Closer to Home
COVID-19 cases are falling in the U.S. and the global economy is recovering, but risks remain through 2020.
The battle between public health officials and COVID-19 continues, and, as we had feared, cases in the United States increased significantly in recent months. However, global economic activity continues to rebound from its historic drop, new cases in the U.S. have started to decline and financial markets have remained buoyant. While the economic momentum is noteworthy, we still see risks on the horizon and believe some prudence is warranted.
The COVID-19 resurgence in the U.S. has led to reopening rollbacks, school closings and new travel restrictions. Even countries with relatively small case increases like Australia and New Zealand have implemented significant new restrictions. Fiscal policy has been a critical lifeline in recent months. Income support programs across Europe have systemic resiliency, while the supplemental unemployment insurance and stimulus payments in the U.S. are one-time affairs. The U.S. presidential election is less than three months away, and may be complicating negotiations on a fourth fiscal package. It is critical that further support be given to those whose incomes have been devastated by the economic downturn, including consumers and state and local governments.
Economic growth in recent months has been better than we expected, although the U.S. has lagged its major peers as shown below. The composite U.S. Purchasing Managers’ Index nudged just above 50 this month, while both China and Europe are nearing the 55 level. The pace and level of growth from here is still clouded by the health outlook, however. While U.S. cases have declined in recent weeks, we may face a flu season without a widely distributed vaccine. The corporate earnings outlook improved somewhat after June quarter earnings, leading to a bump of 2.5% to our 2021 U.S. forecast. Earnings expectations were little changed outside the U.S., however.
There are significant uncertainties through 2021, including the path of COVID-19 and its impact on growth, the U.S. election and U.S.-China relations. We have moved the tactical asset allocation recommendations in our global policy model “closer to home”. This included reducing our recommended overweight to high-yield bonds after their recent strong performance, and reducing our recommended underweight to emerging market equities as their relative return potential has improved. While markets have staged an impressive rebound, investor surveys indicate that few expect a “V” shaped economic recovery to continue. That cautious sentiment could provide some cushion should disappointing economic reports appear in months to come.
- Treasury auctions have ballooned in the wake of COVID-19 stimulus programs.
- Issuance of this size would normally have led to higher rates.
- We are modestly long duration in client portfolios.
At its July meeting, the Federal Reserve reaffirmed its stance to support the economy, leaving interest rates unchanged at 0.00% to 0.25%. Chairman Powell emphasized the Fed’s commitment to use “its full range of tools for as long as it takes,” supporting our view that interest rates will be lower for an extended period of time. Prior to the meeting, the Fed extended most of its emergency lending facilities through the end of 2020 due to virus uncertainty and a muted growth outlook. The dovish commentary was in line with market expectations.
To fund the large amount of fiscal and monetary stimulus, Treasury auctions have ballooned in size across the entire yield curve. Historically, increased supply at a time of a recovering economy, improving risk assets and widening TIPS breakevens would lead to higher rates and a steeper curve. Over the last month, neither outcome has materialized. The spread between five- and 30-year Treasury bonds, a gauge of future growth, has declined. Both Treasuries have fluctuated at the lower end of their trading ranges. This could simply be a risk-asset hedge, or it might suggest the markets are expecting lower growth or an increase in Fed bond purchases, limiting an upward rise in yields. We are modestly long duration in client portfolios.
- High-yield downgrades surged in April due to the pandemic.
- Upgrades in ratings have now exceeded downgrades for the first time in nine months.
- We pared our recommended overweight to high yield after its strong recent performance.
Corporate health has attempted to recover alongside the global economy. Over the past four months, management teams have insulated their balance sheets via new issuance at record-breaking speed. Many companies raised cash in order to maintain excess levels of liquidity. These decisions, along with an improved economic backdrop, led to a drastic reduction in the number of corporate downgrades from rating agencies. July has seen only 16 bond issuers downgraded following 67 in May and a record 194 in April. Prior to the pandemic, the monthly high for bond issuers downgraded was 137 in February 2016. Importantly, the upgrade-to-downgrade ratio is now above one for the first time since October 2019.
While the trailing 12-month upgrade-to-downgrade ratio is the lowest since October 2009, the metric is important because a turn in the trend is a credible indicator of corporate balance sheet strength. Upgrade activity also has a positive impact on credit performance. While volatility stemming from the looming U.S. presidential election and the race toward a COVID-19 vaccine may impact high-yield markets, rating agency actions highlight the positive steps management teams have taken to insulate their businesses from future economic instability.
- Second-quarter earnings beat on cost controls.
- Lack of visibility leaves future estimates little changed.
- We have modest return expectations for equities for the next year.
This past month’s rise in global equities was led by value, a rare occurrence for some time, as the U.S. market pushed its all-time high. Aiding sentiment has been improvement on the macro front, progress toward a vaccine and better-than-expected earnings. While earnings look like they’ll finish down 35% from a year ago, that compares favorably to expectations of down 44%. Nearly all of the benefit to earnings came from cost controls, as sales showed only modest upside. Still, there has been little uplift to earnings expectations for the balance of the year. Third- and fourth-quarter earnings expectations have leveled off, but not improved. This is partially a reflection of limited forward guidance from companies, but also a lack of conviction in continued upside to macro conditions.
Valuations continue to increase. The P/E multiple on 2021 earnings is now over 20x, a level not seen since the tech bubble (25x next-year earnings). At present market levels, for the market to trade at an 18x P/E (still elevated versus history), earnings would need to be 15% higher than their 2019 level – something we think won’t be achievable until 2022 at best. Given valuations in the U.S., combined with the potential market risks from the upcoming presidential election, we modestly favor developed-ex U.S. equities.
- Gold is on many investors’ minds as a hedge for any number of concerns, including inflation.
- We view a mix of natural resources and inflation-linked bonds as a better way to protect against inflation.
- We are currently underweight inflation-linked bonds and equal-weight natural resources.
There has been increased interest in buying gold as a hedge against high inflation, falling markets and dollar debasement. We do not currently recommend an allocation. As we wrote in our recent report, The Role of Gold, we do not anticipate another material near-term drawdown in equity markets, nor are we bearish on the long-term outlook for the U.S. dollar. Finally, we continue to expect inflation to remain under control over our tactical horizon. That said, we do appreciate the potential for longer-term inflation pressures (see our Stuckflation Tested theme in our most recent Five-Year Outlook), but we view inflation-linked bonds (ILB) and natural resources (NR) as better sources of inflation protection.
For some investors, NR display too much volatility while ILB have too little return potential. But these asset classes should be viewed in the context of the overall portfolio. As a simple example, we created a 50/50 mix of NR and ILB (labeled 50/50 in the chart). It is true NR’s higher inflation protection comes with higher volatility and ILB does not give much bang for your inflation buck. However, the two together have shown more inflation sensitivity and less volatility than an allocation to gold. In a fully diversified portfolio, we currently recommend an underweight to ILB and a neutral position in NR – and no allocation to gold.
-Jim McDonald, Chief Investment Strategist
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