Mid-year Update: The Covid-19 Inflection Point
What a roller coaster in the financial markets to date 2020. After falling (19.6)% in the 1Q2020, the S&P 500 Index rocketed back 20.5% in 2Q2020. In the fixed income markets, the Barclay's Aggregate U.S. Corporate Investment Grade Index returned 9.0% in 2Q2020 after being down (3.1)% in 1Q2020. Second-quarter 2020 returns benefited from the Federal Reserve and the Treasury significantly stepping up efforts to support the economy and liquidity in the financial markets. We see continued volatility in the financial markets in the second half of 2020 based on Covid-19, economic developments and the upcoming U.S. presidential election.
The Economy:
As the U.S. economy moves from the first half of the year characterized by surprise, confusion, and green shoots of hope, we see the second half characterized by resilience, capitulation, and election volatility. Irrespective of the shape of the U.S. economic recovery, the longer-term outlook for potential gross domestic product growth remains subdued.
The recovery in the stock market has been premised on what comes after; that is what corporate earnings may look like after the negative "Coronavirus" impact. Below we share a chart based on data from the U.S. Congressional Budget Office. Potential gross domestic product (GDP) growth for the U.S. is forecast to move downward toward 1.7% through this decade, as shown in Exhibit I. In a period of slow growth and high public debt levels, the most likely outlook for U.S. inflation and interest rates is to remain low.
Exhibit I – Potential Gross Domestic Product (GDP) Growth
*Shaded areas indicate U.S. recessions.
Source: Federal Reserve Bank of St. Louis
The consequence of 2020's brief but debilitating recession is the magnification of the "digital divide" – those companies that have invested in technology to increase productivity are enduring the effects of this pandemic comparatively better. We call these companies "the resilience leaders." The weaker competitors are increasingly apt to flounder and be either subsumed by these resilience leaders or go bankrupt. We see the second half of 2020 as the beginning of this longer-term evolution of "fewer, bigger, stronger" companies dominating the U.S. economic landscape.
The U.S. economy has shifted to a new economic paradigm, one in which the most influential competitors will gain increasing market share. These large, well-financed companies will also have increasing power and expertise to change the narrative on solutions to social and economic problems this country and the world face. Solutions to basic Maslowian needs is critical to long-term stable economic growth.
The Financial Markets:
2020 to date includes a steady stream of corporate bankruptcies. J.C. Penney, Brooks Brothers, and Neiman Marcus are just a few notable retailers, followed by Hertz on the travel side, and Garden Fresh and Sustainable Restaurant Holdings on the restaurant side. While the reincarnation of these recent bankruptcies has yet to materialize, what is notable to us is what they symbolize. They symbolize the past credit-driven cycles of consumer spending. Growth in consumer spending, which currently makes up about two-thirds of U.S. gross national product, is evolving within a slow-growth economy. This economy is characterized by high consumer debt at $14.1 trillion as of the fourth quarter 2019, high nonfinancial corporate debt at $6.8 trillion as of the first quarter 2020, and lastly, high total public debt at $26.5 trillion as of July 12, 2020. Finally, the Federal Reserve has lent ample support to the financial markets in recent economic and liquidity stress such that its balance sheet has dramatically expanded to $6.9 trillion from $4.2 trillion at year-end 2019.
Consumer spending and the services side of the U.S. economy are not likely to recover to pre-pandemic growth rates and significance. Offsetting this loss, we see technology innovation and investment, healthcare productivity, and some housing-related spending providing ballast. Just as the first half of 2020 was disproportionately negative on equity returns within the consumer discretionary, energy, and financial sectors, we anticipate the second half of 2020 to see further disruption in industries most impacted by slow economic growth and constrained government spending.
In the fixed income markets, Treasuries have been the standout performer. For the six months year-to-date, the U.S. Treasuries component of the Bloomberg Barclay's U.S. Aggregate Bond Index returned 8.7% compared with the U.S. Corp Investment Grade Index return of 5.0%. The Municipal Bond Index returned 2.1% year to date through June 30. The variability is notable, and credit quality was a significant differentiator. This performance included wide variability between the first and second quarter, in addition to the wide variability in returns based on peceptions of quality and safety. We see continued volatility in the Treasury, corporate, and municipal markets as investors adapt to new and updated Coronvirus-related information, global central bank activity, and emerging economic data.
The November Election:
The current unsettling U.S. socioeconomic conflicts are moving to center stage as the upcoming U.S. presidential election in November looms increasingly large. Tax policy, social mandates, and global cooperation or discord will all contribute to potential volatility in the financial markets as candidates debate and provide more details on their initiatives. Just as geopolitical events' potential was a wild card coming into 2020, so is the U.S. election as the second half of 2020 gets underway.
Conclusion:
In an environment of slow economic growth, coupled with high public debt levels and an impending presidential election, we see not just the remainder of this year, but also this decade as a new economic cycle. This cycle will be characterized not by industries that benefit, but by individual companies that can thrive in a period of financial repression. Financial flexibility, thoughtful leadership, and a dynamic workforce are crucial to success in an increasingly volatile and fractured global economy.