The past few months we’ve been examining the economy and markets as COVID-19 recovery takes hold. We’ll continue that analysis while also stepping back for a mid-year review and sharing our outlook for the rest of 2020.
Continuing Economy, Fiscal Policy, Market Evolution
The latest high frequency and COVID-19 data show that despite some additional shutdowns amid increased positive test results, there doesn’t seem to be a full reversal of momentum in the future. Still, activity is definitely slowing, which could create a “W effect” in the recoverygoing forward. The market reflected this until last week, when there was more positive news on vaccine development from Moderna and Pfizer/BioNTech.
Shifting to the Federal Reserve, it’s interesting to note how the Fed’s balance sheet shrunk without explanation for four consecutive weeks after ballooning $2 trillion dollars in the prior month. The shrinkage totals about $200 billion, which is four times more than the largest amount of shrinkage on record (December 2018). However, we think the Fed’s balance sheet will grow throughout the year to support markets as additional economic stimulus is implemented.
Speaking of markets, Map Signals’ Big Money Index (BMI) shows markets have been overbought for nearly two months. It’s fast becoming the second longest overbought period in the 30-year history of this metric.
More importantly, looking at the BMI on a sector level, we can see buying activity slowing in all major sectors.
Even with this slowing, we’re still eyeing the strongest sectors. As it’s been for most of the year, three sectors lead the way – technology, consumer staples, and healthcare. They still have money pouring in, which is why we continue to be overweight these sectors in our models.
2020 Review and Outlook
Our base case is we’re in for a long, patchy recovery, with an expectation that equities specifically will be choppy and move sideways in the short term. That said, if there’s any real breakthrough on a vaccine, the “sideways” opinion is completely out the window.
The first half of 2020 was…well, it was something. It has created a lot of uncertainty, that’s for sure. Hence, we have an uneven recovery outlook. Support for this theory can be boiled down to four main points.
To begin, the recession was less severe than expected. Similarly, the recovery has been quicker than imagined, with April appearing to have been the low point economically. Sounds great, right? Maybe. Recovery so far looks like a V bottom, but we expect it to trail off, slowing to create that “W effect” mentioned earlier. Our relationship with China, which is deteriorating, will be important here.
Second, a stalling labor market is and will continue to hamper growth going forward. While we continue to see unemployment decline, wage growth has been problematic especially when government stimulus payments are removed from consideration.
Next, the power of monetary policy has lifted markets in the first half of the year. However, that support is likely to wane some in the second half, the main reason being the Fed’s policy is no longer accelerating and has become about as accommodating as possible. Nonetheless, discussions continue on more stimulus, albeit with many unresolved issues, so it’s anybody’s guess.
Lastly, the big question remains – how will we pay for all this stimulus? For now, the world remains in a deflationary environment. But at some point soon, we need to figure out how to pay for everything. There need to be multiple options on the table, though some of them will be affected by the November election results.
When Markets Quickly Sink and Rise, Expect a Bumpy Ride
It’s natural for markets to ebb and flow over time for various reasons. But when it happens in a short time span, things can get rocky. We think the second half of 2020 will be turbulent in the markets for a few reasons.
First, the speed and magnitude of the market comeback has been shocking. That begets potential volatility. Stocks came roaring back in April and May, though June brought some sluggishness and volatility leading to a more “sideways” performance.
That more-recent bumpiness will be the norm for the short-term. In our view, the strength of the recovery can be attributed to the fact that a black swan event drove markets down, rather than deficiencies in fundamentals and financial weaknesses.
Second, over the short-term, we think investors will focus more on the negatives, especially as second quarter earnings are released and we understand the real effects of the economic shutdown. For now, we see the positives and negatives as relatively balanced. Still, that will create ups and downs in markets throughout the summer.
Finally, one year from now we think stock prices will be higher than they are today. The economy will recover, even if slowly, and earnings should grind higher at the end of 2020 and into 2021.
For all these reasons, our outlook suggests sector selectivity within portfolios will matter a lot. Cyclical areas of the market, specifically technology and healthcare, will be more attractive than defensive ones. Across all sectors we much prefer companies with high levels of cash, strong balance sheets, and nimble management teams that demonstrate creative agility (it will be needed in spades in a post-COVID-19 world).
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