We have reached the midpoint of a year destined for the history books.
After its longest-ever period of growth, U.S. economic activity and markets collapsed during the first quarter in response to the initial pandemic shock and stay-at-home mandates. In the second quarter, markets shrugged off virus fears as policymakers pressed the stimulus accelerator to the floor, setting the stage for a strong rebound in asset prices and economic data from artificially depressed levels.
Following the fastest bear market in history in the first quarter, and amid a pandemic that has killed hundreds of thousands, the second quarter saw the S&P 500 Index’s biggest jump in more than 20 years.
In this highly uncertain environment, policymakers, business leaders, and investors have been frustrated that some traditional economic tools do not work well under such novel conditions. Models of economic activity, unemployment, and consumer behavior are based upon long-term trends and business cycles; they simply were not built to accommodate the type of abnormal shocks the COVID-19 pandemic has created. This is further compounded by data collection problems, such as tens of millions filing for unemployment via systems not designed for such volumes.
The result has been some market-jarring data surprises. For example, economists braced for a loss of more than 7 million jobs ahead of the May jobs report. When released in early June, the report instead showed the addition of 2.5 million jobs—an unimaginable 9.5 million jobs miss.
The second half of 2020 begins with virus cases again on the rise across the nation and with significant outstanding medical questions. Conditions are evolving rapidly. In this edition of Investment Strategy, we will recap an eventful second quarter, seek to understand the drivers of this performance, and explore how these forces could influence the rest of the year and beyond.
Second Quarter Markets Recap
Fueled by historic levels of policy support and reopening optimism, major asset classes posted significant gains during the second quarter, as shown in Figure One. Even the hard-hit real estate investment trust (REIT) category, despite ongoing concerns over falling rents, rising vacancies, and the long-term implications of the workforce better able to work and shop from home, recovered half of its 2020 losses.
Figure One: Q2 2020—Major Asset Class Returns
As seen in Figure Two, the second quarter rally pushed the S&P 500 Index to within 4 percent of its year-end level—demonstrating the V-shaped recovery for large U.S. companies’ share prices that pundits hoped for in the early days of the crisis. However, beneath the surface lies a very uneven picture that more closely resembles the letter K—a large performance gap between a small group of growth-oriented technology leaders and the rest of the market. The recovery in the S&P 500 is better described as the S&P 5—Facebook, Amazon, Apple, Microsoft, and Alphabet (Google)—with the remaining 495 companies lagging behind.
Figure Two: S&P 500 Year-to-Date Price Performance
Source: Bloomberg. Data indexed to 100 at 12.31.2019
The degree of concentration within the S&P 500 has now far eclipsed levels seen during the leadup to the dot-com bubble. Today, the combined weight of the top 10 constituents is 27 percent of the index’s total market capitalization—with the top three companies (Microsoft, Apple, and Amazon) representing 17 percent. This degree of concentration within such a small group of companies is not a healthy trend for markets, as it does not illustrate a broad-based recovery and may portend regulation or antitrust action.
The performance gap between growth and value sectors also widened during the second quarter, as investors placed a priority on balance sheet strength and resilience to pandemic pressures. On a year-to-date basis, large-cap growth stocks have outperformed small-cap value stocks by a staggering margin of more than 33 percent. Over the past 12 months, the gap has widened to nearly 41 percent.
International markets joined the U.S. with a vigorous rally in the second quarter—particularly emerging markets, which were aided by a weaker U.S. dollar. European markets also fared well, fueled by an expanded commitment to monetary stimulus from the European Central Bank, a proposed 750 billion euro recovery fund by the European Commission, and improvements in virus trends that allowed progress on the reopening of hard-hit economies. China continued along its path to recovery as the first in and first out of the pandemic crisis, with Chinese stocks posting a 15 percent return in the quarter—lifting its year-to-date returns into positive territory at 3.6 percent. The pace of recovery in China also lifted regions sensitive to China trade, such as Germany.
U.S. Treasury rates did not move much during the quarter. As shown in Figure Three, credit sectors mirrored equity markets in a reversal of the first quarter’s flight-to-safety environment. Investment grade and high yield corporates outperformed Treasurys, as the expansion of the Fed’s bond-buying program to include corporate bonds for the first time likely spurred appetite for credit. Returns were further buoyed by a modest decline in interest rates for intermediate maturities. The 10-year Treasury’s yield dipped to 0.66 percent from 0.70 percent during the quarter, and 30-year fixed rate mortgage rates sank to record lows, serving as a tailwind for the housing market.
Figure Three: Fixed Income Yields and Returns
Themes for the Second Half of 2020
The forces that drove markets in the first half of the year are powerful, including both the negative impacts of the virus and the positive impacts of monumental stimulus and relief programs. Although conditions exist for continued risk-asset outperformance—namely, low interest rates and unprecedented policy support—significant questions remain, and we expect a wide range of potential outcomes in the near term.
By far, the greatest issue facing capital markets for the second half of the year is success in solving the medical crisis. Until effective treatments and vaccines are available, the economy, and especially impacted industries such as travel, leisure, and hospitality, will be unable to return to anything approaching normal.
The type of widespread lockdowns enacted during the spring were blunt instruments, necessary to manage risks during the peak uncertainty of the crisis’s early days. But the hope is that more targeted policies can bridge the gap and contain the risks of overloaded health systems until medical solutions become available, with less severe disruption to the economy, education system, and daily life.
Economic and other sources of real-time data paint a mixed picture of the economic recovery’s pace. It is always important to distinguish between data that describe the present state of the economy and data that speak to the recent trend. These can sometimes tell very different stories.
Nothing illustrates the disconnect between trend and state better than the current employment picture. As shown in Figure Four, the weekly initial jobless claims data released on July 9 showed a larger than expected decline in the number of initial jobless claims and marked the 14th consecutive week of declining initial claims—an extremely positive trend. However, the state of employment remains grim, with more than 18 million Americans filing continuing claims for unemployment as of the end of June.
Figure Four: A Positive Trend…But a Dismal State
Similar stories can be seen across the spectrum of economic activity. For the real economy, electricity usage data suggests substantial recovery in industrial activity, although steel production remains depressed. Levels of retail sales have recovered meaningfully as states have begun to reopen, although not all businesses have shared in this recovery. And, as shown in Figure Five, the level of mortgage applications has recovered and surpassed year-end levels, while the personal savings rate remains elevated—a troubling sign for future consumer spending and consumption.
Figure Five: Homebuying Has Rebounded…But Savings Rates Remain Elevated
Policy Cushions Blow
The fiscal and monetary stimulus unleashed within the U.S. since March is not only the largest in history, it also arrived quickly despite a fractious political environment. The combination of central bank liquidity programs and fiscal relief packages is estimated to exceed $9.5 trillion—a staggering number that represents more than 40 percent of U.S. gross domestic product (GDP). It is hard to fathom numbers this large. For perspective, it’s enough to buy every person in the U.S., both adult and child, a new Toyota Camry, with money to spare for rubber floor mats and undercoating.
Financial markets can react more quickly than the real economy to such stimulus, and aggressive policy action has been the largest driver of the recovery in capital markets during the second quarter. While such disconnects between markets and the real economy often exist, rarely, if ever, has one been so stark.
An important driver of the future path of the recovery will be avoiding policy mistakes of the past, such as stopping stimulus too quickly during or after a crisis. Examples include the Great Depression, when monetary policy errors prolonged the crisis; the European response to the global Financial Crisis; and Japan’s Lost Decade of the 1990s.
As a result, all eyes are now on the expected next round of fiscal stimulus, expected between the end of July and mid-August. Failure to agree on the next package by August 8, when the Paycheck Protection Program is slated to expire, could pose particular risk.
And finally, there is the question of the long-term implications of open-checkbook stimulus and relief programs. As shown in Figure Six, the level of U.S. public debt may exceed 100 percent of GDP this year, a level not seen since the peak of World War II. We entered the current crisis with relatively high levels of deficits and debt. Although the historically low level of interest rates makes such levels of debt an easier burden to bear, it isn’t free. More importantly, this level of debt could boost inflation and hamper growth in the long term.
Figure Six: Federal Debt Held by the Public as Percentage of GDP
Source: Congressional Budget Office, Committee for a Responsible Federal Budget (CRFB), CAPTRUST Research
Labor Market Stress
The initial, heart-stopping spike of job losses in March drove the unemployment rate to 14.7 percent—the highest level since the Great Depression. As states have begun to reopen, we have seen significant improvement as workers sidelined by lockdown restrictions have been recalled. But despite these gains, the unemployment rate remains at a highly elevated and worrisome level of 11.1 percent. As shown in Figure Seven, this level still ranks as the highest level since 1960 and marks only the third time in the last 70 years that the rate has exceeded 10 percent.
Figure Seven: U.S. Unemployment Rate
Labor market recovery is a critical precursor for limiting the damage of this recession. For the remainder of 2020, we will watch closely for signs that effective virus containment efforts can co-exist with job recovery, as well as any signs of increases in permanent layoffs as businesses adjust to a post-pandemic business environment.
Balance Sheet Health
The virus isn’t the only health concern on the minds of investors and policymakers; the financial health of corporations is also in focus. We entered 2020 with storm clouds on the horizon in the form of elevated levels of corporate debt. Today, debt-saddled firms face an unprecedented revenue shock, and we have already seen many storied brands in troubled sectors fall victim to the crisis, including Hertz, J. Crew, Gold’s Gym, Neiman Marcus, and Brooks Brothers. Already, the pace of bankruptcy filings has reached levels not seen since 2009, prompting some to fear that we could be on the brink of an avalanche of business failures.
The unique nature of the current crisis does, however, allow room for optimism. During prior recessions, levels of economic activity were quick to fall, but slow to recover. This time, because the drop-off in activity was largely artificial—driven by lockdowns and social distancing requirements—we could see a sharper recovery once virus risks subside. Only time will tell. In the meantime, amid this uncertainty, it should come as no surprise that many firms have withdrawn future predictions of near-term business conditions, with more than 170 companies suspending earnings guidance over the past three months.
Finally, markets will watch the election season unfold with great interest, attention that will only intensify after party conventions. Although current polling suggests a lead for the Democratic challenger, we are still more than 100 days away from Election Day—an eternity in politics. Historically, presidential incumbents who faced a recession within two years of reelection have rarely won. However, this recession is anything but typical, and it remains to be seen whether this time will be different. We are mindful of the risk that a politically charged environment could slow or derail continued policy support for economic recovery and of the potential escalation of trade disputes.
Investing amid Uncertainty
The breathtaking drop and breakneck recovery we have witnessed over the past four months represents perhaps the hardest but greatest lesson of all time on the dangers of market timing. Those who moved to the sidelines in March missed a rally for the record books. However, investors, institutions, and retirement plan participants who stayed the course or took the opportunity to rebalance portfolios may have benefitted from some of the extreme price dislocations witnessed during the first quarter. While we hope the next six months will be a smoother ride than the last, we expect volatility to persist as markets react to the fast-changing medical, economic, and political conditions described above. This degree of uncertainty underscores the importance of risk tolerance, asset allocation, and portfolio diversification. These foundational principles can give retirement savers a greater ability to seek out the new opportunities that will undoubtedly emerge from the first global pandemic of the modern era.
 Hill, Jeremy; Crombie, James, “Big Bankruptcies Sweep the U.S. in Fastest Pace Since May 2009,” bloomberg.com, 2020
 Strategas, 2020