KCS Quarterly Market Review for Q2 2020
July 13, 2020
What a difference a quarter can make! It was only ninety days ago that the world economy—and markets along with it—were spiraling into the abyss. At the same time, the safety and comfort of our daily lives were being upended, replaced with fear and uncertainty for our health and basic needs. The invisible cause of this turmoil was the rapidly-spreading novel coronavirus, whose ultimate toll was unknown but likely devastating to lives and livelihoods. This was a time when the frequency of using the word “unprecedented” was itself unprecedented.
It should have surprised no one that markets tanked in March. What did we know at the time? A virus of unknown, but likely significant fatality, was spreading rapidly across the globe; several countries were enacting extreme countermeasures to control it; and the economic impact of those countermeasures was negative to an extent rarely seen in economic history. World leaders faced a difficult choice: Should they allow a modestly devastating disease, which might ultimately kill around 0.5% of the population, to freely circulate? Or should they enact policies to protect against the virus but which would grind the economy to a near halt. Most countries, including the US, chose the latter. In response, the sharp decline in markets made sense.
What has changed since then? One, governments around the globe have enacted levels of fiscal stimulus unprecedented in size and speed. Two, with time and research, we now have much more information about the disease and its course, lethality and treatment. Three, we’ve seen multiple countries succeed in their containment or mitigation measures. And fourth, the economy in those countries—as well as the US where mitigation has only partially succeeded—have opened up significantly since late April.
Even so, what occurred over the subsequent three months was mostly unexpected. While economists correctly forecasted a moderate contraction of the global economy in Q1 (and continue to forecast a historically severe one in the quarter just ended), hardly anyone expected these conditions would foster one the best quarters for stocks in decades, with the global MSCI All Country World Index finishing the period up a hefty +19.2%. Bonds also rebounded nicely in this period, finishing the quarter up +3.3% and regaining their positive territory for the year (though stocks remain down year to date).
How could this have happened in the face of spiking unemployment, a precipitous economic contraction, and a pandemic that is far from controlled? The primary reason is also the key to understanding stock price behavior: the stock market looks to the future and cares not at all about the past or present. Here’s what we said on March 26th, just 3 days after the market’s low:
How long will this awful market last?
…The average bear market lasts 254 days, or over 8 months. But during no bear market in history have stocks fallen as quickly as they have this year. Their rapid fall corresponds to what is likely to be a very dramatic decline in GDP. But at the same time, the recovery should also be relatively rapid, suggesting that the bear market will be on the short side. Note that the stock market leads the economy by 4 to 6 months. Thus, even if the economy doesn’t begin to revitalize until late August, that suggests the stock market recovery has already started. A secondary bottom later this year would imply that the recession won’t end until the final quarter of 2020, which seems a less likely scenario.
The data now indicate that the economy bottomed and began to recover by late April, and while that month’s data was dreadful (20 million US jobs were lost), May surprised to the upside and the economy has continued to mend itself ever since. You can see the economic decline and recovery in the first chart below, which shows that total credit card spending in the US, while still down 9% from early March, has recovered sharply from its April bottom when it was down over 30%.
The stock market, not afforded any lead time in foretelling the economic recovery during this hyper-speed recession, has basically tracked consumer spending. The second chart below shows the path of the MSCI ACWI during the same period, having recovered from a decline of 34% from its highs and now sits about 8% below its peak this year.
However, while both the economy and the markets are improving, we are not yet out of the woods. As opposed to earlier in the year, when China and then Europe were bearing the brunt of COVID-19’s health and economic impact, our chief concerns now reside in the United States, where some economic indicators have dipped recently. Two primary risks weigh on the United States:
- The COVID crisis persists or worsens
A full economy recovery cannot occur until the US achieves better control over the spread of coronavirus, and the latest dip in spending coincides perfectly with recent delays in re-openings and the reinstitution of restrictions on business in some states. New cases and hospitalizations have soared recently in the Sunbelt, and we have lost the option of a successful track-and-trace policy in these states. As a result, this virus will be with us for many more months, likely well into 2021. (The graphs below show recent US data on COVID-19, and other than deaths, the data are not pretty.)
But all is not doom and gloom, as a more positive outcome is possible. First, we think that daily COVID-19 deaths are unlikely to again reach the levels seen in April, despite the recent sharp rise in cases. Improved treatment, along with a lower median age of infection, should help mitigate such an unwelcome outcome. Second, it’s very possible that we will receive good news on a treatment or vaccine, as several key updates are anticipated over the next few weeks. (We suspect that more effective treatment will come much sooner, and be more of a game changer, than a vaccine. We’ll write more about this in another newsletter.) If either of these happens, we believe that the US reopening and economic recovery will accelerate from its current pace. Conversely, if deaths trend up sharply and stay elevated, and/or if rising hospitalizations lead to the kind of capacity constraints we saw earlier this year in Northern Italy, the market will be forced to come to terms with a longer recession than it currently expects.
- The government withdraws fiscal support
Our second concern focuses on the eventual expiration of our lavish government stimulus. Between April and June of this year, $2.0 trillion of deficit spending support was provided to our economy. This is a staggering figure and represents more than a full month of US GDP. There is little question in our minds that the recession would be even worse in the absence of this support, and if federal spending wanes before the economy is ready to stand on its own two feet, the recovery could falter. However, this is an election year (as we know all too well) and Republicans in both Congress and the White House realize that their reelection chances will plummet if the economy were in a deep hole come November. For this reason, we believe the odds favor a continuation of at least a portion of the current deficit spending.
The next few weeks will be critical in answering several of our key questions. An ideal scenario would be one in which deaths from COVID-19 continue to trend down and the government extends benefits at their current rates. We believe it’s more likely that coronavirus deaths tick up over the next few weeks before declining again, and that the government extends its support at reduced levels. These outcomes would support our expectation for a “square root recovery,” with the economy continuing to recover gradually from here as coronavirus concerns subside. We expect the market to continue to track the economy, and becoming more of a leading indicator, suggesting modestly higher stock prices in the second half of this year.
Given the above, how should your portfolio be positioned?
First, be aware that there have been significant divergences between the performance of most individual names and the major benchmarks. More than 75% of S&P 500 stocks remain down by over 10% this year, while nearly 40% of the companies in the index are still in bear market territory (down at least 20%) and over 25% are down more than 30%. As a result, an equal-weighted investment in the S&P 500 has lost –12% this year compared with less than –2% for the (capitalization-weighted) S&P 500, owing to strong performances by a handful of very large technology companies, which are now starting to look overvalued. (In the same vein, the All-Country World Index ex-US is down –8% for the year.) We believe that, as the economy continues to improve, this situation should reverse, especially outside the US where coronavirus is much better controlled. In the shorter term, however, big technology is likely to continue to rule.
Second, investors appear to have chased several “story stocks” to irrational levels. For example, Tesla’s market value is now larger than Toyota’s. Tesla makes about 400,000 vehicles per year compared with nearly 9 million for Toyota. And Toyota made almost $11 billion in profits last year while Tesla lost money. This seems out of whack to us. Similarly, the market says that Zoom is worth $76 billion, which is 95 times its annual sales of $830 million. For a little bit more, you could buy Costco with its revenue of $160 billion (193 times Zoom’s). One more example: the success of Square’s Cash App has driven the company’s stock to a valuation of $60 billion, as the app has helped the company develop a fast-growing deposit base of $1.3 billion. For about 4 times that valuation, you could buy JP Morgan with its deposit base of $1.8 trillion (almost 1,400 times larger), and those deposits grew by $300 billion in just the past quarter. Each year, JP Morgan makes almost enough profit to buy all of Square.
Needless to say, we think a lot of investors in story stocks such as these will be very disappointed in their performance (and potentially a lot less wealthy). Ironically, the catalyst for that outcome may well be an improvement in the overall economy.
Third, we think international equities are poised to have another year like 2017, when they bested the S&P 500 by 5%; we have seen hints of this already in their performance over the past month. One reason for this is their far greater success in containing the coronavirus (see the graph below comparing US cases in purple to the EU in green). In several of these countries, real-time indicators like mobility and restaurant dining have already recovered nearly to pre-pandemic levels. With both cheaper valuations and a clearer roadmap to recovery, we think that international stocks are well positioned for the rest of this year.
Lastly, we continue to be lukewarm regarding fixed income relative to equities over the medium term. This is especially true in the highest-rated, longest duration categories (for example, 10-year US treasuries). Bonds historically have served to stabilize portfolios by virtue of their interest payments and, especially since the global financial crisis, by moving in the opposite direction to stock prices. The latter occurs when stock declines lead to lower interest rates. However, with the 10-year US treasury yield now just 0.65%, you aren’t earning much interest and there is little room for yields to fall further. (We believe that negative interest rates in the US remain highly unlikely.) As a result, their value as a hedge against stock market declines is considerably lower than it was just a few months ago when the US 10-year was at three times its current yield.
For this reason, we are currently positioning our fixed income portfolios with a mixture of bond types to accomplish two opposing goals: 1) to provide a partial hedge against equity declines (by using both long treasuries and derivatives that tend to move opposite stock prices) and 2) to obtain higher returns than the traditional fixed income portfolios that emphasize US government bonds. We seek to accomplish the latter by going beyond traditional bond indexes to include several types of securities that pay both higher yields and offer the potential for capital appreciation. These include preferred stocks (which are really bonds), convertible securities, floating rate loans, emerging market bonds and various types of US corporate bonds.
2020 will be a year to remember or, more likely, try to forget. COVID-19 will be probably with us for well over a year, and life won’t return to “normal” until the virus is finally quelled by herd immunity from both infections and vaccines. The economy, which suffered a severe shock in March and April, will likely continue to recover from here, though gradually and unevenly. Barring a major surprise—either positive or negative—the markets should also recover gradually and unevenly. While equities are unlikely to return to their February highs during the next quarter or two, we also don’t see them falling back anywhere near their March lows. The “easy money” has already been made, but the risk is also much more manageable than it was just two months ago.
The key adjective in the paragraph above is “uneven.” We believe that the next few quarters are likely to be far more rewarding to active managers than any time in the past decade, as the winners of yesterday become tomorrow’s laggards and vice versa. The valuation differential between market darlings—mostly “work and shop from home” tech stocks—and everything else is wider than at any time since the dot.com bubble. We are optimistic that as the recovery progresses, valuations will revert toward normal, with undervalued names outperforming the massive tech companies that currently rule the markets.
The KCS Investment Team
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