The word for Q2 is unprecedented.
Today, the markets and economy are telling two completely disconnected stories. While we’ve seen a V-shaped recovery in the overall markets, the economy—the underpinning to corporate performance—obviously has not rebounded. We're still in the middle of last quarter’s horrible economic slide, and we don’t know if we’ve hit bottom. But part of the market seems oblivious. Tech companies, which are usually riskier with weaker balance sheets, have bounced back, yet value companies and traditional businesses have not. Even though the market looks healthier, there are reasons to be concerned about its near-term performance. This is a highly unusual environment, and we’re getting a mixed message.
We are, however, cautiously optimistic, as these environments offer opportunities to prosper. To be clear, we believe we’re in a bear market and can expect market corrections. Our strategy is to play for the long term yet stay fully prepared for a near-term correction.
This letter accompanies your quarterly reports for Q2 2020. Our goal is to provide helpful information that clarifies and contextualizes market conditions in today’s rapidly changing environment. If you do not receive our emails, I encourage you to contact our team or sign up online.
Below is our recap of key factors and results for last quarter as well as a look forward into the rest of 2020.
The COVID-19 pandemic impacted worldwide economies and markets last quarter more than any other factor. Recent estimates show the U.S. economy contracted by 5% in the first quarter and possibly by as much as 12% in the second. Lack of consumer and business spending and an estimated 10-15% unemployment level are key factors of the negative GDP numbers. Government stimulus money and action by the Federal Reserve helped to moderate the economic damage during Q2 and even may have fueled optimism in the markets. The quarter ended still very much in a state of economic transition, with uncertainty about our true economic reality and future—especially as some states begin to retract reopening allowances. Travel and related businesses are particularly hard hit, as the recent bankruptcy filing of car-rental company Hertz indicates. The magnitude of personal and business future bankruptcies is an unknown that could have significant trickle-down effects.
With a lack of consumer discretionary spending, the savings rate in the U.S. hit a level we’ve not seen since 1975, and much of this money made its way into the stock market. New trading accounts at discount brokers like Charles Schwab, Robinhood, and E-Trade caused a surge in day trading that may explain the rapid recovery in stock prices, with the NASDAQ setting a new record in recent days even while the economy itself continues to struggle.
The Russian-Saudi oil price war reluctantly found a temporary resolution during Q2, but with all-time-low demand, the resolution did not greatly impact price. The price of oil dropped 65% in Q1 (from $61.18 per barrel on January 2 to $21.65 as of March 30, 2020) and recovered nearly 50% of that loss in Q2. Demand remains weak from the lack of travel, but as workers resume their commutes and vacationers drive rather than fly, we could see demand for gas and oil surge this summer. We expect oil and commodity prices to remain relatively weak until the risk of deflation subsides and a more robust global economy changes the course.
The Federal Reserve Bank reduced key interest rates to near zero while purchasing almost $7 trillion of bonds to stabilize the bond market in Q2. Low rates also have helped support residential real estate markets, initially feared to experience large corrections from the recession. Bank regulations were recently relaxed, allowing banks to trade in their own accounts—an effort to replace revenues lost due to low interest rates. Bank lending and participation in stimulus money distribution are extremely important for an orderly economic recovery. Recent actions provide some assurance that we will not see another Great Depression but likely a slow economic recovery similar to—but more severe than—the 2008 Great Recession.
Q2 EFFECTS ON ASSET CLASSES
Global stock markets fell in unison during February and March but did not recover in tandem. With an economic iceberg, most economists did not expect a traditional V-shaped recovery in the markets. Let's review some key performance data to understand the YTD performance impact.
U.S. stock prices fell dramatically in March, as the coronavirus recession and a Saudi-Russian oil price war triggered panic selling. In a surprising twist, Q2 ended with increases in values and a remarkable reversal, especially in tech companies.
As of June 26, the S&P 500 was only down 4.55% after losing almost 20% since January 1, 2020.1
As noted in the opening, the Q2 performance winners were a bit surprising, and not all companies and industries participated equally. While growth companies ended the year with a gain (Q2 up 27.8%, YTD up 9.8%), value did not, despite a rebound during the quarter (Q2 up 14.3%, YTD down 16.3%). Global markets rebounded during the quarter but, overall, were still down for the year (Q2 up 15.6%, YTD down 11.2%). Commodity prices plummeted and staged a partial recovery as politics and medical data continue to dominate the news.2
Bond markets overcame the complete panic selling during March to post some decent returns for Q2. The Federal Reserve Bank’s quick move to purchase bonds on the sell-off's heels helped create a more stable market, and rates have remained steady for the last few months. They remain extremely low for very high-quality bonds like Treasurys, while rates for riskier bonds moved back to more modest levels. Some mortgage-backed bonds, which remain riskier due to the current high level of mortgage deferment, are an exception.
High yields recovered much of their March losses during Q2, but not all (Q2 up 10.2%, YTD down 3.8%). Emerging market bonds nearly recovered (up 11.2% in Q2 and down 1.9% YTD).2
We believe the bond market hit a bottom in March 2020 and should remain less volatile due to the Federal Reserve’s action and investor confidence.
Economy: The U.S. economy continues to face an extremely challenging period. Because we don’t have a clear view of when this shelter-in-place lifestyle will change, it is difficult to estimate the magnitude and length of economic contraction. Major revisions in the way consumers shop, travel, and live their daily lives may forever change industries such as travel and entertainment. This recession could easily last more than one year if we are facing another round of sequestration and a vaccine is not available until late 2021.
It’s unlikely we’ll see positive U.S. growth until early 2021, and it may be longer if the opening process is delayed by a second virus wave. Our economy is highly unstable at this time, and efforts by the Federal Reserve and Congress remain critical if we are to avoid a much deeper trough in economic activity, which will extend the recovery period. One thing we know: Americans are tough, smart, and resilient. We will make the modifications necessary to emerge from this in a better place.
Equities: The March meltdown erased the substantial gains of 2019, moving the markets downward to levels we have not seen since 2017. However, an unexpected V-shaped recovery began in April and completely erased the losses in the NASDAQ (tech-heavy index). The more conservative industries remain weak and priced at a discount. We believe the mixed market, weak economy, and overconfidence in the tech sector will lead to more volatility in the markets over the next several months. As we write this, many states have reversed reopening due to large gatherings over Memorial Day weekend and graduations. The fear of a second wave could lead to another round of shelter-in-place orders, which would be demoralizing for many. The coming presidential election creates additional uncertainty, which will not abate until the election is over.
We believe the stimulus and support for the banking system, bond markets, and unemployed will create a solid backdrop for economic recovery. The stock market, as a leading indicator, should move in a positive direction when the recovery is clearly visible and under way. The current rally may be a bit premature, but it shows investors’ commitment to owning quality companies and benefiting from their long-term performance.
Bonds: Bond prices also rallied from the bottoms seen in March. We believe the worst is over and bond prices should remain more stable than stock prices, which will help a diversified portfolio. Interest payments are more reliable than stock dividends and can help with compounding values if reinvested. We will likely see more defaults and bankruptcy filings in the coming months, so individual bonds and certain industries will be riskier than index funds. Investors and portfolio managers will need to exercise care when rates are relatively low and bond selection is more important.
We still believe the safest parts of the bond market will continue to pay very little in interest until we make it through the recession and global rates rise again (several years from now). The demand for safe bonds remains high, and investors need to seek a higher yield by taking on credit risk, interest rate risk, or currency risk in lower-quality bonds. Diversification and selection are more important in this environment. A delicate balance between safety and return is necessary in order to maintain an appropriate allocation of bonds in the portfolio.
We continue to strive to earn the target return that matches your financial plan. We believe that forward-looking information provides clarity, and our team welcomes your questions via phone or video conferencing as well as by email. We look forward to reviewing your strategy, goals, and tax picture in a coming meeting.
We wish you a healthy and safe summer.
Kelly Crane, CFP®, CLU, CFA, MBA
President & Chief Investment Officer
1 Source: All asset-class quarterly data pulled from Barron's Lipper Quarterly Performance Report, dated 6/26/20.
2 Source: All data in this section is sourced from LPL Financial. Data as of 6/30/2020.
The Standard & Poor’s 500 Index is a capitalization weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. The Dow Jones Industrial Average is comprised of 30 stocks that are major factors in their industries and widely held by individuals and institutional investors.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained. Bonds are subject to market and interest rate risk if sold prior to maturity.
Bond values will decline as interest rates rise and bonds are subject to availability and change in price. An increase in interest rates may cause the price of bonds and bond mutual funds to decline.
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