Second Quarter, 2020

Macroeconomic Commentary 

After a first-quarter plunge, equity markets rebounded in the second quarter. The S&P 500 rose 20%, its largest quarterly gain since 1998. At mid-year, the index was only 8% below its all-time high despite an almost 10% second quarter decline in year-over-year GDP and the highest U.S. unemployment rate since the Great Depression.

What explains the apparent disconnect between financial markets and macroeconomic conditions? We see three inter-related reasons:

  • Widespread expectations that the economy will bounce back fairly quickly;
  • Massive monetary and fiscal stimulus;
  • A collapse in real interest rates, which increases the present value of future cash flows.


Will the Economy Bounce Back?

It’s hard to forecast the economic outlook, because there’s no obvious historical precedent for the COVID-19 crisis. Perhaps the best financial analogy is a natural disaster. Following a natural disaster, the labor market typically stages a more or less linear recovery because an exogenous event, rather than excesses within the economy, caused the disruption. As an example, employment plunged in Louisiana after Hurricane Katrina but began to pick up two months later and returned to pre-hurricane levels within two years. The graph below shows that similar to Katrina, but unlike the Global Financial Crisis, U.S. employment fell sharply when the COVID-19 pandemic set in and began to pick up two months later. 

While comparing the labor market data for COVID-19 and Hurricane Katrina may be somewhat comforting, COVID-19 is not an earthquake or a hurricane, which occurs quickly and then ends. Unlike after a hurricane, there are real risks to resuming life as usual until the virus is eradicated or an effective vaccine becomes available. We expect the economic impact of the pandemic to last longer than the impact from most natural disasters. 

Statistical modeling suggests the virus will spread faster if economic activity returns to even one-third of its pre-pandemic level, supporting our expectation that the economy will recover slowly. We believe consensus expectations for earnings are too optimistic. Consensus projections for 2021 S&P 500 earnings of $163 are roughly flat with 2019. In our view, companies are unlikely to deliver this level of earnings if the U.S. economy is operating well below 2019 levels. 

Further, while other countries have dramatically slowed the spread of COVID-19, U.S. progress in combatting the pandemic has been disappointing. The disease’s recent spread across the U.S. is worrisome. As the display below indicates, COVID-19 has gradually gone from being a huge problem in one region of the U.S. to a big problem in most of it. Initial optimism about successful economic re-openings has begun to fade, and some planned re-openings have been paused to prevent the situation from getting worse. 

Some market commentators cite “human ingenuity” as a reason to be bullish. They believe (or hope) the global effort to find a treatment or vaccine will bear fruit by the end of the year. We are relatively optimistic about a treatment but less sanguine about a vaccine. Vaccines typically take a long time to develop. Since they are given to otherwise healthy people, scientists need to ensure they will not adversely impact any segment of the population. In this instance, potentially hundreds of millions of people would be given a prophylactic treatment. The safety bar must be extremely high. Further, the vaccine must be proven to work for a meaningful length of time. If not, individuals may believe they are protected when they are not. This likely necessitates trials that extend into 2021. 


The Monetary and Fiscal Response 

We think the main drivers of relatively strong equity market performance have been extraordinary monetary and fiscal policy actions. “Don’t fight the Fed” is usually sound investment guidance, especially now, when the Fed is being more aggressive than at any point in history. Broad money supply growth has greatly exceeded nominal GDP growth. Money supply has vastly outstripped demand. Since money must go somewhere, it has poured into financial markets. If this continues, it will likely sow the seeds for the next bubble, which can make it problematic to be underinvested in the equity market. 

Massive stimulus is not solely a U.S. phenomenon, although policy makers have been more aggressive in the U.S. than in most other nations. While the global policy response to the 2008-09 financial crisis was extraordinary, the chart below shows that many countries have delivered much larger stimuli this time to revive economies nearly paralyzed by the pandemic.

In the U.S., the Federal Reserve and Congress have thrown nearly everything they have at offsetting the pandemic’s impact on the economy. Many laid-off workers have been eligible for benefits greater than their prior incomes. Congress has passed four fiscal packages totaling almost $3 trillion; this summer, it is expected to pass another $1.5 to $2.0 trillion package, equivalent to 7% to 10% of GDP. With some initial programs expected to expire July 31, any delay or disappointment in the size of a new fiscal package will likely exacerbate equity market volatility. 



Ultra-Low Interest Rates 

Negative real bond yields and money-market rates have also been driving equity markets higher. Many institutional investors have high cash levels and are taking on more risk to try to attain better returns. At 1.9%, the S&P 500 dividend yield is higher than the 0.16% yield on 2-year U.S. Treasuries. The yield of dividends plus buybacks (the combined cash yield of stocks) is currently 4.2%, far higher than the 0.66% yield on 10-year Treasuries. 

Low yields raise the present value of stocks by reducing the discount rate applied to future cash flows. Because much of the value of growth stocks comes from earnings expected to materialize further in the future, growth stocks are particularly sensitive to changes in the discount rate and, to some degree, less exposed to misses or hits to near-term earnings. 



How Does It End? 

Three scenarios could unfold as the world fully reopens for business. 

The most likely scenario, in our view, is that economic activity picks up, but global growth remains slow and inflation, non-existent. In this scenario, growth stocks and long-dated bonds will continue to outperform more cyclical assets—until the valuation disparity gets too wide and reverts. We assign this outcome odds of 55%-65%. We think it’s also the implicit consensus view. 

A less likely—and more painful—scenario is that the end of social distancing leads to a sharp rise in new infections and a relatively rapid move back to sheltering at home. If this scenario comes to pass, the best investor positioning would be to underweight equities and own gold. We assess the likelihood of this scenario at 10%-20%: low, but higher than the nearly 0% likelihood that equity markets appear to be ascribing to it. 

The third scenario is that pent-up demand, record-high budget deficits, low oil prices and unprecedented central bank stimulus lead to strong global growth and high inflation, after years of price stability. In this case, cyclical, financial and emerging-market stocks would likely outperform, and growth stocks would lag. We estimate the odds of this scenario to be 20%-30%. 



Valuation and Sentiment 

Market valuations are high. At quarter-end, the S&P 500 was trading at approximately 22 times 12-month forward earnings, and the median multiple for stocks in the Index was 24 times 12-month trailing earnings, far above its 52-year average of 17 times. Price-to-book, price-to-cash flow and most other traditional valuation metrics also indicate that the market is expensive. 

Sentiment has been swinging wildly. In March, the Global Sentiment Composite dropped from above 80% (extremely optimistic) to below 10% (panic). Since then, in the fastest sentiment swing on record, it has rebounded to above 80%, on exuberance over the reopening of the economy. Continued acceleration in virus spread could knock it back down. 

In our view, as long as fiscal and monetary stimuli continue and yields remain low, the downside to equity markets is likely limited and the possibility of a bubble developing, not negligible. Signs of irrational behavior are appearing. For example, in early June, the value of a Chinese property company jumped more than 10-fold, from $800 million to $10 billion in four hours, as a storm of social media messages noted that its name, Fangdd Network, made it look like a cheap ETF for the FAANG technology giants. The following week, the market capitalization of Nikola, an aspiring electric vehicle manufacturer with no revenues that went public in March at a market capitalization of $300 million, reached a $30 billion valuation, representing a 100-fold increase in just three months. 

Those who lived through the 1998-2000 boom know that the final expansion of a bubble can be immensely profitable—and its bursting, immensely painful. 



Equity Portfolio Positioning 

Given both the unprecedented economic decline and the enormous fiscal and monetary response, predicting even near-term economic growth is challenging. Both the bullish and bearish tail risks are unusually large. 

  • Continued or accelerated virus spread
  • Significant progress on treatment or vaccine
  • Rising geopolitical tensions (particularly between the U.S. and China)
  • A greater than expected fifth stimulus package
  • A disappointing fifth stimulus package
  • A rush into equity markets due to “fear of missing out” from the ample cash on the sidelines (i.e. an expanding bubble)
  • A drop-off in employment growth after PPP expires
  • A drop-off in consumer spending after unemployment benefits revert to normal
  • November election surprises

At current valuations, we believe the long-term risk/reward balance for equities is negatively skewed. That is leading us to keep balanced portfolios at the lower end of target equity ranges. We aren’t reducing equity exposure further because massive stimulus is making a significant correction unlikely near-term. Too much caution could miss strong market gains, particularly during an inflating bubble. 

Our portfolios are currently more evenly balanced between growth and value and between U.S. and foreign equities than at almost any time in recent years. Our sector positioning is close to neutral as well, with the exception of a fairly large overweight in Healthcare. With an outlook that is particularly hard to discern and depends on uncertain medical breakthroughs and the size and scope of governmental actions, we think it’s prudent to minimize factor exposures. 

We’re optimistic that the Healthcare sector can prosper in most economic scenarios and is attractively priced. The sector has consistently outperformed during inflationary periods, as well as over the long haul, but fears of a more restrictive drug pricing regime and Medicare for All were pushing down valuations when 2020 began. Those risks have dissipated somewhat, yet valuations are still at or below historical averages. We expect healthcare companies to lead the way back to a healthier economy due to pandemic-related increases in healthcare spending. Healthcare spending is also rising globally, the result of aging populations in developed markets and adoption of healthcare safety nets and higher medical standards in emerging markets. 

In contrast, expectations priced into many technology stocks are simply too high, in our view. The 75 fastest growing companies, many in the technology sector, are now expected to grow earnings 28% annually through 2024 and 16% annually for the five years thereafter; these growth rates are 5.5 and 3.5 times the rates for the overall market. While the pandemic has boosted the long-term prospects for some of these companies, it is easy to overestimate growth, particularly during periods of massive dislocation. We have sold or trimmed several of these stocks. 




We are asked how the pandemic has influenced our thematic thinking. The short answer is that the impact varies. Wealth Migration and Urbanization has been affected most. We sold several holdings that were well-positioned to capitalize on the movement of wealth from U.S. suburban to urban areas, because we now expect a pause. While the coronavirus does not necessarily spread faster in more densely populated locations (Hong Kong, Taipei and Singapore, all densely populated cities, weren’t overly affected) many of the urban amenities that attract wealthy people to cities are not available now and may be significantly less available for some time to come. Further, ample living space is a luxury that becomes more desirable when people work at home and spend more time there. We would not be surprised if the pandemic sets off a temporary move away from more expensive, densely populated areas of the U.S. and a rise in second home purchases. 

The coronavirus has also disrupted supply chains and commodity markets, leading us to neutralize our underweights in several related sectors, including energy. While we still believe that the End of China’s Emergence created overcapacity in commodities and many industrial subsectors, pandemic-related bankruptcies may accelerate capacity reduction. We will revisit this theme when the pandemic ends and we can better assess supply/demand balances. 

Our other themes are well-positioned in the current environment. Spending on Molecular Medicine is accelerating, and more genomic population studies are being conducted to understand which groups of people are most at risk of contracting COVID-19 or of having a bad outcome if infected, or both. Advances in genomic understanding will be critical to developing treatments and vaccines. 

Our Heterogeneous Computing theme is timely. An executive at one firm we have invested in said in a conference call, “COVID-19 has created the largest-ever change in human behavior at scale and almost instantaneously, requiring companies to fill new demand trends, change how they engage with customers, and adapt quickly to volatile market conditions, all of which require a strong digital foundation, just as they also face massive cost pressures.” Some of the most obvious virtualization companies are now discounting wildly profitable growth for as far as the eye can see. Zoom Video Communications, for example, is trading at 300 times earnings. Our focus is on less obvious tech companies that enable new kinds of communications and computing applications and are reasonably valued relative to promising long-term prospects. 

Our Inequality Paradox and Supply Chain Automation themes are also unfolding faster than they would have if the pandemic hadn’t occurred. In general, higher-income individuals are less affected by the pandemic than the larger population; we believe companies with a global footprint and a focus on this segment are well-positioned to prosper. Several of these companies are also at the forefront of automation-related technologies, such as ultra-high frequency RFID and vision systems that enable better inventory management between online and in-store operations. 



Fixed Income 

After falling from 1.88% to 0.70% in the first quarter, 10-year U.S. Treasury yields traded in a relatively narrow range for most of the second quarter. Yields spiked to 0.91% briefly after the surprisingly strong May employment report, and then quickly reverted to the 0.60%-0.70% range that prevailed for most of the quarter. We expect interest rates to remain very low in the short to medium term.