Mid-Quarter Investment Update

We hope this note finds you well.  As our client interaction remains more on the virtual side, we will continue to be more active with our periodic notes and updates.

Following a strong second quarter, most trends have continued into the current quarter.  Stocks have moved higher and interest rates continue to probe new lows.  Stocks showed resilience as a much-anticipated pullback did not materialize after the resurgence in COVID-19 infection rates last month.  More recent figures show the uptick in positive cases and deaths has now crested in previous hotspots, albeit at levels that remain high.

Q2 earnings season is mostly completed.  Results show that the downward revision of earnings expectations that took place in the teeth of the crisis were too pessimistic.  Many companies saw their stock price rise in the face of the worst year-over-year earnings and sales decline in their history.  Stocks have a low bar to meet these reduced expectations until the second quarter of 2021 when year-over-year comps are expected to improve by 40%.

News on the vaccine front continues to be positive as more trials advance to Phase 3 and qualify for financial backing from the government.  Results could arrive as soon as October, though more likely to come in November.   The prospect of good news has provided support to current market levels and has helped investors rationalize their participation in a market that has already experienced its best four months since the Great Depression.  While a positive announcement would provide a much-needed boost to our collective psyches, once past the initial response, stocks will face the more difficult task of reconciling current high valuations with realities of a deep recession.

Heretofore, this reconciliation has been pre-empted by the government’s overwhelming financial response.  Current stock prices imply this support will continue, shielding investors for now from the consequences of high unemployment, pressure on wages, growing bankruptcies, and reduced capital investment.  As evidenced by the current impasse in Congress to agree on a Phase 5 relief package, future relief efforts will be politically harder to come by as the immediacy of the crisis diminishes.

The election cycle is officially in full swing.  The polls give Biden the edge, but there seems no discernable impact on the markets.  The market already knows there is a possibility of higher taxes and legislation that could constrain economic growth.  It also knows that these policies might not be practical in today’s economic circumstances.

Growth strategies and the favored-few mega-cap tech stocks have continued to dominate. There is growing support, however, that value stocks will be a primary beneficiary of a vaccine.    Value strategies typically perform better in the early stages of an economic recovery and a vaccine would be the catalyst to solidify the recovery.  While high growth valuations might be tested in this scenario, we expect investors will come back to the companies with superior business models, distinguished cash generation, and attractive growth prospects.

The collapse of interest rates is helpful to home borrowers, companies raising funds for growth or reserves, and municipalities accessing funds to offset the decline in tax revenues.  For investors, who have been dealing with nominal yields on safe investments for years, investment-grade bond yields have declined to levels where there is little difference from holding cash.

The overwhelming impact of the pandemic and shock to global economies is deflationary, coming from lower wages and oil prices, adoption of new technologies, and reduced demand.  The policy responses to stimulate economies by taking on record levels of debt have longer-term implications that would be considered inflationary.   Lower bond yields reflect a conviction on the side of deflation, though the recent ascent in gold prices and decline in the dollar’s value relative to other currencies show that inflationary concerns are at least back on the radar.

These observations impact our management of your portfolio(s) in several ways:

We understand the natural unease when markets disconnect from economic fundamentals.  Still, we know markets are often driven by macro policies.  We believe the government will continue to do whatever it takes to mitigate the damage to investors to from the shock of the economic shutdown.  Portfolios remain relatively fully invested relative to policy guidelines while this plays out.

We expect the uncertainty of the election outcome to eventually weigh on the markets.  That said, we would not be inclined to make major portfolio changes based on an expected outcome and the market’s short-term response.

We do think there is a stronger case for value stocks today than previous appeals based solely on valuation.  However, we see this as more of a broadening of strength beyond growth stocks rather than a zero-sum rotation from growth to value.  Beyond the initial recovery stage, this cycle may be less robust than previous recoveries, with slower growth again being supportive of growth strategies.

Cash is rarely our asset of choice for fixed income, but we are inclined to allow fixed-income cash balances to rise for now when bonds mature.  We will also explore other risk-management investment options.

While the S&P 500 flirts with all-time highs (even as most risk assets in the broader market are still down for the year), it is not hard to appreciate that under a different set of circumstances, our markets could be meaningfully lower.  Fortunately, a constructive view about getting the virus under control and seeing continued improvement in economic activity has played out.  From here, the historic volatility we’ve seen in the past five months reminds us to keep a longer-term perspective, especially as we navigate what is likely to be slower economic progress through the pandemic cycle, and perhaps several years beyond that.