After a halt in economic activity aimed at containing the spread of COVID-19 that caused first-quarter GDP to fall by 5.0%, markets rebounded sharply during the second quarter to recover some of the losses from earlier in the year.
The S&P 500 Index of large-cap companies ended the second quarter up 20.5 % but down 3.1% for the year. The Russell 2000 small-cap index rose 25.4% during the quarter but is still lower by -13.0% for the year. Similarly, the MSCI EAFE International Stock Index increased 15.1% for the quarter but remains down -12.59% for the year.
Economic activity declined sharply in the early part of the second quarter, as measured by retail sales, housing starts and—most dramatically—unemployment, which reached levels not seen since the Great Depression of 1929. In sharp contrast, the stock market rebounded strongly through the second quarter, leaving many investors wondering if the broad stock market had become disconnected from the real economy.
The stock market was taking its cue from the governmental fiscal stimulus that began to flow into the economy. The CARES Act injected over $2 trillion dollars of fiscal stimulus into the economy through programs such as enhanced unemployment benefits and PPP (Payroll Protection Program) loans to businesses. The amount of fiscal stimulus was significantly larger than all 2008 Great Financial Crisis stimulus combined and is now the largest economic stimulus package in the history of our country. This was a key catalyst to begin the stock market’s recovery.
Further Support by The Federal Reserve
Beyond dramatically cutting interest rates earlier in the year, the Federal Reserve (Fed) provided unprecedented additional monetary stimulus by purchasing bonds or fixed-income securities (known as Quantitative Easing), intending to reduce long-term interest rates and restore liquidity to the overall bond market.
In a matter of just weeks, the Fed’s securities purchases surpassed the nearly $3 trillion dollars it made over the five years after the Great Financial Crisis of 2008. Moreover, the Fed added to the types of securities purchased. In addition to purchasing U.S. Treasury and mortgage-backed bonds, the Fed announced for the first time it would purchase municipal bonds, certain exchange traded bond funds (ETFs) and corporate bonds—including those corporate bonds whose credit rating fell to junk status during the COVID-19 outbreak.
The stock market rebound reflected optimism that the large stimulative actions by both the Fed and the U.S. Government would allow the economy to begin to recover, even in the face of initially worsening economic data. Then, as plans to “reopen the economy” from the COVID-19 shutdowns across various states and regions throughout the country began to take shape, unexpected improved data arrived. A May payroll report that surprised investors by registering an improvement in employment by 2.5 million jobs. The unemployment rate dropped to a still lofty 13.3%—but the directional change supported increasing optimism that economic conditions may be bottoming. Both U.S. and foreign stocks recorded gains on this economic optimism plus reports of early progress in developing therapeutic treatments and a potential vaccine for the novel coronavirus.
A Recovery in Asset Prices and Falling Interest Rates
During the second quarter, every sector within the S&P 500 large-cap index recorded gains, led by growth stocks, particularly companies in the technology and health care sectors. Value, small‑cap and international stocks rebounded strongly but are still recording losses for 2020.
Bond returns also recovered, as the yield on the benchmark 10-year Treasury ended the quarter at 0.60%. The recovery in the prices of corporate and mortgage bonds led to an increase in the Bloomberg Barclay’s Aggregate bond index of 2.90% for the quarter and 6.14% for the year.
Lower credit quality bonds outperformed as investors embraced riskier assets and proved willing buyers of bonds issued by a growing number of “fallen angels”—companies that have recently lost their higher-quality investment-grade ratings. Municipal bonds also performed well as limited supply and favorable yields relative to U.S. Treasuries attracted investors who had fled the sector in March and April.
Will This Recovery Last?
As we look ahead to the second half of 2020, investors ponder what level of economic recovery is achievable after shelter-in-place orders have been lifted. Questions abound as to whether we will endure a second wave of COVID-19 cases, particularly as case counts spiked at the end of June. Finally, potential policy changes that could result from the November elections are another unknown. Uncertainty is a constant with investing and markets, and the current environment is no different.
Going forward, our clients can count on our investment decisions to be grounded in alignment to financial objectives and risk tolerance. After a strong decade for stocks, now is a reasonable time to reflect with our clients on their willingness to take risk. While we have these discussions with clients on an ongoing basis at Windsor, some clients are seeing things in a different light after a severe market decline. Changes to risk tolerances and portfolios are best made in periods of calm rather than during a storm.
We will closely monitor the level of activity as the economy continues to reopen. At this point, it seems unlikely for the global economy to fully recover to pre-COVID-19 levels this year. Demand in some consumer discretionary industries, such as travel and leisure, will take time to return to their prior levels of activity. In addition, companies are likely to face higher costs due to changes in the post-COVID-19 environment. Anticipated changes in supply chains, required social distancing, and new operating procedures will lead to increased costs.
The Fed has committed to maintain low interest rates, targeting a range of 0.00%-0.25% for the overnight federal funds rate. Interest rate projections imply no rate increases are expected in either 2020 or 2021. Still, overall economic activity as measured by Gross Domestic Product (GDP) could fall considerably, with an unemployment rate at or near double-digit levels.
Investors wonder what the ultimate outcome of unprecedented levels of government borrowing and stimulus may mean for the future. One possible outcome could be inflation coupled with a declining value of the U.S. dollar. While we have not seen any signs of inflation for many years now, we will closely monitor for any increases in inflation due to the size and speed of recent monetary and fiscal stimulus. However, if the U.S. recovery takes place at a slower pace than markets anticipate, that would push inflation risks off several years.
Political headlines, including those related to social unrest, could further foment market volatility through the remainder of 2020. The strength of an eventual recovery will depend in large part on the duration of required containment measures, the depth and breadth of unemployment, and the extent to which consumers overcome lingering fears about resuming normal activities. While there are signs that a recovery is taking place, there continues to be a resurgence of coronavirus cases, and this bears continued close monitoring going forward.
Control the Controllable
The speed of the decline and the subsequent sharp recovery of the markets highlight once again the importance of aligning portfolios with financial goals and maintaining an appropriate level of portfolio risk. The benefits of consistently and proactively aligning financial planning priorities with investment portfolios, along with thoughtful rebalancing, have been demonstrated clearly in the first half of 2020.
Uncertainty abounds about the “handoff” to the real economy—that is, the economic engine shifting from stimulus back to normal activity. But as I noted above, uncertainty is a constant in investing and markets. In this period, like all others, Windsor remains focused on building and managing quality portfolios aligned with clients’ long-term financial objectives.
Our investment due diligence process continues to search out the best long-term growth prospects and valuations opportunities as we rebalance portfolios and control risk. In particular, we continue to maintain investments in high-quality fixed income securities and look to core bonds as a cushion to portfolio risk.
As always, please reach out to your Windsor advisor should you have any questions. Our team has been working in a business as usual environment with a focus on employee and client health and safety. Virtual meetings are now common. Do not hesitate to request time from our professional team. We strive to continuously earn your trust and confidence in everything we do for you.