdowns.
Regardless, broad skepticism about the prospects for a V-shaped economic recovery remain. We believe the worst of the economic contraction occurred in April, but May and June’s recovery only reverses a small fraction of that retrenchment. Odds are this quarter will show the steepest contraction in modern history, but most investors are focused on directional improvement. As such, we are comfortable saying we are turning the corner. Steepening yield curves, a weaker US Dollar, tighter credit spreads and record levels in economic surprise indices have supported that view.
While markets have been focused on the growth outlook, we believe that monetary and fiscal policy will remain a key driver of the market rebound. The Fed’s balance sheet is now three times larger than it was in 2008, and they got there in record time. The fiscal response to this crisis has been equally impressive and dwarfs the Global Financial Crisis in terms of size and speed (Congress has passed four economic support packages worth almost $3 trillion). All of that liquidity has been added to the capital markets at a blistering pace.
The initial Covid-19 contraction is larger than the great financial crisis, we believe its cumulative impact on the economy will likely be less as long as the policy response remains strong enough to cushion the blow. A central bank ‘backstop’ makes a re-run of the March panic in financial markets unlikely, a key assumption underpinning our current positioning.
Investor focus will soon shift towards how long it takes to get economic activity back to pre-pandemic levels. The U.S. economy was healthy leading into the COVID-19 crisis and the ensuing recession was caused by an exogenous shock. This is not a typical end to the business cycle driven by economic overheating and could hold promise for the recovery. Regardless, we believe it is prudent to be guarded and continue to suspect more of a U-shaped recovery.
While COVID-19 trends are dominating the headlines, we are keeping our eye on other macro catalysts. We believe intensifying US-China tensions have increased trade uncertainty but, much like last year’s trade war, will ultimately avoid the most-dire scenarios. Election-related volatility is sure to pick up as the year progresses, but, like most elections, will play second fiddle to the economic backdrop.
Fundamentally, we are focusing on the trend in corporate profits and credit metrics. Mirroring the economic contraction, we suspect the pullback in corporate profits troughed in April. Visibility remains limited (more than half of the companies in the S&P 500 have withdrawn guidance), but it is improving as the reopening gains steam.
We monitor credit closely as a risk metric and measure of liquidity. The credit backdrop has improved with both investment-grade and high-yield spreads more than halfway back to their old pre-crisis levels. Continued tightening here is consistent with the ongoing rally in stocks. Capital raises (e.g. secondary offerings, corporate bond issuance) have exploded as balance sheets are fortified. Our phones were ringing off the hook as secondary offerings in the U.S. raised $113 billion in the second quarter, the most on record.
Valuations are stretched as the rally (and depressed earnings) has pushed P/E multiples to the highest levels in two decades. Sector and industry valuations differ, of course, with a record amount of dispersion (the top 20% of the S&P 500 trades at 28x vs. 11x for the bottom 20% - the widest in 20 years). Now is the time for earnings growth to take over and, encouragingly, profit revisions have trended higher over the past two months.
It should be noted that valuation is often reviewed in the context of interest rates. On that front, the 10yr Treasury yield stands at 0.65% today, just 15bps above its record low set earlier this year. Those historically low rates make the earnings yield offered by stocks attractive relative to bonds and provides a counter-point to valuation concerns.
Technical trends continue to improve. Market breadth (a measure of participation) and relative strength carry significant weight in our work. Both are showing signs of improvement, but return attribution clearly shows the largest names are carrying the load by record amounts (i.e. almost half of the the S&P 500’s 25% return in the second quarter was due to the top ten stocks). So, there is room for improvement as far as participation goes.
The relative strength of various asset classes, sectors and industries is encouraging. The best performing sector since the March 23rd lows has been energy, a deeply cyclical (economically sensitive) group. The worst groups have been telecom and consumer staples, both historically defensive sectors. Should investors continue to reward these portions of the market, confidence in the recovery will be emboldened.
Investor sentiment remains subdued (a good thing). There was over $1.5 trillion put into money markets from March to May, and that trend has only started to reverse with its first unwinding (-$84 billion in June) in four months. We suspect elevated volatility continues to play a role here. The S&P 500 has moved +1% up or down on over half (54%) of trading days so far this year and the Volatility Index (the VIX) has remained stubbornly high. Should those trends reverse, expect more money to enter the equity market.
Our investment philosophy is based on a dual mandate of growing, and protecting, client assets. Currently, our short-term metrics are in a neutral position, while long-term trends, which are influenced by our recessionary and bear market views, have healed (also neutral). Pull backs and consolidations have been few and far-between since the market bottom, but we have remained active in our strategies, opportunistically using recent volatility to invest our dry powder.
With our cash positions now residual in nature, we are focusing on strategy ‘tilts’ vs. our respective benchmarks to control risk. We have championed a ‘barbell’ approach by investing with secular winners while simultaneously allocating capital toward assets that will benefit most in a recovery. Should our base case hold, we plan to hold our positioning steady. Of course, should the backdrop not continue to stabilize, we will take a more defensive stance.
While there is notable uncertainty about what lies around the bend, we believe we are turning the economic corner and are firmly in recovery mode. Asset prices should stay volatile as investors swing from recovery optimism, to shut-down pessimism, and back again. The next few weeks will be most influenced by virus-related news flow, and specifically reports of economic traction regarding re-openings. Headlines related to geopolitics and corporate earnings will also carry significant weight.
Given the volatile and ever-changing backdrop, we believe a strategy that combines disciplined fundamental, technical and macro analyses has the best chance of generating superior risk-adjusted returns. While our forecasts are subject to revision, our commitment to client service is rock solid. Should you have any questions, please reach out to us. We are happy to share our thoughts in greater detail and welcome your questions or comments.