TCM 2nd Quarter 2020 Market Outlook and Strategy
Stephen M. Mills, CIMA® Managing Partner, Portfolio Manager
Brad Bays, CIMA® Partner, Portfolio Manager
Highlights: ? The global economy and financial markets continue to be impacted by the Covid-19 virus. ? We currently have no vaccines to combat the virus however there are treatments and existing drugs that are being tested and used in reducing symptoms. ? The U.S. government and Federal Reserve have implemented powerful measures to combat the economic impact of the virus. ? We remain optimistic that our economy and financial markets will continue to recover from the effects of the Covid-19 pandemic.
The global coronavirus pandemic has been wreaking havoc throughout the world for much of 2020. This pandemic has not only caused significant health problems in virtually every country in the world, but it has also inflicted substantial economic damage as governments and communities moved into “lockdown” mode in February and March in order to mitigate the spread of the virus.
In early March, as the virus case count rose and the death rate soared, many U.S. states and local communities issued “shelter in place” mandates and ordered “nonessential” businesses to close their doors. Many businesses were forced to lay off workers leading to the highest U.S. unemployment rate since the 1930s Great Depression. The U.S. economy virtually fell off a cliff beginning in March with Gross Domestic Product (GDP) plunging in April and May, effectively ending the longest economic expansion in history. The stock market nose-dived 35% in less than five weeks beginning February 19, as measured by the S&P 500 Index (S&P).1 It was the fastest ever bear market (defined as a drop of 20% or more in average stock prices) in U.S. stock market history. It looked like we might be in for one of the worst bear markets since the 1930s. However, beginning the day after the S&P bottomed on March 23, stocks began to rally and over the next 60 days, the S&P recovered about 90% of its five-week losses.1 As of the of date this writing, the S&P now stands about 7% below its February 19 high and down only 3% since January 1.1
We believe there were two significant factors that changed investor sentiment and turned the stock market around. The first was the actions by the U.S. Federal Reserve Board (Fed) beginning March 23 when it announced extensive new policy measures to support households, businesses and the overall U.S. economy.2 Over the next 30 days, the Fed took unprecedented action to strengthen the financial system and blunt the economic damage caused by the Covid-19 virus. In addition to the Fed’s actions, in late March, Congress passed and President Trump signed into law the Coronavirus Aid, Relief, and Economic Security (CARES) Act which put immediate cash into the hands of business and taxpayers. The record setting $2 trillion aid package provides relief for individuals and businesses impacted by the unprecedented public health and economic crisis related to the COVID-19 pandemic. We believe the investment community gave these two policy actions a great deal of credence in their ability to support the economy and fuel a recovery. As positive economic announcements were released in April and May, investors began to embrace a “V” shaped recovery outlook for the economy which called for the economy to essentially get back to its pre-virus growth rate by the first quarter of 2021. In our opinion, the optimism about a quicker recovery along with the Fed and U.S. government actions, helped fuel one of the most incredible stock market recoveries in history.
It is hard from us to fathom how stocks could stage such a dramatic recovery in the midst of the highest unemployment in 50 years and the steepest decline in economic activity since the Great Depression. However, in our view, the stock market is a forward-looking indicator because as a whole, investors are looking out into the future and projecting both economic activity and corporate profitability. We believe since March 23, investors have been looking past the virus pandemic to a time in the not-to-distant future when the economy will be back into a growth mode and corporate profits will recover to pre-pandemic levels. We believe this sentiment has been supported by the progress made in fighting the virus, optimism about the development of a vaccine, and by better than expected economic reports.
One important note, the recent surge in Covid-19 cases may have some in the investment community concerned. Daily new cases hit pandemic highs in the U.S. during the first week of July. However, in our opinion, what is not really being widely talked about but has certainly caught the eye of investors is the substantial reduction in the death rate. The number of daily deaths due to Covid-19 has been falling consistently since early May. The recent surge in cases will likely cause daily deaths to rise somewhat however, it appears to us from the trend that the death rate as a percentage of the those infected by the virus will continue to decline. Some medical experts now believe that the percentage of deaths to total cases is below 1% and could be as low as .5%.
Positive developments on the health and economic fronts have given us optimism about the U.S. economic recovery. Before Covid-19, the U.S. was enjoying one of the longest economic expansions in history. 2020 would have marked the 11th year of expansion since the Great Recession ended in 2009. Our economy was growing at about a 2.5% clip at the beginning of 2020 and looked to be picking up steam as the unemployment rate had dropped to a 50 year low at 3.5% in the 3rd quarter of 2019.4 Unfortunately, the economic fallout from Covid-19 has done a great deal of short-term economic damage. The unemployment rate up stands at 13.2% as of the end of June according to the Bureau of Labor Statistics (BLS).5 However, the BLS June employment release reported a surprising increase in nonfarm employment of 4.8 million workers as states and communities began allowing nonessential business to open up and bring back their employees. These job gains followed a May increase in nonfarm employment of 2.5 million according to BLS. The May and June employment reports show very encouraging signs of economic improvement. Other recent economic reports showing improvement in manufacturing activity, housing, and consumer spending indicate the economic downturn could be shorter than expected.
In our first quarter letter published on April 2,6 we presented three possible economic and market scenarios based on the information we had gathered at the time. We discussed what we called our Base Case scenario for the stock market and the U.S. economy which we believed was the highest probability. We want to update our Base Case scenario since so far it still appears to be the most likely scenario. This scenario is based on our opinions and is subject to change. This is for informational purposes only.
In our 1st quarter Base Case, we believed U.S. economic growth would be significantly impacted in the 2nd quarter due to the partial nationwide lockdown and the U.S. economy would experience its first recession since 2008-09. It now appears that 2nd quarter U.S. GDP may have fallen as much as an astounding 53%, according to the Atlanta Federal Reserve estimate.7 Our original Base Case called for a recovery in the U.S. economy beginning in the later part of the 2nd quarter and that it would accelerate into the 3rd and 4th quarters as the virus spread receded and the economy began to open back up again. We felt that the severity of the economic decline would be mitigated by massive U.S. government stimulus and efforts by the Federal Reserve to stabilize the financial system and support the economy. We still maintain this outlook for the U.S. economy however with the recent surge in virus cases the opening up process may be slowed until the surge passes. We do not believe that we will see another widespread business shutdown like we experienced in March and April.
As for the stock market, in our original Base Case we expected market volatility would continue until there was more visibility on the progression of the coronavirus and its economic impact. We believed at the time of our 1st quarter letter, we could see the major averages test the March 23rd lows when the S&P 500 hit 2,191 and the Dow Jones Industrial Average (DJIA) hit 18,213.1 In this scenario, we believed that those levels would hold based on both fundamental and technical factors. However, since our 1st quarter letter, neither the S&P 500 or the DJIA has retested the March lows but both have continued to rally. It is starting to appear that the economic cost of the pandemic is going to be shorter and less severe than was expected back in March when stocks were plummeting.
We believe investors are now less concerned about the near-term economic impact of the virus and are instead looking ahead to an eventual economic recovery and a return to growth by the first quarter of 2021. In the meantime, we continue to expect stock prices to be volatile especially when we get to the third quarter and the focus will turn to the Presidential election, the outcome of which could have a significant impact on the financial markets. We will take a closer look at the implications of the election in our third quarter letter.
Although visibility about our economy is still very cloudy, we are optimistic that the economic recovery that started in May and has picked up steam in June, will continue. There could be temporary set-backs as a result of the recent surge in Covid-19 cases as well as the possibility of a second wave in the fall and winter when viruses tend to be more active. However, we believe the advancements in virus treatments and a better understanding of how to mitigate virus spread by social distancing and wearing masks, will help contain the virus spread until we get a vaccine. We believe the Federal Reserve will continue to backstop the financial system and provide liquidity to businesses. We may also see another federal government stimulus package to help individuals, state governments, and businesses.
Of course, we are always looking for attractive investment opportunities especially when we see the type of secular shift in markets and sectors that we have experienced over the past 90 days. In our opinion, this pandemic has exposed weak areas of our economy as well as shined a light on stronger areas. There will likely be winners and losers coming out of this pandemic. We believe the winners are going to be companies that are able to adapt to the new environment and offer products and services that meet changing consumer and business desires and needs.
Technology is one sector we highly favor as we continue to see both businesses and consumers utilizing technology solutions. For instance, we believe the work-from-home trend has been dramatically accelerated by the pandemic. Companies that offer technology solutions to enhance the ability for people to work from home could do very well over the next several years. The ecommerce trend, that emerged over the past several years providing the ability for both consumers and business to make purchases on-line and have the items delivered next day, has seen a dramatic increase as a result of Covid-19. Again, companies that are involved in ecommerce could be very attractive investment opportunities. Healthcare is another sector we favor for the next several years particularly with the Baby Boomer generation moving into the age category that typically requires more healthcare products and services. There could also be tactical opportunities in the commodity sector as price weakness both recently and over the past several years is slowly reducing supply capacity. For instance, the dramatic decline in oil prices over the past 90 days to under $40 per barrel is quickly reducing supply perhaps to a point where once demand returns, there could be a supply shortage.
Lastly, we have no doubt that we will get through this crisis and will come out on the other side stronger than ever. Our country has shown time and time again, its resilience in the face of a crisis. We have the economic and governmental systems in place to potentially handle any crisis as well as the ability to adapt to our new reality. We already see how the private sector is innovating our way out of this crisis.
As always, we greatly appreciate the trust and confidence you have placed in us. We will continue monitor the global financial markets and to keep you updated on new developments. Stay safe!
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