Market Outlook and Q2 Summary
It was certainly a busy quarter in terms of news flow. Through it all, the market rallied strongly, especially during April. As we publish this update in mid-July, the Nasdaq continues to reach all-time highs and the S&P 500 turned briefly positve for the year-to-date period earlier this week before retreating.
We are now entering Q2 reporting season where earnings are expected to be down nearly 45% and US GDP down 35%. While these numbers are truly horrible, they are relatively known at this point, and the bar has also been set quite low so that earnings can be horrible but still beat expectations. Forward guidance, for those companies willing to give it, will be closely watched by an investor community that has already written off 2020 and is looking toward 2021 and 2022 for clues on future profitability. We expect volatility to remain elevated. Days with market moves over 1% up or down have grown more common this year, as shown below.
Overall Asset Allocation
Global stock and bond markets recovered strongly in Q2, especially in the US. The recovery is not built on as solid a foundation of earnings growth and robust economic activity as fundamental investors would typically prefer, but it has been a dramatic recovery nonetheless. Stimulus and intervention in stock and bond markets during Q2 revived risk assets. The Federal Reserve and other central banks continue to do whatever it takes to prop up the economy. This unorthodox support of the economy seems a lot closer to distorting asset prices and encouraging moral hazard than ideal, but it has been deemed a necessity to try to limit the socioeconomic pain of the pandemic.
Even if we do manage to get back to pre-COVID levels of social activity soon, the “new normal” will still be quite unstable in economic terms given the uncertainty of the upcoming election, the regression in US/China relations, the degree of social unrest, the retrenchment of globalism, rampant deficit spending, ravaged municipal budgets and a variety of other issues. These factors lead us to maintain a modest underweight to equities. However, this tide of worry is swamped by the unprecedented support programs in place around the world. While being completely in the market at maximum risk allocation is not recommended, neither is being completely out of the market in the face of such abundant stimulus and such a wide cross section of possible outcomes.
US Equities
The second quarter saw a robust rally with the market bottom having been set just before the calendar turned to Q2. The S&P 500 was up 21% to claw back to down only 3% for the first half. The rally in tech and growth stocks had the Nasdaq up 31% for the quarter and up 13% for the first half. The consumer discretionary, technology and energy sectors were all up over 30% in Q2 but had divergent performance over the first half: consumer discretionary +7%, technology +15%, and energy -35% (oil was down 59%). Technology and energy were the top and bottom performing sectors for the first half. Small cap stocks, as measured by the Russell 2000 Index, recovered by 25% in Q2 but finished the first half still down 13%. The Dow Jones Dividend Select Index recovered by 11% in the quarter but finished the first half down 22% as investors fear further dividend cuts on top of their avoidance of some of the value and cyclical names that are prevalent in dividend indices.
The action of the stock market in Q2 was yet another reminder that the economy is not the stock market, especially in the short run. And these days the “stock market” may not even be the full S&P 500 as the direction has been confined to a relatively narrow set of large capitalization tech and consumer companies such as Facebook, Apple, Amazon, Netflix, Google (Alphabet) and Microsoft.
We own many of these global leaders in tech and consumer sectors as well as many other software and hardware names benefiting from e-commerce and the spike in work-from-home technology needs. However, many of our positions in these names and sectors are already fully sized in our portfolios so our recent additions to risk and diversification have been into new individual equity names, bank loans on the fixed income side and gold as a unique alternative asset. We also expect to be adding some international exposure as opportunities arise.
International Equities
International indices (as measured by the MSCI All Country World ex-US) were up 15% for the quarter to finish the first half down 12%. The MSCI Emerging Markets Index was up 18% in the quarter and down 10% for the first half.
The push and pull in the debate of international versus US stocks is that the US market and its bellwether indices consist of more growth and tech companies, but international markets have more room to run in terms of beaten down valuations and member countries that are currently handling the virus relatively better than the US (with the exception of certain emerging markets getting hit particularly hard). Also, any weakness in the US dollar that might come from fiscal/trade deficits and the excess liquidity being pumped in the system would tend to help international equities in dollar-price terms.
Core Fixed Income
Despite seemingly having no room to grind out positive returns from such low starting yields, bonds had a positive quarter and continue to show their merit as a diversifier in times of stress. The 10-year US Treasury bond ended the quarter at a yield of 0.66% and is at 0.62% as of this letter. The Barclays 1-10 Year Muni Index was up 2.7% for Q2 and 2.1% for the first half. The Barclays Aggregate Bond Index was up 2.9% for Q2 and 6.1% for the first half.
Much like the stock market, traditional price discovery is at least being partially distorted by government intervention. For example, during Q2 the Federal Reserve, in an unprecedented move, began to buy corporate bonds, including companies that had been downgraded into high yield after the COVID outbreak. The program and related stimulus calmed the bond market by reviving liquidity, tightening spreads, and unlocking the new issuance market. In fact, those corporations that can issue debt are now doing so to build a larger capital cushion at exceptionally low yields.
We continued to reinvest and add to investment grade corporate and municipal bonds during the quarter.
Opportunistic Fixed Income
Opportunistic fixed income positions recovered nicely. High yield bonds were up 10% for the quarter and emerging market debt was up 14%. Both bond classes finished the first half down approximately 3%. We added positions in bank loans in the quarter with their favorable intermediate risk profile: bond-like characteristics with equity-like upside via attractive entry points. We expect there will be further opportunities in the bond market as dislocations continue, and we could add to positions on any weakness.
Conclusion
The challenge in the current moment is not the lack of upside scenarios. Even if there is appropriate skepticism for the economic and physical health of “Main Street”, there are certainly scenarios where the stock market could be up another 10-15+%, especially considering that market capitalization based indices (such as the S&P 500) are dominated by the well positioned, large cap companies that are holding up through crisis. Similarly, the announcement of an effective vaccine could at the very least induce a short-covering rally as well as draw the large amount of cash on the sidelines back into the market. Rather, the albatross to portfolios is that the negative tail risk present in the market (though always there, by definition) seems larger than normal, both in likelihood of playing out and magnitude of market drawdown that a worst case could induce. Certainly, the recent deterioration in some of the virus news comes into play here. It will also be crucial that government aid packages are successfully extended and renewed consistent with demanding market expectations.
Further, from a risk management perspective, modest underweights to stocks are now often effectively the equivalent of larger exposures in risk-adjusted terms due to the ongoing volatility. Also, on a sector and individual stock basis, even if relative positioning has not changed, the tracking error (versus benchmark) surrounding those tilts has expanded due to the current environment. Therefore, we are not recommending adding more exposure at these levels. We maintain a modest underweight to equities, a neutral position in fixed income and an overweight to cash as liquidity for opportunistic reinvestment. We also added positions in gold for most portfolios in Q2 as a diversifier.