Second Quarter Commentary

Stocks had their best quarter in over 20 years as the rebound from the March lows was almost as swift as the decline. This in an economic environment resembling the worst periods of the great depression. The unprecedented $1.6 trillion stimulus package from the Fed and Congress (and similar programs from other developed countries central banks and governments) lifted most stocks. The government support amounts to over 10% of developed economies GDP. The Fed has indicated that interest rates are likely to be near zero for at least the next two years. Chairman Powell not only stated that the Fed is not thinking of raising rates, but that they “are not even thinking about thinking about raising rates”. Investors are clearly looking through the dire economic situation with expectations of a sharp recovery. With interest rates almost near zero, only equities have potential for positive returns that are greater than low single digits.

The Fed and the US Treasury department being “all in” in addressing the recession also led to a rally in bonds. The Fed recommitted to its monthly pace of buying treasury bonds and agency backed securities. The current yield on the 10-year treasuries is below 0.7%, and the corresponding yield on 10 -year government of Canada bonds fell below 0.6%. The average yield on US and Canadian stocks is around 2% and 3%. While stocks are not cheap by most metrics, they are cheap relative to bonds.

The economic picture remains bleak. Nearly 20 million people have lost their jobs, and the unemployment rate is above 10%. Retail sales remain far below year ago levels and manufacturing activity has also contracted. The congressional budget office predicts that the US economy will contract over 35% in Q2. The hope is that with the governments support, the recession will be short.

This quarter also saw protests and rioting related to racial inequality and police violence. Riots, while tragic, do not directly impact earnings or markets. People are impacted. Small private businesses incur significant losses, but it does not materially affect large publicly traded companies. Looting is bad but will probably not change the American political system or bring about the demise of democracy. Hopefully, it will change the political discussion around racial inequality, but the only concern of the market (and stock prices) is money and not human liberties.

One potential impact of the unrest is that it may boost the probability of Joe Biden winning the presidency in November. While it is still early in the campaign, we have already seen a marked increase in support for Biden in the polls. The odds of a blue wave (Biden wins presidency, and Democrats retake senate) with Democrats controlling all 3 branches of government is increasing. This would imply higher personal taxes (including capital gains) and more spending (beyond the COVID extravaganza spend) on social programs. Analysts say a Democratic-controlled government would also likely roll back the tax cuts Congress enacted in 2017, constraining corporate profit margins. While having a more rational albeit more geriatric president, a significant move to the left is not constructive for rising stock prices. It is uncertain whether Biden will campaign on his traditional left of center platform, or whether he will be pulled further to the left by progressives in the Democratic party.

Western relations with China continue to deteriorate. Heightened fears of a shooting war or a world that is split into two economic zones have increased tensions between the two largest economies. In the short term these problems are not as consequential for stocks if the Fed is providing support and western governments continuing to subsidize their economies. In the long term, a continued strain in relations has the potential for supply chain disruptions, inefficiencies and higher costs which would impact margins and profits.

Investors have been looking past the current bad economy and dismal corporate news anticipating a vaccine some time in the next nine months with everything then returning to normal. While optimistic relative to the typical vaccine development cycle, it is not unrealistic. Accelerated timelines has multiple drug companies starting phase 3 trials this summer. The US government is expediting reviews and approvals and funding a portion of these trials. It is also committing billions towards manufacturing for the delivery of hundreds of millions of doses.

Unfortunately, even with aggressive vaccine timelines, the US budget agency has said that the US economy is not expected to recover from the pandemic and related shutdowns for the better part of a decade. This implies that not all companies will safely make it to the other side. This impacts smaller companies more than larger companies, but it will have a dampening effect on the overall economy. Some states that contained COVID early in the pandemic are currently seeing an explosion in COVID cases. This is not necessarily a second wave, but part of the initial surge. This has resulted in delays in reopening the economy or in some cases a re-closing of previously opened states. The recovery will be bumpier and take longer than the best-case scenarios.

Even with a vaccine, social distancing will still be prevalent as it will take time for entire populations to be inoculated. We remain cautious, even with stocks being cheaper than bonds, as they are not cheap relative to historical levels. While the pandemic will be controlled, it might take longer than investors are anticipating. The road to recovery will be choppy, as evidenced by the failed reopening in some states following a surge of new cases. Stock have priced in a lot of good news. A lot needs to go right to justify these valuations. We do not foresee another significant decline as central banks and government support will prevent the economy from falling into a depression. Client portfolios are conservatively constructed with an emphasis on capital preservation.

As always, we welcome your thoughts and comments.