3rd Quarter 2020
2nd Quarter Recap, Key Takeaways, & A Look Forward
"Go on, take the money and run!"
said Fed Chairman Jay Powell during the 2nd quarter, and not The Steve Miller Band. In an effort to mitigate the economic downturn, the Federal Reserve flooded the markets with massive amounts of liquidity.
During the 2nd Quarter, the S&P 500 and the Dow Industrials had their best quarterly performance since the previous millennium (1998). The NASDAQ finished with its best quarter since 2001.
Market stability will be critical in the 3rd Quarter. Investors will be looking for a reduction in volatility to maintain hope for a potential V-shaped recovery.
Towards the end of the 2nd Quarter, Fed Chairman Powell suggested the Federal Reserve has already gone to extremes and would like to hit the pause button for a while. Unless the economy craters in the second half of the year, you could say Powell “wiped his hands in muddy water and said what has been done is done.”
It appears investors believe the worst of the downturn is behind them. However, a recent rise in virus cases suggests the pandemic isn’t over yet. Any future economic reclosures could negatively impact investor confidence.
During the 3rd Quarter, Oakworth’s Investment Committee will be looking to build upon the strategy shifts it made during the first two quarters. Once the true health of the US economy becomes more readily apparent, we anticipate making some changes to reflect the new economic reality.
We will be closely monitoring the available liquidity within the economy. If the government doesn't act soon, much of the relief/stimulus package(s) will either expire or ‘dry up’ during the summer.
At the start of the 2nd Quarter, Oakworth’s Investment Committee made a number of predictions for the quarter. Here are a few of them:
- Analysts and investors will have a hard time putting a comfortable valuation on the markets because the economic downturn has been so swift and so complete.
- Although they will be nerve wracking at times, the markets probably won’t experience the same level of panic selling they did during the 1st Quarter.
- A new normal will emerge in the economy with more businesses shifting towards things like flextime and remote work environments for their workers.
- The potent combination of monetary and fiscal policy stimuli coupled with low consumer borrowing rates and energy prices will help fuel an economic recovery in the second half of the year.
- The markets will rally, and should make up much, if not all, they lost during the first part of the year.
All of these are directionally correct. It is impossible to correctly value a market where there are few earnings and even less guidance. While there were a few nail-biting days over the last several months, the markets didn’t revisit the 1st Quarter’s panic level. Businesses have found they can deliver their business model with associates working remotely. The various financial lifelines the Federal Reserve and the Congress have extended HAVE given the markets and the economy a meaningful boost. So much so, the NASDAQ Composite ended 2Q 2020 strongly positive for the year to date, and the S&P 500 was only slightly negative.
This despite the worst economic data any of us has ever seen.
For instance, on Friday May 8th, the Bureau of Labor Statistics (BLS) announced the US economy lost 20.687 million payroll jobs during April 2020. This was easily the most shocking number Wall Street has seen in decades, if not ever. It almost doesn’t compute. To put it into perspective, that total would be roughly the entire populations of the following states (according to 2019 Census Bureau estimates): Mississippi, Kansas, New Mexico, Nebraska, West Virginia, Idaho, Hawaii, New Hampshire Maine, Montana, Rhode Island, and Delaware. That lot or Florida; you choose.
As incomprehensible as that report was, and still is, the Dow Jones Industrials Average rose 455.43 points that Friday. However, it wasn’t an anomaly during the quarter. In fact, there was no shortage of economic data that was the “the worst reading in the series,” “the worst since the 1930s,” “the worse decline since the 1980s,” and so forth. Even the so-called good releases had qualifiers.
For instance, although the BLS announced the economy created 2.509 million jobs in May 2020, it gave some pretty depressing qualifiers on page 6 of the report which most people promptly ignored. These included:
- The household survey is generally collected through in-person and telephone interviews, but personal interviews were not conducted for the safety of interviewers and respondents. The household survey response rate, at 67 percent, was about 15 percentage points lower than in months prior to the pandemic.
- In the establishment survey, workers who are paid by their employer for all or any part of the pay period including the 12th of the month are counted as employed, even if they were not actually at their jobs.
- However, there was also a large number of workers who were classified as employed but absent from work. As was the case in March and April, household survey interviewers were instructed to classify employed persons absent from work due to coronavirus-related business closures as unemployed on temporary layoff. However, it is apparent that not all such workers were so classified. BLS and the Census Bureau are investigating why this misclassification error continues to occur and are taking additional steps to address the issue.
- If the workers who were recorded as employed but absent from work due to “other reasons” (over and above the number absent for other reasons in a typical May) had been classified as unemployed on temporary layoff, the overall unemployment rate would have been about 3 percentage points higher than reported (on a not seasonally adjusted basis).
Change in Nonfarm Payrolls
Intuitively, funds from the Payroll Protection Program (PPP) were making their way into the labor markets. While people who had been furloughed were still not physically back at their jobs, their employers were now paying them to not work, thanks to funds from the Federal government. In the world of bureaucratic number crunching, that counts as a payroll job gain. That didn’t stop plenty of people from marveling at how strong the labor gains had been during the month.
With a few exceptions, investors were able to find silver linings in the economic dark clouds during the quarter. So much so, stocks (as defined by the S&P 500) had their best quarterly performance in over two decades. Again, despite the near collapse in global economic activity at times during the first half of 2020, the total return on the S&P 500 was down less than 4% for the year to date at the end of 2Q. While not a great start to the year in absolute terms, it was nothing short of miraculous given the severe contraction in global output. In fact, the 2nd Quarter was the best calendar quarter in the S&P 500 in over two decades, up over 19%!
S&P 500
For their part, after a lot of wringing of hands and gnashing of teeth during 1Q 2020, bond investors mostly watched the fun from the sidelines.
10-Year US Treasury Note Yields
Suffice it to say, there was a sharp disconnect between economic activity and asset prices. While there is, or should be, a positive correlation between the two, the correlation was almost perfectly negative during the quarter.
But why?
It was an unprecedented amount in a very short period of time. While money doesn’t solve everything, it is much better at solving economic problems than the alternative.
So, when the Fed shows up to the party with a punch bowl, don’t ask why, just grab a glass. What is the old expression? You can’t fight the Fed? Also, when the Congress throws money at you, try to catch it, as much as you can. It seems large amounts of cash floating about the financial system can do wonders for investor confidence.
In the end, the best way to sum up the 2nd Quarter of 2020 is:
The powers that be flooded the markets with liquidity. This helped lead to one of the best quarters in stock market history despite the fact it was one of the worst for economic activity. We don’t know and probably never will know how bad it would have been or even will be if they hadn’t.
Perhaps we will get an idea during the 3rd Quarter as some of these funds start to dry up.
2nd Quarter Bond Commentary
While not quite as extreme as the equity market, there was also a slight disconnect between how bonds behaved and economic reality during the quarter.
The fixed income markets had panicked in the 1st Quarter, with Treasury yields falling sharply and corporate bonds taking a tremendous hit. However, the Federal Reserve mitigated much of the downside and investor anxiety by announcing on March 23rd it planned to make significant purchases of investment-grade corporate debt on both the secondary and primary markets. Obviously, bonds rallied on the news.
Then, on April 9th, the Fed extended the scope of its purchasing program to include high-yield securities, previously known as junk bonds. This cased the corporate market to ‘get back’ into the black for the year to date, and more, by Easter. It was wild 3-week run, which saw long-term corporate debt rally in excess of 33%, as defined by the Vanguard Long-Term Corporate Bond ETF (VCLT).
Vanguard Long-Term Corporate Bond ETF (VCLT)
However, after April 9th, there wasn’t much happening in ‘bond land.’ On that day, the iShares Core US Aggregate Bond ETF (AGG), a common proxy for the investment-grade US bond market, closed at $117.25/share. It closed the quarter at $118.21/share, for an 0.81% principal return for the remainder of 2Q. While better than the alternative, it is a pretty ho-hum return.
iShares Core US Aggregate Bond ETF (AGG)
To be sure, there were some fluctuations during the first two weeks of May. After that, with the occasional daily exception, the bond market seemed to take the path of least resistance: gradually grinding just a little bit higher. Treasuries didn’t do much of anything extraordinary. Neither did corporates, municipals, or mortgages. This despite the most extraordinarily bad economic data in a lifetime. It almost didn’t compute; stocks rallied and bonds essentially yawned as the data suggested the US economy had fallen apart during the quarter.
In hindsight, it seems as though fixed income investors got the bad news ‘out of their system’ pretty quickly, and let the Fed do its work. By the end of June, bonds seemed to be relatively stable. The yield curve was slightly positively sloped. The Fed had the markets’ back, and all was right with the world….at least for now.
2nd Quarter Stock Commentary
The miserable first quarter for equities ended with a very strong last 6 trading days. The strength we saw at the very end of the first quarter carried through to the second quarter, as equity markets realized some of the strongest quarterly returns ever. In an odd year of shocking economic data, extreme stock volatility, and crazy news headlines, not many could have predicted the strength in equities this past quarter.
The NASDAQ was the strongest performer for the quarter. The NASDAQ index is now dominated by 5 stocks (Apple, Microsoft, Amazon, Facebook, and Google). These stocks account for more than 45% of the weight of the index, and the average return for these 5 stocks was 40.4% in the 2nd quarter. These are also the largest companies in the S&P 500, with a combined weight of 21.8%. The performance of these stocks turned a great quarter of performance into a spectacular one.
The quarter news cycle was, as you would expect, largely driven by a mix of COVID-19 infection numbers and the staged reopening of the economy. If the news was positive with regards to the reopening of the economy, small and mid-cap stocks, along with the financial, industrials and energy sectors showed strong outperformance. Let’s call this the “reopen basket.” If the news was on spiking virus numbers and the slowing of the reopen, technology and companies that benefit from working from home, along with healthcare stocks would outperform. We can call that group the “stay at home basket”. Each day of news would dictate the best performers of the day.
Standout sectors for the quarter included technology (+30.5%), consumer discretion (+32.9%) and energy (+31.9%). After showing the best performance of any sector in the 1st quarter, technology stocks followed that with another great quarter. Performance was let by the above-mentioned Apple and Microsoft.
Consumer discretion showed the strongest sector performance for the 2nd quarter. With most Americans spending more time at home, many turned into weekend warriors, doing projects around the house. Both Home Depot and Lowes had great quarters to join the retail juggernaut Amazon to lead the sector to solid performance.
The energy sector was more of a rebound story. After a dismal first quarter return of -51.6%, the price of oil rebounded from just below $20 per barrel back to over $40. Still a far cry from the $66 per barrel at the start of the year, but the rebound from below $20 makes the outlook for the sector a little less bleak than it showed at the end of the first quarter.
The sectors that struggled, relative to the other sectors, include utilities (+2.7%), consumer staples (+8.1%), and financials (+12.2%). Both utilities and consumer staples had strong relative outperformance in the first quarter, just behind technology. As we started to reopen the economy in the second quarter, these sectors would be expected to lag, but still showed positive returns. The financial sector, however, has been one of the lowest performing sectors in both the first and second quarters this year. The combination of loan loss concerns and a prolonged low interest rate environment has been a difficult one two punch for these stocks to avoid.
The stock market is often considered a leading economic indicator, meaning that stocks will move down before we see the economy weaken, and will move up before we see the strength return to the economic data. In the chart below, the total return of the S&P 500 is plotted against official recessionary periods shaded in gray.
What had been so unusual this year, the indicators stocks would typically use to recognize future weakness in the economy were not there. When the synchronized global slowdown happened in the first quarter, the markets reacted quickly. What would have been a 12 to 18-month downturn in the markets happened in just eight weeks. At the same time, the markets are looking ahead 12 to 18 months, and things look much brighter.
After all, low interest rates, low energy prices, and stimulative fiscal and monetary policies have typically been positives for the US economy. The sooner researchers can develop a vaccine or more effective treatment to halt the spread of COVID19, the quicker the economy will bounce back to more normal levels. The longer the delay, the greater the likelihood economic growth and the markets could stall.
We should have a clearer understand as to the health of the US economy by the end of the summer. Right now, the old mantra continues to hold true: “you can’t fight the Fed.”
Strategy and Allocation
With the theme of our predictions for the market consisting of lots of change and unknown, it made sense to position ourselves a little more defensively than maybe we had been previously. Defensive positioning can mean several different things though, so how do we get more defensive while not taking ourselves ‘out of the game’ or missing return towards the upside?
Our investment committee knew we wanted to get more defensive, and that can either be through raising cash, going overweight to bonds, or even positioning in more defensive sectors such as Healthcare, Consumer Staples, or Utilities. Things with inelastic demand. For us, the best option was a combination of the three flowing from the most defensive (raising cash) to the least defensive (defensive equity sectors).
Even before the pandemic, we knew the bull market was aging and there were signs of it slowing, so we had proactively lightened up on more aggressive sectors over the previous year and added to more defensive ones. Going in to the year we maintained an overweight to Utilities, Consumer Staples, and Healthcare. This continued to evolve in the early days of the pandemic, selling equities and parking it in cash.
However, as the Federal Reserve slashed rates to essentially zero this caused the money market funds or the interest on cash to pay essentially nothing as well. Without wanting to add a whole lot of risk but wanting to also generate some return, the logical next step was to add to short term corporate bonds. These still generate a strong relative yield, while not adding a ton of risk to our portfolios.
So where does this leave us now, and going forward? Currently we are neutral cash with a slight overweight to fixed income and slight underweight to equities. As the market continues to digest the data of how well the economy is actually recovering, we continue to look for opportunities to add to areas that we believe will outperform. As the economy starts to recover from the recession, the big question going forward will be when, and with what, do we start getting more aggressive. This could mean adding broad equity exposure or to individual names and sectors that should outperform in the early stages of growth in an economic cycle. We continue to digest the data to determine the extent of the recovery and are actively pursuing opportunities for return for our clients.
A First Look at the 3rd Quarter
1. After a better than expected 2nd Quarter, investors will be anxious to see how the economy responds when various relief packages start to expire towards the end of the summer.
2. The 2nd Quarter earnings season should be interesting given the lack of forward guidance corporate America has been giving. As long as it isn’t a ‘worst case scenario’ and forward guidance isn’t a disaster, investors could move past it more quickly than you would imagine.
3. As the quarter progresses, investors will increasingly turn their attention to the November elections. If the Republicans can hold the Senate, the economy is ensured another 2 years of gridlock, no matter what happens with the Presidency.
4. The recipe for growth is in place: low energy prices, low interest rates, and expansionary monetary and fiscal policies. However, another mandated lockdown of the economy will render that irrelevant. Our elected officials have to be extremely careful.
5. Two things are certain about 3Q: Stock market returns won’t be as strong as 2Q’s historic ones and we will have a better sense of the economy’s true health by the end of the quarter than we have at the start.
As always, if you have any questions, please call your Oakworth Capital Client Advisor.
Meet the Oakworth Capital Bank Investment Committee
The Oakworth Investment Committee is always available to meet with clients when convenient for them to review investment performance and objectives. We are accessible to answer any and all questions and information is distributed on a regular basis in an effort to educate all of our clients about pending investment decisions, the current state of the markets, and the state of the economy.
The investment committee consists of experienced professionals with integrity and a true passion for their work. At the end of the 2nd Quarter 2020, total assets under advisement were approximately $1.293 billion.
Oakworth Capital Bank Wealth Advisors
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Created with images by Ljupco Smokovski - "Businessman running with a bag full of money" • neinarson - "buttons" • srisakorn - "Women who are unemployed in economic conditions have problems and epidemics." • mikecohen1872 - "liquidity"