Q2 2020 Market Commentary

Director of Investments Todd Jones, MBA, CAIA®, weighs in on the current financial environment, critical market trends to watch, and what it all means going forward.

This quarter, Todd is focused on: 

  • Monetary and fiscal support will likely be with us for the foreseeable future
  • Growth vs value dynamics are unusual but not alarming

  • Remaining cautious is the prudent course of action

There is no other way to say it, but what a difference a quarter can make.  Extreme downside price movement in first quarter reversed to become extreme upside price movement in the second quarter.  When we published our Q1 2020 Market Commentary in mid-April (found here), we identified some reasons why we felt the sell-off in the stock and bond markets was, in our highest probability scenario, an overshoot to the downside.  Some of the conditions that led us to this conclusion were:

  1. (1) Emerging market stocks began to recover before a recovery started in developed market stocks
  2. (2) Volatility in stocks (as represented by the VIX or volatility index) was coming down off of much higher levels

In observing what’s happened since we published our Q1 2020 Market Commentary, it appears that our assessment of the situation was correct.  Furthermore, this conviction in our beliefs allowed us to actually add to our equity exposure during the week of March 17th, adding incremental return.  To be fair, we didn’t get everything correct.  One area we underestimated was the bond market.  In the commentary we suggested that a rise in bond yields would be an indicator that would potentially foreshadow growth returning to the economy.  Upon further reflection, this was a poor indicator to use as the Federal Reserve explicitly targeted bond yields in their support for the economy, and, was effective at driving bond yields lower.  In all, with global debt levels elevated and valuations for stocks on the higher end of “average” we think volatility, like the kind we have witnessed in the first half of 2020, will likely be the new normal for the foreseeable future.  Thus, being prepared to take advantage of these types of price movements, in our opinion, is absolutely essential.

Financial Market Observations/Outlook

For most of the second quarter, financial markets seemed to defy grim economic news, the continued spread of COVID-19, and worldwide protests against racial inequality. Global equities performed strongly for the quarter. The S&P 500 Index gained an incredible 21% and, as of June 30, is now down only 3% for the year, despite the huge drawdown in March. Developed international and emerging-market stocks gained 17% and 19% according to Morningstar.

Enormous levels of money printing and government spending certainly helped the investor mood. Central banks around the world provided unprecedented support to markets and economies. On the fiscal side in the United States, trillions in direct payments and loans have been or are going to be delivered to impacted citizens and businesses. The level of stimulus globally already surpasses by far what was issued during the 2008 financial crisis. 

Interestingly, this significant level of stimulus in the US has led to short-term interest rates declining further (near zero or negative in most of the developed world). The 10-year Treasury yield fell slightly this quarter but has revolved around 0.7% for some time according to Morningstar.  This dynamic continues to reinforce our belief that adding more debt to the economy further reduces the growth potential over the medium term and creates longer-term inflation risks. 

Next, we did want to touch on a question that many clients have mentioned to our advisors over the last few months which is “do you think value stocks will outperform growth stocks anytime soon”?  It’s a very complicated question.  The chart below shows a 1yr look-back at the return of the Russell 1000 Value index (blue) versus the Russell 1000 Growth index (black).  This 1yr difference in growth versus value now stands around 33% and is nearing historic levels!

Source: Stockcharts.com

Part of what makes the question so hard is the way “value” has been measured.  In our opinion, academic measures of “value” are becoming more outdated.  Changes in accounting measures and business model adaptations have made historical valuation metrics less meaningful.

Our best estimate, is that the divergence between growth and value will persist until key indicators change.  What’s likely to change that assessment?  A return of inflation above 2%.  Simply put, many of the companies in the Russell 1000 Value index (specifically banks, commodity producers and industrial companies) respond favorably to rising inflation of the type that would accompany an improvement in economic growth.  Unless we observe a discernible change in trend economic growth and/or inflation, the growth v. value dynamic will likely persist.  We have, and will, continue to adjust portfolio positioning to account for this observation.

Final Thoughts

In all, we can understand why many investors would feel the recent recovery in the stock market is built on a foundation of sand.  Economic data looks poor relative to the start of the year, investor sentiment is depressed due to the recent significant sell-off, and the governmental response to the crisis has been poor.  Yet, out of the crisis and subsequent recovery in the stock market, we are reminded to two key concepts in investing: 

  1. (1) The stock market is a forward-looking entity.  To that end, many academics estimate the stock markets project 9-12 months into the future.  That means that as of July 2020, the stock market is already pricing in earnings for somewhere between April and July of 2021.  (By then, maybe a vaccine will be in circulation?)
  2. (2) In every situation there are opportunities, one just has to look carefully.  When the stock market is going up, it’s easy to overlook a material change in a company due to an overpowering trend (e.g. 2000-era profitable technology companies versus non-profitable, story-driven technology companies).  When the stock market starts going down, however, true differences are exposed.  Currently, companies that facilitate remote working or limited-contact retail sales are likely longer-term winners.

We look forward to updating you again after the third quarter.  With government debt dynamics shifting, trade-wars raging and a US Presidential election on the horizon, there will be a lot to discuss.  As we mentioned in the opening section, preparing for more volatile markets ahead (by rebalancing accounts and raising cash levels again) is the most prudent course of action.  Have a great rest of your summer.

Authored by:

Todd Jones, MBA, CAIA®

Director of Investments
Investment Strategy
 

Disclosures:

Gratus Capital is an SEC-registered investment adviser. Registration with the SEC does not imply any level of skill or training. Our ADV documents are available upon request. The opinions expressed are as of January 2020 and may change as economic conditions vary. The information provided is not intended to be relied upon as specific investment advice and is not a recommendation, offer or solicitation to buy or sell any securities. Examples provided are based on current market conditions, and there is no guarantee that any applicable condition will remain in place. Portfolio holdings are subject to change at any time and may differ materially in the future from case studies presented. No graph or chart by itself can be used to determine which securities to buy or sell or when to buy or sell them. As with any investments, past performance is not a guarantee of future results. There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.

[1] Source: Envestnet