November Investment Comments
We have a long way to go, but so far the post-COVID economy looks surprisingly robust. If colder weather does not bring a resurgence of the virus, then it feels safe to say that we are firmly on the road to economic recovery.
From peak to trough, U.S. GDP contracted by 10%, the third largest decline since at least 1910. The second-quarter average was -9%. More recently, September’s unemployment report published by the Bureau of Labor Statistics measured unemployment at 7.9%, down from a peak of 14.7% in April. This probably overstates the rebound slightly, as the labor force participation rate ticked down to 61.4% and is about 2% below its pre-pandemic levels. Some workers have stayed on the sidelines and aren’t counted as unemployed.
Interest rates are pinned at zero. The Federal Reserve publishes its board members’ expectations for future rates, and short-term rates are expected to remain near zero for at least three more years. This partly reflects the Fed’s obsession with fighting deflation at all costs while preserving ample amounts of banking system liquidity. It also reflects the economic reality that recovering to previous levels of peak activity will probably take years. Don’t hold your breath waiting for your savings account to pay interest again.
The Fed is determined not to tighten too quickly under any circumstances. In late August, Jerome Powell announced a new policy targeting average inflation of 2%, as opposed to targeting current inflation of 2%. The difference is that the Fed plans to allow for catch-up inflation after periods of below-target inflation. The 2% inflation target, while widely recognized, is really a made-up number to begin with. The Fed’s original mission of full employment and price stability implies that, if anything, it should aim for zero inflation, but monetary economists have gradually established a consensus opinion that 2% is just high enough to spur economic activity without unacceptably damaging the currency. By changing its 2% target to an average instead of a constant, the Fed pushes a little further out on the inflation limb. We note somewhat cynically that a wider variety of more inflationary interventions can be excused under a “2% average” policy than a “2% constant” policy.
This all sounds quite bearish for paper money, but currency markets do not seem bothered. In the wake of these two Fed announcements, the U.S. dollar briefly rallied, and gold fell, before both eased back closer to their recent averages. The market basically shrugged, and perhaps the best explanation why is that the Fed is simply articulating what everybody knows. Measured consumer price inflation is currently too low to justify higher interest rates, and higher inflation would probably be positive for the economy overall, at least to a point. We may be sowing the seeds of very high inflation long term, but we don’t live in the long term. For now, consumer prices are mostly controlled.
Asset price inflation is another story, with the S&P 500 up 6% through September and bonds also higher in 2020 due to falling interest rates. Gold has been quiet in recent months but remains up 27% on the year. Among major asset classes, only commercial real estate is struggling, with the real estate investment trust (REIT) sector down 12% through September.
Zooming in on U.S. equities, the two hottest sectors in 2020 are Consumer Cyclical and Technology, both up 33% through early October according to FinViz. The weakest are Financial stocks, down 15%, and Energy, down an eye-watering 47%. One has to wonder whether investors may be projecting the current state of affairs forward too far? We are not going to sit home on our computers spending stimulus checks forever. Eventually people will get out and travel by car, and even plane, again. Even the poor, beleaguered banking sector must eventually improve once the yield curve returns to a more normal shape.
Across sectors, growth has trounced value, with J.P. Morgan measuring growth’s outperformance at 25% in small stocks, 27% in mid-cap stocks, and 36% for large stocks. This makes some sense, as the pandemic has accelerated trends that growth stocks benefit from. If value pays you now, and growth pays you later, then pulling the future forward favors growth under “discounted cash flow” valuation models. As with the sector performance extremes noted above, however, the huge magnitude of growth’s outperformance feels overdone.
And within the hottest sectors, the hottest stocks seem to be gobbling up more than their natural share of investor dollars. JP Morgan’s Guide to the Financial Markets from September 30 notes that the five largest S&P 500 stocks by market capitalization—namely Apple, Amazon, Microsoft, Alphabet, and Facebook—currently comprise 23% of the overall index value. The previous peak came in 2000 at 18%.
Lawmakers are noticing. Multiple news sources have stated that various government agencies will soon file complaints against Apple, Alphabet, Amazon, and Facebook. The timing here just before the November election is no coincidence, as both parties are concerned about big tech’s influence on voters. Challenging their competitive practices could help crimp them at this sensitive time.
Which brings us, finally, to the election itself. Betting markets currently give Donald Trump approximately a 33% chance of retaining his office, down from 50% in March. Polling data implies that Trump is way behind at the moment, but the betting markets seem to imply that a late surge is possible. The Senate is considered more of a tossup. If Joe Biden wins along with the Senate tipping into Democrat control, then the market will probably anticipate a combination of higher taxes and more rapid fiscal stimulus. It is a little early to speculate about the potential market impact of policy changes following a future election. We note there is a possibility that a mail-in voting surge overwhelms clerks’ ability to count votes and delays election results. This frustrating and divisive possibility sounds a little unlikely, but the way 2020 has gone, we really should expect the unexpected.
Miles G. Putnam, CFA