Key Takeaways
- It will likely take some time before the economy fully heals itself, with debt levels remaining high.
- The market appears to be currently priced for perfection and is focused on improvements, not challenges.
- Through ongoing stimulus, the government is keeping this economy – and market – afloat.
- With the likelihood of ongoing volatility, investors should continue to benefit from rebalancing and calibrating their portfolios to their time horizon and goals.
- The election introduces new uncertainty, particularly as it relates to tax rates.
With millions of lives upended and many more households dealing with ongoing disruptions to normal daily life, investors can’t be blamed for wondering if and when the economy will fully recover – especially now that many financial markets have surprisingly rallied back to pre-virus levels. By most measures, the economy already has shown a great deal of improvement with a V-shaped recovery off the bottom, if only because the trough was so deep. With that said, the rate of economic growth is now beginning to show signs of slowing down. We attribute much of the improvement thus far to re-hiring as productive capacity was brought back online following the economic lockdowns, as well as various government stimulus programs. However, we believe the private sector – while slowly healing and regaining its confidence – is not ready to fully take the baton just yet. A vaccine would likely speed up the process somewhat, but widespread availability is not be expected until well into 2021 when long-lasting damage could already be done to consumer confidence and corporate balance sheets as bankruptcies mount.
As a reminder, recessions are typically characterized by consecutive quarters of below-trend growth where a mismatch between supply and demand is sorted out through adjustments to production or labor. Fortunately, the invisible hand of capitalism does this effectively. This time, however, we believe the process will take longer before the economy can become self-sustaining. The intricate fine-tuning between supply and demand must sort itself out in a relatively more aggressive manner as entire industries have been impacted, not just individual product lines or a slump in one geographic region. We are now living in a world where people are less likely to consume, travel, or work in the same manner as they previously did before COVID-19. Even well-insulated businesses must figure out how to connect with consumers who have modified their interests and entertainment habits (e.g., bicycling, streaming video), as well as their daily behaviors (e.g., less frequent trips to stores, working from home). In fact, optimism in the Nasdaq 100 is approaching levels of exuberance last seen in the late 1990s, and we have noted a bifurcation in the market where “stay-at-home” technology stocks of e-commerce companies and purveyors of software have outperformed most other stocks (see following chart, Figure 1).
The Trend is Your Friend
What has mattered to the market thus far is the direction and acceleration of economic growth and less so the absolute level of economic activity. That may soon change. While we are rebounding off the bottom of what is likely to be one of the ugliest quarters in history, it feels powerful as the surge in demand is so high relative to the trough. (For example, a hotel that goes from 25% to 55% occupancy cannot double its occupancy again.) Initial economic growth has a way of re-kindling “animal spirits,” and this enthusiasm often tends to feed upon itself. With rising confidence to resume face-to-face interactions, consumers feel more comfortable spending their money, retail sales improve, jobs are created, and future spending rises even more as others join the crowd.
As we peer into the second half of 2020, we do not envision another nationwide economic shutdown absent a mutation of the virus to a more lethal state, combined with rapidly rising case growth. We see the potential for further growth, but we do expect this additional improvement to come in fits and starts. After all, the virus is still with us and there will continue to be emerging hotspots, followed by a rise in more cautious consumer behavior. After the initial surge this spring in pent-up demand from the stay-in-place orders and government transfer payments that elevated household savings, the private sector has begun a lengthy process of backfilling the gigantic employment crater from the pandemic’s aftermath. Fortunately, it is inexpensive for businesses to borrow money to fund new growth initiatives – many of which will help fuel new job creation. However, today’s economy is not as capital intensive as it once was, and CEO confidence is still lacking given all the uncertainty. For the moment, job growth is much more dependent on a return of consumer confidence. Still, no one expects employment to top former levels until we have a vaccine that has been developed, tested, approved, produced, and distributed across the entire globe.
Government to the Rescue?
While relatively unsuccessful at controlling the virus compared to other developed market peers (see following chart, Figure 2), the U.S. was quick to provide massive doses of fiscal and monetary stimulus to address the economic pain. Currently, Congress is negotiating a fifth round of relief, and the amount of direct aid and lending facilities dwarfs what was provided during the Great Financial Crisis of 2008-09. Meanwhile, the European Union experienced a watershed moment in July when it announced plans to issue commonly funded debt to provide fiscal stimulus to the hardest hit countries in its economic bloc.
All this stimulus, while necessary to halt a full-blown market panic which could have led to corporate solvency issues, has sparked a sharp rebound in performance. Markets have looked past weak economic data, and excess central bank liquidity may now be artificially puffing up valuations beyond what is reasonable for many stocks based on their underlying fundamentals (i.e., earnings, growth prospects, financial strength). With any further rally in financial markets, it may be seen as increasingly disconnected from economic reality on Main Street. Therefore, we strongly believe active rebalancing makes sense for most investors as it has for the last decade (see following chart, Figure 3). We anticipate stocks could be stuck in a range as the pace of market increase slows and expect volatility to remain above-average in the year ahead as uncertainty reigns – Will there be a vaccine? Will we continue to pull back on our trade relationship with China? Will a new U.S. administration come to power, and what does that mean for taxes?
Rebalancing As a Sensible Step
Most market pundits expect to see a vaccine in some form before the end of 2021, and possibly earlier, but its eventual efficacy is clearly unknown at this point. Until a vaccine is created and widely available, we are likely to continue to see budget deficits at all federal, state, and local levels – with the latter two most vulnerable to future downturns in tax revenue since they are required by law to run balanced budgets. The silver lining is that ultra-low interest rates make it possible for our federal government to finance large sums of debt that were already becoming quite large even before the virus rattled household incomes and tax receipts.
For now, deflationary pressures loom large due to drops in income and employment. In the long run we expect to see money supply growth result in rising prices, making inflation-hedge assets (i.e., real estate, floating rate notes, precious metals) that offer higher yields or diversification more interesting to investors than government debt. The existing rate environment, with century-low bond yields, means that the returns from high quality fixed income is likely to remain poor for many years to come, while the higher yields offered by junk bonds come with elevated risks. Moreover, the ancillary role of bonds as a diversifier may be less helpful than in the past. With bond yields close to the effective lower bound and the Fed likely to remain accommodative for some time, the potential for further declines is limited. In this context, investors with long-time horizons might be wise to consider an additional dollop of stocks and practice patience by averaging into areas where the most compelling long-term values reside (e.g., international stocks, value stocks, inflation-hedge assets) while avoiding the temptation to time the market based on shorter-term events.
What’s Your Time Horizon?
While the bond market is not currently confirming optimism about the prospects for an economic recovery, for investors with longer time horizons, history shows that stocks typically beat bonds as one lengthens their time horizon. In fact, over a decade, stocks have beaten bonds most of the time (see following chart, Figure 4). However, we counsel investors to avoid rushing headstrong into equities after such a powerful rally, lest they experience a potential bout of volatility ahead of the election and COVID-19 uncertainty this fall. When combined with an asset allocation that is appropriately tailored for your risk tolerance, time horizon, and investment needs, the JNBA Investment Committee continues to believe a globally diversified, tax-efficient, and low-cost portfolio will continue to prove its mettle over the test of time. In addition, our discipline in reviewing portfolios every 10 business days and rebalancing when opportunities present themselves should continue to serve clients well.
In addition to assets being priced close to perfection for an ongoing V-shaped economic recovery that appears to be losing some momentum, we are increasingly worried over rising nationalism in the U.S. and China and what it means for one of the world’s largest trading partnerships. In our view, any economic grievances will not be easily resolved as in the past, as they center around the use of intellectual property. As such, we would expect additional frictions in this relationship as the election draws near, with the prospect for geopolitical tensions creating additional market turbulence that may create the opportunity to redeploy low-yielding fixed income into stocks with their prospects for higher long-term returns.
The Election (and Taxes)
Many clients have asked about the election, and the one thing we can say for certain is that the stock market typically follows a four-year pattern. It also usually rises regardless of who is in office (see following chart, Figure 5), as our nation has a deep culture of entrepreneurship and strong institutions that foster growth. Tax policy is also likely to be a key talking point during the campaign. It appears that regardless of who is in office, higher taxes will be part of the solution if we do not want our central bank to monetize our debt indefinitely given the sorry state of our nation’s finances. The JNBA Investment and Financial Planning Committees plan to host a podcast on this very topic in the coming weeks.
Lately, the odds of a Biden presidency have risen, as recessions and market declines do not bode well for incumbents. In fact, it appears increasingly likely that a clean sweep for Democrats may make life a bit more difficult for investors enjoying some of the lowest tax rates in their lifetimes. Ned Davis Research estimates that corporate profits might fall by around 13% due to an increase in tax rates under a new administration, while the top marginal tax rate on individual incomes could return to 39.6% (from 37%). Other possible changes might include the elimination of a step-up in cost basis for inherited assets as well as taxation of capital gains and qualified dividends at ordinary income tax rates on incomes above $1M.
Playing the Odds
History shows that year-end rallies are often weakest when an incumbent Republican has lost, so if there is a need for liquidity in your portfolio (home or car purchase, for example) it might make sense to build out the cash portion to meet those needs now. Fortunately, the data also shows that weakness after Republican losses typically reverse in post-election years (see NDR charts, Figures 6, 7 and 8, below) supporting the investment philosophy that most long-term investors would be wise to avoid making any material changes to their asset allocation strategies in advance of a downturn. In our opinion, the data in the tables below is so wide it also would be unwise to base any major investment decision on who might – or once it is apparent who will – win an election.
In our view, most investors would be better off identifying and taking advantage of good entry points for stocks, which is a much better use of their time. To that end, we are finding meaningful opportunities in international and value-oriented stocks. This is because dividends are materially higher and valuations are relatively lower, and valuation is almost all that matters for long-term stock returns in the long run (see following chart, Figure 9). For those with debt, refinancing into a lower fixed-rate mortgage might make perfect sense to create more cash flow to invest in some of these promising areas.
Currently, the underperformance of value stocks remains near its widest since the dotcom bubble. U.S. stocks constitute close to 60% of global market capitalization, up from closer to 40% just 10 years ago. In fact, if you exclude the most popular FANG stocks from U.S. indexes, the U.S. equity markets have performed largely in line with foreign markets. These are fertile areas we may be adding to as the election year is normally positive for value stocks. Yet, we have seen the exact opposite this year, as investors frightened by the pandemic have piled into “defensive” tech stocks that may be subject to more regulation in the future.
In summary, we know this environment has been challenging for most investors, which is why it is critical to have a strategy to implement when uncertainty reigns. After all, stocks have re-rated to higher valuations so the path from here is now likely to follow the economic recovery, and that in turn depends on how policymakers and consumers respond to its health impact.
In such a fluid environment, the JNBA Investment Committee will continue to monitor client portfolios and adjust as necessary. Thank you for your continued trust in JNBA as your financial advocate. Please reach out to your advisor if you have any questions.
Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from JNBA Financial Advisors, LLC.
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