Ideas

Markets continued their roaring comeback in the third quarter of 2020 as extremely accommodative central bank and fiscal stimulus coupled with a budding recovery in the economy outweighed the continued overhang of COVID-19. The near-term outlook continues to rely chiefly upon the pandemic and the economic developments arising from it. As we write, we are seeing many states experiencing an increase in reported cases with some reversing recent loosening. Many expect cases to rise materially during the traditional flu season and potential vaccines sow seeds of optimism, which the market has been reflecting.

2020 has been a year of records. The longest economic expansion ended with the biggest drop in economic activity and the highest level of unemployment since the Depression. As we know, this all started with the rapid spread of COVID-19, becoming a global pandemic--the worst since the Spanish Flu in 1918. To slow the spread of the virus, social distancing and wearing masks has helped, but at great economic cost. Many consumer and service businesses were shut down and it will be difficult for many to resume their operations.  

The emergence of COVID-19 is proving to be one of the most significant events facing the economy since the collapse of Lehman Brothers almost 12 years ago. Over the course of the last month, stock prices, interest rates and the price of oil plummeted as global economic activity is being severely impacted by the stay-at-home orders and social distancing rules. The longest economic expansion in the U.S. ended abruptly and financial markets are working through the worst liquidity crisis since 2008.

The long-term trend in the economy continues to be positive, with 2.0% growth in real GDP and inflation averaging around 2.0% expected for the year 2020. Last year there was considerable weakness in industrial and manufacturing businesses, while the consumer and service-oriented parts of the economy remained strong. The stock market is said to climb a wall of worry, and in 2019 the focus was on trade and the Fed.  As progress was made in the trade negotiations with China as well as with Canada and Mexico, the market has responded positively. The risk of a major trade war is hopefully averted.

The steady stream of negative headlines would lead one to believe that our economy is mired in an economic crisis. Talk of an imminent recession seems to be all over the headlines. According to a recent Bloomberg survey, the number of articles mentioning the word “recession” reached a level last seen in late 2011. Legitimate headwinds within our economy do exist. The U.S. manufacturing PMI has steadily declined and business spending has slowed. Added to that is the constant turmoil in Washington D.C. and a presidential election next year.

The first half of the year ended on an optimistic note, as the U.S. and China appeared to be making some progress in their trade talks and the Fed is now expected to lower the federal funds rate at the July meeting. The global economic expansion has slowed, but we believe that the risk of a recession in the U.S. remains a low probability. While investors continue to worry about these and other things, the S&P 500 index has continued its upward trend to new highs.

Equity markets rebounded strongly in the first quarter, even as economic growth has slowed, when it became apparent that the Fed would not continue to raise interest rates in 2019. In addition, investors have increasingly come to believe that progress is being made in the trade negotiations with China.  

What a difference a year makes!  In 2017 the U.S. stock market was continually setting new highs while volatility remained extremely low and for the first time ever the market rose every month. 2018 began with a high degree of optimism, but that suddenly changed and in the fourth quarter the focus of many investors shifted from the continuing strength in the fundamentals to apprehension about what might happen in the future.

With so many differing investment approaches being promoted today, a couple of lessons from professional sports may be helpful for us to keep the right perspective in the decisions we make. It was in July 1961 when Vince Lombardi spoke to the disconsolate Green Bay Packers with his famous line that pointed to the essential nature of the fundamentals of the game. "Gentlemen, this is a football.” 

The S&P 500 index started the year strong, rising the first few weeks, followed by a 10% decline. Since then, equity markets have been choppy while trending higher and most U.S. stock indices were back in positive territory for the year-to-date as of the end of June. We know that longer term price moves reflect changes in the fundamental value of an investment, while short-term price swings are largely driven by emotions and how investors are reacting to the uncertainties about the future. Others may also be influenced in their thinking by moves in the market itself and how they are feeling, with some wondering if we are in the later stages of the bull market.

The S&P 500 advanced by 300% from March 2009 low, and after peaking on the 26^th of January, the market experienced a correction, dropping 10% for the first time since January 2016.  This is a big change following a year in which there were only eight days with a move of 1% or more and the biggest decline was less than 5%. By comparison there have been greater than 1% moves about half the time since the peak in January, and we just experienced our 7^th day with a 2% decline this year. In 2017 there were none. For perspective, the S&P 500 Index is now about unchanged from the end of 2017.   

The Economist recently wrote that we now have a bull market in everything. Nonetheless, there are still naysayers. Could we be facing a “Minsky moment” whose theory was about how excessive debt threatens financial stability and morphs into instability?

The extremely low level of volatility in the markets may be tempting some to increase their risk exposure, but this may be balanced by other investors that are nervous about the future and have low expectations for long-term returns. 

There is often a sense of calm before the storm. This calmness we have enjoyed in the financial markets, in fact seems to be at odds with actions predicted by the Trump administration, which seems to be in chaos with a growing uncertainty surrounding the prospects for his populist agenda. The President said he might exit the North American Free Trade Agreement, build a Mexican wall, overhaul the health care sector, cut taxes and increase infrastructure spending. At the same time the tensions with North Korea and his comments charging “fire and fury” are not reassuring for investors.  

In 1942 Austrian economist Joseph Schumpeter described the way free markets function as “creative destruction, where the opening up of new markets, foreign or domestic, revolutionizes the economic structure from within, incessantly destroying the old one and creating a new one.”  He described capitalism as “the perennial gale of creative destruction, how economies evolve.”

The amazing popularity of the musical Hamilton has been a reminder of the legend that British bands played the music of “The World Turned Upside Down” as they surrendered at the siege of Yorktown in 1781 in the last major battle of the revolutionary war. Indeed, the world was turned upside down by the American victory and a new nation was born. Now, with the election of Donald Trump as president of the United States and signs of populism sweeping across Europe, many are asking whether our world has again been turned upside down and how political leaders will be reacting to this new force, the voice of the people and the future for democracy. 

Last January you described your outlook as being cautiously optimistic. Many are saying that the election of Donald Trump as President has ushered in a new set of uncertainties that affects the global economy and markets. With the policies he has espoused and all the uncertainties his election brings, are you still cautiously optimistic? First of all it is important to remember that we do not attempt to make forecasts. No one knows what the global economy will be like over the next twelve months and beyond, much less how markets might react to any outcome. These things are unknowable. Even so, considering how it possibly could change the investment environment, it will be important to monitor how the rhetoric of the President’s campaign is translated into the reality of the presidency. But yes, we are cautiously optimistic.

It may seem harder to find good investment opportunities today, but it’s always difficult. There is a mounting belief that global economies are getting worse, not better. But the facts differ. The principal ongoing concerns include: Europe’s recovery prospects after Brexit, the effectiveness of ECB’s monetary easing program, the deflationary price trend for commodities, the slowdown in China and emerging markets, slow U.S. growth, geopolitical and terrorism risks, and, last, but not least, the outcome of the U.S. elections. The IMF’s outlook just released projects this year’s global growth rate at 3.1% and next year at 3.4%. While some of these concerns in the market might happen, we know from experience that more bad things could happen in the future than will actually happen. 

It is said that when the drafting of the American Declaration of Independence was completed, Thomas Jefferson was asked of its significance. He replied, “A great event has occurred, of which it is difficult to speak, but impossible to remain silent.” The same could be said of the surprising outcome of the June 23rd British referendum on whether to leave or remain in the European Union. Contrary to the expectations of many, the leavers outnumbered those who voted to remain. This has provoked widespread speculation on whether Brexit is a “great” event, but it is certainly noteworthy. The future is always uncertain, and unknowable, but new questions now revolve around the impact of Brexit and its possible impact on global economies, currencies and markets, and the outlook for interest rates. 

There is widespread uncertainty about the outlook for the U.S. economy and the stock market reflecting concerns about China, Europe, the dollar and the decline in the price of crude oil. Investors have also had to assess the impact on the economy and markets of the actions by the European Central Bank that has been cutting rates while the U.S. Federal Reserve has taken the first step toward raising rates.

We know you don’t make forecasts, but in the past, you’ve described your outlook as being cautiously optimistic. With all the turmoil the global economy and markets experienced in 2015 and into the first days of 2016, is that still a reasonable expectation?

Given the financial press coverage of the recent stock market declines, we would like to take the opportunity to provide some context around the market volatility.

The U.S. economy got off to a sluggish start again in the first quarter under the weight of heavy snowfalls and disruptions at west coast ports with GDP contracting at a minus 0.2% rate. However, growth has revived in the second quarter as expansion in consumer spending has been led by growth in the housing sector. Housing starts and new and existing home sales have reached record levels since 2009. U.S. nonfarm employment has been steadily expanding with more than 12.4 million jobs having been created since the financial crisis and the unemployment rate has dropped from 10% to 5.3% over the last five years.

After a strong equity market last year some might have expected stock prices to decline in the first quarter, with news on the U.S. economy becoming much more negative than was expected.

U.S. GDP growth has been picking up, but some commentators are worried that inflation may be too low with the impact of lower oil prices and the drop in the consumer price index for December.

This followed the warning by the IMF that there was a chance that the Eurozone economies could slide into its third recession since the financial crisis.

This is the biggest drop in five years, but that is old news and as we said in April (“Better Times Ahead”), the economy is now recovering from the weather-impacted quarter. With less fiscal drag, and gains in manufacturing, housing, consumer spending, oil production, and employment, indicators are pointing toward a stronger GDP in the just-ended second quarter and for the second half.

As we in the northern hemisphere begin to thaw out from the polar vortex winter, confidence is improving. Incomes have increased with gains in employment leading to stronger consumer spending. GDP grew at just 1.9% in 2013, but is expected to be in the neighborhood of 3.0% in the current quarter.

It’s complicated. I’m a bit more cautious, but also optimistic. There are some major problems out there, for which there seem to be no satisfactory solutions, but they seem to be manageable, and over time, markets tend to climb a wall of worries. Investors need to be more selective this year, but there are good opportunities.

The objective of asset allocation is to develop an appropriate investment portfolio tailored to client specific investment objectives and the preservation and growth of capital on a real basis without assuming too much risk. The process has been exacerbated by the Federal Reserve’s monetary policy over the last five years that has pushed interest rates to their lowest levels since the 1950’s.

Ben Bernanke’s press conference on June 19 after the latest FOMC meeting when he sought to clarify the Fed’s goals seems to have changed the investment outlook for many. It wasn’t so much what he said, but what everyone thought they heard, that caused turmoil in markets, as traders jumped to the conclusion that quantitative easing was ending sooner than expected. What he actually said was that, depending on a substantial improvement in the labor market and, as long as inflation remains quiescent, the Fed could start reducing the pace of its bond buying program later this year. When the economy is healthy enough, maybe by next summer, quantitative easing programs could be ended, reducing the stimulus by not tightening.

Everyone agrees that asset allocation is an integral part of the investment process, but there are wide divisions on the methods to be employed, potential benefits and outcomes. In its most basic form, asset allocation describes how an investor splits up funds for investment into assets such as stocks, bonds, real estate, cash and other investment alternatives. History is replete with studies that have claimed that asset allocation alone accounts for a high percentage of portfolio returns, the level of risk, volatility of prices and variation of returns among portfolios.

The current focus of many is on risks in Europe and the subsequent actions of the IMF and ECB, the U.S. elections and the fiscal cliff drama. Company earnings were also an area of concern as growth rates in the U.S. and around the world slowed significantly. The Fed and the ECB pursued easy monetary policies to buy time until their economies got better. A possible Greek exit and Spanish bankruptcy was feared until Mario Draghi said he would do everything possible to hold the euro together and Mrs. Merkel agreed. A year-end spill over the fiscal cliff in the U.S. was averted, but substantial headwinds still lie ahead. Taxes are increasing for most taxpayers and businesses, the debt ceiling limit looms at the end of February and cuts in spending need to be addressed by March. The market took these issues, which are well known, in stride and U.S. stock prices moved higher, but most of last year’s uncertainties remain and others will emerge.

In the face of all the negative news and seemingly dismal prospects, stocks got off to a strong start in the first quarter, advancing by 13%, only to experience a correction of 11% between April and June as investors worried that the European debt crisis was being badly managed. The market had a late summer rally sparked by ECB President Mario Draghi’s pledge on July 26 that “he will do whatever it takes” to save the euro. The ECB said it would undertake a bond-buying program without limitation that would avoid defaults and make it easier for troubled countries to issue new bonds. Europe is in a recession, but the ECB has averted a crisis flash point. The basic problems still remain, but this was encouraging news and markets have responded positively with higher bond and stock prices.

Investors have had to deal with all the negative headlines about the problems in Europe, the U.S. hanging on the edge of recession, the slow-down in China, the ramifications of the health care bill, Dodd-Frank, the prospect of higher taxes, and the November elections. Fundamentals matter, but, as we have repeatedly said, over the short-term, expectations and investor sentiment drive markets.

Stocks had one of the best opening quarters ever, climbing a wall of many worries, supported by improvement on the job front, overall stronger business activity, higher consumer spending and some gains in the confidence surveys.

No one knows what the New Year will bring and even as the markets have continued to move higher, so far at least, optimism is not the consensus sentiment. Investors remain anxious about the outcome of the euro zone crisis, weak economic growth, the presidential election year in the U.S., and worrisome reports of dangerous geopolitical conflicts dominating the news.

Reports of a global economic slowdown in the Euro zone are raising the specter of recession. Every morning and throughout the day we are bombarded with quotes from commentators who do their instant analysis and warn that the market is on a slippery slope that looks very much like the environment that led to the market crash in 2008.

J. Pierpont Morgan’s reply when asked what the market will do is regarded as the safest prediction. This year the market’s increased volatility has been driven by continuing worries about the possible contagion of the eurozone banking and debt crisis and concerns about the slowing global economy.

The market declined sharply in July with the spectacle of Congressional bickering over raising the debt limit, the ECB floundering amidst a continuing sovereign debt crisis, and an array of weak macroeconomic reports heightening concerns of a recession. Equity markets had staged a steady recovery from the March 2009 low, reaching a peak in early May. Price declines continued in August, especially in Europe where many markets entered bear market territory. The S&P declined 18% from the July high until early August. Markets have been highly volatile, awaiting policy responses that offered hope of ending the malaise.

Four events over the last month that put financial markets into turmoil resulting in wild equity gyrations for stocks and bonds. On July 21st the European sovereign debt crisis flared up again and, in response, the European Central Bank drew upon the European Financial Stability Facility to do a second Greek bailout to avoid default. Further, faced with soaring interest rates, the ECB bought $32 billion of bonds to prop up markets in Italy and Spain. Worries about contagion for sovereign debt and banks spooked investors and traders and triggered a decline in global markets

U.S. economic data reports during the first half were mostly lower than was expected. Economic activity has been sluggish with little progress seen in housing, employment and manufacturing activity. The position we take on the prevailing gloomy outlook is that it was most likely impacted by the Japanese earthquake and tsunami that upset global supply chains, and higher oil prices from the rumblings in the oil-rich Arab world. The outlook is more encouraging for the economy in the second half of this year. We think the positives continue to outweigh the negatives with low interest rates, continued monetary accommodation and not very serious threats of either inflation or deflation.

Stocks are down 6% from the April high and demand for bonds has pushed prices up and brought yields down to the lowest level for the year. After a 100% advance in stock prices since March 2009, this is a minor draw down and within the normal range of market volatility and the S&P 500 is still up slightly in 2011 for the year-to-date.