Global risk assets staged a major comeback in the second quarter, as a much-needed revival in sentiment across investors, consumers, and corporations was bolstered by better-than-expected incoming economic data and a surge in monetary and fiscal accommodation. Fears of a second wave of COVID-19 and slumping odds of a successful reelection campaign by President Trump demanded asset allocators’ attention in the final weeks of the quarter.
Global equities rebounded sharply, as U.S. large cap (S&P 500) posted the strongest quarterly gain (+20.5%) since 1998, essentially reversing the first quarter’s decline of 19.6%, which was the sharpest quarterly sell-off since 2008. International equity returns were also positive, although they paled in comparison to the outsized performance from domestic sectors. From a capitalization standpoint, U.S. small cap (Russell 2000) generated a 25.4% total return, outperforming large cap by nearly 500 bps, representing the strongest quarterly outperformance since fourth quarter 2016. Stylistically, U.S. growth’s multi-year trend of outperformance versus value was unabated, with near-record low interest rates and an essentially flat sovereign yield curve weighing on the relative performance of the financials-heavy value indices.
Despite an overwhelmingly risk-on market environment, performance across the higher quality segments of U.S. fixed income continued its positive trend, as core bonds (+2.9%) notched their eighth consecutive quarter of positive absolute returns. Explicit commitments by the Federal Reserve (Fed) to purchase both investment-grade and below investment-grade corporate debt obligations through a recently created credit facility placed strong downward pressure on credit risk premiums, which tightened to their historical average during the quarter.
The bid for risk assets helped drive the strongest quarterly return for energy infrastructure master limited partnerships in the history of the Alerian MLP Index, with a 50.2% gain. However the rally did not fully compensate for the 57.2% total return decline experienced in the first quarter. A labor market mired in weakness and elevated uncertainty related to office space needs in a post-COVID-19 world helped contribute to modest underperformance by real estate investment trusts (REITs) (FTSE NAREIT All Equity) versus risk assets exhibiting comparable risk profiles, as REITs witnessed a 13.2% gain during the quarter.
KEY MARKET THEMES AND DEVELOPMENTS
Incoming U.S. Economic Data Surprising to the Upside
As anticipated given the shuttering of many major sectors of the economy and the associated decline in risky asset valuations, as-reported U.S. economic data displayed significant weakness in the period from March to May. The labor market, for example, witnessed the highest headline unemployment rate since 1948, hitting 14.7% in April and surpassing the previous recession’s peak of 10.0% in October 2009. On a related note, first time filings for unemployment insurance have totaled a staggering 50 million claims since mid-March.
For perspective around the level of jobless claims activity since COVID-19 shutdown measures were initiated, through June, the Bureau of Labor Statistics (BLS) reported the size of the civilian labor force in its entirety was just shy of 160 million persons.
The discounting mechanism of the market, however, compels investors to care most about what lies ahead and the trajectory or “rate-of-change” of the path forward versus the backward-looking lens that historical economic data—much of which is revised—provides. The above jobless claims chart helps highlight this dynamic, as the level of weekly claims remains historically elevated, but the rate-of-change is improving. It is this backdrop of negative-but-improving economic data which helped support broad-based gains across risky assets during the quarter.
Economic surprise indices, such as Bloomberg’s U.S. Economic Surprise Index, further demonstrate the better-than-expected economic backdrop in the first half of 2020, as the index has not only remained above 0.0 for the duration of the year-to-date period through June—indicating that incoming data is exceeding estimates—but has exhibited a gradually upward bias since early 2019.
It may be that the worst of COVID-19’s shock to the economic system is behind us, which would partly explain the outsized performance witnessed among many major sectors of the global investment landscape during the quarter. Indeed, the BLS reported an increase of 2.7 million jobs in May, followed by 4.8 million in June. Survey-based measures of the health of the services sectors, such as the Institute for Supply Management (ISM) Non-Manufacturing Purchasing Manager Index (PMI), have also rebounded, as the Services PMI jumped comfortably back into expansion territory in June with a 57.1 index reading. The multi-trillion dollar efforts of the Fed and the U.S. government since March are also likely attributable for a great deal of the market’s historic rebound.
Dual-Pronged Stimulus Approach Limiting Downside Pressures
The organic disinflationary pressures that accompany a severe shock to the economic system, such as that dealt by COVID-19, have been truncated by the introduction of inorganic ultra-accommodative monetary and fiscal policy measures by the Fed and U.S. Congress, which have totaled at least $5 trillion to date.
On the monetary front, key components of the Fed’s stimulative measures in 2020 thus far include policy rates at the zero-bound, open-ended asset purchases, an increase in U.S. dollar (USD) liquidity swap lines with primary central bank counterparties, and the creation of special purpose vehicle liquidity facilities that maintain the ability to purchase corporate obligations of investment-grade and below investment-grade quality as well as municipal debt. The asset purchase program has resulted in a nearly $3 trillion increase in the size of the Fed’s balance sheet through the first half of the year.
Of course, lower interest rates are no panacea, particularly when tens of millions of individuals are out of work and, presumably, seeing their demand for credit recede. Congressional passage of the $2 trillion Coronavirus Aid, Relief, and Economic Security Act (CARES Act) in late March extended aid to small businesses, provided relief to the healthcare industry, increased the level of unemployment benefits, and provided most taxpaying Americans with monetary payments, representing the largest fiscal relief package in the modern era.
The CARES Act, combined with a pronounced downward trajectory across GDP growth, has sent the budget deficit-to-GDP ratio to the weakest level since the Global Financial Crisis. We believe this ratio will likely decline meaningfully further once second quarter GDP growth—which is expected to potentially decline by more than 30% from first quarter, according to the latest Bloomberg median sell-side consensus estimate—is incorporated into the data series.
The above visuals paint a potentially bleak outlook for the U.S.’s longer-term fiscal well-being, at least when viewed in isolation. Most developed economies around the world are facing similar growth challenges brought on by the outbreak of COVID-19 and have taken drastic stimulative measures of their own.
So far, the trillions of dollars in aid extended by the Fed and Congress—which is assumed to be temporary—has yet to trigger any obvious negative consequences in the underpinnings of the market structure. Risk premiums have narrowed, interest rates remain essentially at their historical lows, inflation expectations have rebounded after suffering a first quarter decline, consumer and business confidence levels are improving, the shape of the yield curve has remained stable, and the USD has not displayed meaningful directionality, recent weakness aside. However, what will happen to financial conditions if/when policy makers attempt to reign in the current hyper-accommodative monetary and fiscal postures remains a growing question.
Rest of Year Outlook and Concluding Thoughts
The second quarter of 2020 brought a welcomed reversal of fortune to investors, as nearly every major asset class and category posted substantial positive performance following first quarter’s blockbuster rout. Despite being negative on balance, incoming economic data has exceeded sell-side estimates and, in conjunction with unprecedented monetary and fiscal stimulative measures, laid the groundwork for a rebound.
The potential for multiple waves of COVID-19, betting odds data pointing to a potentially unsuccessful reelection campaign by President Trump, and further souring of U.S.-Chinese relations may all serve to turn the second quarter’s rebound into merely a transitory “bounce.” As many risky asset valuation levels have rebounded to near historical averages and some, like U.S. Large Cap equity, near cycle highs, the danger that many asset categories are now “priced to perfection” appears to be a key downside risk in the second half of the year.
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Published July 2020
The Alerian MLP Index is a composite of the 50 most prominent energy Master Limited Partnerships that provides investors with an unbiased, comprehensive benchmark for this emerging asset class.
The Bloomberg Barclays Capital Aggregate Bond Index is a benchmark index made up of the Barclays Capital Government/Corporate Bond Index, Mortgage‐Backed Securities Index, and Asset‐Backed Securities Index, including securities that are of investment‐grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $100 million.
The HFRI Monthly Indices (HFRI) are equally weighted performance indexes, compiled by Hedge Fund Research Inc., and are utilized by numerous hedge fund managers as a benchmark for their own hedge funds. The HFRI are broken down into 37 different categories by strategy, including the HFRI Fund Weighted Composite, which accounts for over 2000 funds listed on the internal HFR Database. The HFRI Fund of Funds Composite Index is an equal weighted, net of fee, index composed of approximately 800 fund of funds which report to HFR. See www.hedgefundresearch.com for more information on index construction.
The MSCI ACWI (All Country World Index) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 46 country indexes comprising 23 developed and 23 emerging market country indexes. The developed market country indexes included are: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, the United Kingdom and the United States. The emerging market country indexes included are: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey* and United Arab Emirates.
The S&P 500 Index is a capitalization-weighted index of 500 stocks. The S&P 500 Index is designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries.
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