U.S. Financial Market Risk Assessments-2H 2020-Cautions Ahead
We are in a recession.
The U.S. Q2 GDP contracted by -32.9%, coming after a -5% drop in Q1 (annualized rates). This officially put the United States into the textbook definition of an economic recession--a period of temporary economic decline, during which trade and industrial activity are reduced, generally identified by a fall in GDP in two successive quarters.
While the GDP contraction was largely expected by market participants, it still brought significant volatility to the financial markets. We think it is worth pointing out the actual meaning of the underlying data:
Actual Q2 real GDP (without seasonal adjustment or annualization) was $4.31 trillion (T). That was down 7.0% from $4.63T in Q1 on the same basis.
The 32.9% decline in Q2 GDP is the difference between Q1 2020 GDP and the projected Q1 2021 GDP, assuming quarterly GDP continues to fall at the Q2 2020 rate, which is not likely to happen. If we compare Q2 2020 GDP to Q2 2019,then the real Q2 GDP fell from $4.76 trillion in 2019 to $ 4.31 trillion in 2020. This represents. a decline of 9.5%, (or a nominal -9.1%).
Therefore, while the headline number of a -32.9% drop in GDP does catch public attention and drive negative sentiment, it does not necessarily provide any useful value to financial forecasting.
China’s near-term GDP recovery gave people hope that the U.S. might be able to follow. However, one of the key factors leading to a “V” shaped Chinese economic recovery was their aggressive pandemic-containment policy. The Chinese government only started to loosen lockdown measures weeks after recording “zero” new cases, thus minimizing the probability of the COVID-19 infection spreading during the incubation period. The U.S., on the other hand, implemented a completely different approach. Some states eased lockdown restrictions while residents were still experiencing ongoing COVID-19 transmission. This makes the U.S. path to recovery very uncertain.
The V-shaped recovery?
“We’re not thinking about raising rates, we’re not even thinking about thinking about raising rates.”
Fiscal and monetary policy played an important role in offsetting inadequate pandemic containment measures and stabilizing the COVID-19 disruption. Monetary policy, in particular, will likely continue providing a safety net for financial markets as the Fed has committed to keeping interest rates at ultra-low levels until the economy recovers. U.S. economic data did show some positive indications that the economy is on track for recovery as a result of a series of aggressive government policies. The July ISM manufacturing index was up to 54.2 from 52.6 in June; and the ISM service index also rose to 58.1 from 57.1 in June. Non-farm payrolls rose by 1.76m in July, while the unemployment rate fell to 10.2% from 11.1% in June. Although this means that 42% of the jobs lost during the pandemic have now been recovered (Bureau of Labor Statistics), it still leaves 12.9m people out of work. If we look under the ISM index data, the employment component continues to indicate a contraction of 44.3, as companies are cautious about hiring workers back due to demand uncertainty. Another factor to keep in mind is that many states eased lockdown measures early and these data are mostly driven by temporary, pent-up demand. Going forward, the pace of economic recovery will likely slow down as many of these states have already shut down again.
“Despite the recent gains in the LEI, which remain fairly broad-based, the initial post-pandemic recovery appears to be losing steam. The LEI suggests that the pace of economic growth will weaken substantially during the final months of 2020.”- Ataman Ozyildirim, Senior Director of Economic Research at The Conference Board
All the cool kids are long tech.
While the U.S. economy is still in contraction territory, the equity markets have made a “V” shaped recovery, led by the NASDAQ 100, as the index continues to make new, all-time highs. It’s clear that we are in a liquidity-driven market, as many retail investors have to find better yields. This is due to the massive QE by the Fed, which makes safe asset returns such as Treasury bonds vastly unattractive.
NASDAQ led the “V” shape equity market recovery (Red); S&P 500 (Blue).
As we mentioned in the prior outlook, the Tech sector is the obvious beneficiary during the COVID-19 outbreak. Cyclical sectors such as traditional retail, leisure, and airlines are some of the slowest to recover from the pandemic. Tech-driven companies have outperformed other sectors since the March low; the aggressive forward earnings-growth rate started to make some investors wonder if fundamentals still matter. Since a company’s present intrinsic value is arrived at by discounting future cash-flows, most corporate revenue growth has been pulled forward since the COVID-19 disruption. This has accelerated tech-enabled services. Many investors are expecting the Fed fund rate to stay low for multiple years. A low interest-rate environment means longer dated cash flow in the future is more valuable today compared to a high interest-rate environment. Tech companies have benefited from this because they have the longest duration and best growth longer term. Software- focused ETFs, such as Wisdom Tree Cloud Computing ETF, have outperformed the NASDAQ 100 by 36% YTD. While tech-driven companies enjoyed an aggressive run-up for the past few months, some of them are correcting in the current quarter despite beating earnings estimates and raising FY guidance. This could be an early sign of peak earnings, as investors are expecting more and more out of these companies, which simply won’t be able to keep up with overly optimistic expectations.
The inevitable correction.
The deviation between the financial markets and the economy won’t last forever; the higher the equity market, the higher the risk of a drawdown. As we get deeper into the 2nd half of 2020, we see three major tail risks that could bring further disruption to the market: 1) A twin epidemic of COVID plus Flu. 2) Political dominoes of geopolitical tensions and U.S. elections. 3) An early vaccine development.
Twin epidemics: Asia was the first region to get hit by the Coronavirus and the first region to implement lock-downs restriciton. We started to see second-wave regional outbreaks in other Asian countries about 2-months after their various reopenings. Even a strict governing system like China’s still registered more than 100 cases in just one province (Xing Jiang) during that initial reopening time period. As we are now getting into flu season, the compound effects of these super-spreader diseases will likely become a greater threat to health systems world-wide.
Political dominoes. We should expect more volatility as we approach the November U.S. election. De-globalization will likely cause more conflict between nations. In addition, the recent resurgence of extremism in the U.S. will cause more domestic antagonism, with the growing tension between the radical left and right factions in the political parties.
Early vaccine development. A surprise early vaccine is a double-edged sword. It’s good news for both the economy and the market. Businesses would increase investment to meet demand. An early vaccine would also likely trigger sector rotation to cyclical from defensives (i,e. value over growth). On the other hand, it could also delay fiscal stimulus, which would lead to a drop in purchasing power and increase volatility in the markets. To understand how this would impact individual workers, we can look at the following example: According to the U.S. Bureau of Labor Statistics, the average weekly earnings for Food Service & Drinking Place workers is about $390/week. With the CARES Act, $600/week supplemental payment, the worker is making about $990/week (+150%). This means that if Congress lowers the supplemental payment to $200/week, then Food Service workers would see their weekly income fall from $995 to $595 – a 67% reduction. What's more, with the $600/week supplement payment and an average national state unemployment benefit at $385/week, many benefit recipients are earning more from unemployment than they did from their previous job. This drop in stimulus- check income will have a major impact, not only on personal spending power, but on the ability to keep up with credit payments, such as mortgage, rent, loans, etc.
Besides the above risks, we also want to point out that the increasing frequency of natural and human-caused disasters in recent years, combined with potential U.S. inflation (i.e. USD deprecation) will likely bring more volatility to the commodities markets.
Going forward, risk management is critical in the 2nd half of 2020. Chasing high momentum companies will likely lead to unfavorable risk adjusted returns, where a steeper pullback would likely create buying opportunities. Regardless of your risk tolerance, it’s pivotal to develop and follow your own process.
Like the fisherman said, “Before you go out on the water, you do your preparation: you look at the tide, the weather; you work out where you think the fish are most like to be and go to that area; then, you lay the net and wait. You wait for the amount of time you planned to wait. You might get lots of fish or nothing at all; The next day you come back and repeat the process.”
