The S&P 500 peaked at an all-time high of 3,588 on September 2nd. Over the ensuing 22 days the index has dropped about 10% – enough to officially call it a “correction.” The renewed volatility in September follows an extended period of relative stability in the markets driven by a fairly positive narrative. Infection and death rates from COVID-19 had started to fall across the globe. In response, economies had started to open up again following self-imposed shutdowns of varying degree. China and Europe had seemingly proved to the world that the virus could be defeated if countries were willing to follow the proper protocols. The news flow on the vaccine front was largely positive as well, including the news that several different drug companies were entering phase three trials. There was even speculation that one or more vaccines might become available by the end of this year.
The better-than-expected pandemic news started to translate into greater optimism about the pace of economic recovery. And some of the incoming data in the US supported that notion. Jobs were added at a better pace than initially expected. Consumer spending was also supported by stimulus checks, enhanced unemployment benefits, and forebearances on monthly mortgage and other loan payments. Businesses were supported by ready access to plentiful, low-cost funding through government-backed bank loans as well as the public debt markets. Inflation was low to non-existent, and both short- and long-term interest rates were holding at very low levels. Economists at the Fed and elsewhere began to revise their 2020 GDP projections materially higher following the -31.7% annualized decrease in the second quarter. The anticipation of a quicker return to normalcy finally reversed the trend of falling corporate earnings estimates. Stocks rose. It all seemed to be going better than expected.
But September has brought some abrupt changes in the markets. As noted, stocks have taken a turn for the worse. At the same time, the dollar has appreciated materially and commodity prices have dipped. Each of these developments represents a reversal from the well-established trends of the prior several months. What hasn’t changed is the level of interest rates. Short-term interest rates remain near zero thanks to the Fed, while longer-term rates have been remarkably well-behaved despite all the volatility in other capital markets and the surge in debt levels throughout the world.
Let’s look at each of these markets individually:
- Stocks – The action in the stock market is pretty straightforward. Stocks got hit hard in the initial stages of the pandemic as the effects of the economic shut-downs could not be quantified. The recovery from those March lows was supported by the Fed’s interest-rate suppression, a faster-than-expected recovery in the global economy, and the promise of additional fiscal stimulus to build a bridge until the approval, distribution and administration of one or more vaccines. With September came a reality sandwich. It now appears that a fourth round of fiscal stimulus is not forthcoming, at least not before the election. We’ve also heard about additional outbreaks in the UK and other parts of Europe that may require additional shut-down measures. Will there be a second wave of COVID-19 in the fall and winter? Nobody has the answer. Political infighting is reaching nosebleed levels following the death of Ruth Bader Ginsberg, and there is some question as to whether an inconclusive election in November will lead to a constitutional crisis. Race-related demonstrations, largely peaceful but some not so, continue in certain parts of the country. Trade tensions with China are heating up again. And despite presidential assurances, it is very unlikely that a vaccine will be ready to go by the end of this year.
- The Dollar – The positive economic and pandemic news leading up to September was good news for stocks and commodities, but bad news for the dollar. As is typical during global crises, capital flowed to the relative safety of the US dollar in the initial stages of the COVID-19 outbreak. As the pandemic’s impact became better understood and the global growth outlook improved, the fear trade subsided and the dollar began to weaken again. However, the rush into the dollar resumed in September reflecting the aforementioned risks and uncertainties.
- Commodities – The chart below shows that commodities have traded in virtual lock-step with stocks this year. This makes sense as the expectation for a quicker economic rebound (up until September) would be expected to generate greater demand for commodities. But because most commodities are traded in dollars in the global marketplace, commodities also tend to trade inversely to the dollar. If the dollar is depreciating, buyers will need more dollars to buy a given unit of any commodity. So far in September, though, the opposite has been happening: commodity prices have been falling as the dollar has been strengthening, both reflecting renewed fears about COVID-19 and its impact on the global economy.
- Interest Rates – The action in the bond market (or lack thereof) is perhaps most telling of what is really going on. The Fed has pulled out all the stops to support the economy. The central bank has grown its balance sheet to $7 trillion through asset purchases, cut short-term interest rates to zero, and repeatedly implored Congress to do more. It’s most recent action was to move to “average inflation targeting”, which means that rather than target a certain level of inflation (which had been 2%), the Fed will now allow inflation to run significantly above 2% for a period of time before raising short-term interest rates. We discussed this change in our Market Commentary from September 2nd. In any case, the bond market reaction to this announcement was not what the Fed was hoping. The Fed had been hoping to convince the markets that its commitment to higher inflation (through the long-term suppression of interest rates) would be successful in generating more inflation. If so, longer-term interest would have risen to reflect an increase in inflation expectations. But that didn’t happen, and it’s clear that the Fed is concerned by the lack of reaction to its announcement. The central bank now sees a fourth round of fiscal stimulus as imperative, and the Fed is making sure its voice is heard. On Wednesday we had no fewer than five different Fed members as well has Treasury Secretary Steve Mnuchin make public comments calling for Congress to pass a fourth round of fiscal stimulus. Sound like desperation?
The takeaway from all this? Broadly speaking, the outlooks for both economic growth and corporate earnings have become more uncertain than they were just weeks ago. The markets are telling us that the Fed’s actions alone will not be enough to get the economy to escape velocity and generate the level of inflation consistent with more robust economic growth. Unfortunately, it seems that politics may be taking precedence over advice coming from those who know best, and that could be a problem for all of us.
In this period of heightened uncertainty we believe it still makes sense to remain somewhat defensive. There are plenty of high-quality companies that have lagged the overall market this year as investors continued to favor the mega-cap names. As it eventually becomes clear that the economy can safely reopen, we believe these high-quality laggards should enter a period of relative outperformance. Stick to the program.