Insight
KCS Quarterly Market Review for Q3 2020
October 20, 2020
Strong Markets, Weak Economy, COVID-19 Not Going Away
The COVID-19 pandemic continued to spread throughout the 3rd quarter of 2020, as confirmed cases around the world tripled to over 35 million, while the death toll tragically surpassed one million lives. Efforts to achieve global containment have clearly failed, leaving us with only a few bright spots, mainly in Asia. Such notable successes include New Zealand, which recently experienced 21 straight days with zero cases, and China, where daily confirmed infections have recently numbered in the teens. (China’s draconian lockdowns earlier in the year are paying economic dividends as well: over the weekend, they reported 4.8% GDP growth in the 3rd quarter, nearly back to their pre-pandemic trend.)
At the other end of the spectrum, one of the worst public health responses was here in the United States, as we still lead the world in cases and deaths despite being one of the best equipped in resources and infrastructure. We find it both sad and embarrassing that the US stands at the top of the list of countries most impacted by the novel coronavirus, and that 14 of the top 20 worst hit nations are less wealthy emerging market countries.
The economic consequences of COVID-19 have been similarly significant. Lockdowns, enforced business closures and rapid shifts in consumer behavior have caused the most substantial disruption to ever befall the world economy, and at record speed as well. And we are by no means out of the woods. Unemployment in several US regions remains at double digits, as are government deficits as a percentage of GDP. And while the US economy has recovered substantially from its nadir in spring, there is still a long way to go before our recovery is complete. One obvious indicator is that new jobless claims in the US each week remain higher than at any point during the 2008-2009 recession.
High unemployment and a patchy economic recovery will likely continue for some time as industries adjust to new realities. Some examples of restructuring happening before our eyes include: movie theatres, which are locked in a chicken-and-egg dilemma with studios regarding new feature films; airlines, with air traffic not expected to fully recover until 2024; and restaurants, with 60% of closings estimated to be permanent. In sum, the economy is far from healed.
Stocks again shrug off a crummy economy
Yet in the context of all this bad news, stocks around the world continued their strong recovery from March lows. The MSCI All Country World Index, our global equity benchmark, rallied by +8.1% in the third quarter, recouping losses from earlier this year. Strength was broad-based geographically, led by emerging markets (+9.6%) and the US (+8.9%). Among sectors, cyclical consumer discretionary stocks led the pack, followed closely by technology. Only one sector, Energy, experienced losses during this period, as the demand for oil fell (perhaps permanently).
Why do we see such a disconnect between the market and real economy? We’ve provided several reasons in previous newsletters. Today we’ll focus on the actions of governments and central banks, which unleashed a massive global fiscal and monetary stimulus earlier this year. This “wall of liquidity” infused every corner of the financial markets, but particularly in two key areas. First, the largest and most liquid stocks (well-known names like Apple and Google) continued to enjoy the greatest inflows of cash. Investor preference toward big companies boosted the performance indexes weighted by company size (such as the S&P 500 and All-Country World index [ACWI]). As a result, the standard, “capitalization-weighted” ACWI has outperformed the equal-weighted version of this global stock index by 5.6% in 2020. Second, technology stocks have been leaders during this period of COVID-induced restructuring, with the tech sector up roughly 25% year-to-date. Most other sectors remain down for the year or are just muddling along.
Growth stocks are the leaders—for now
We don’t think this stark performance differential is sustainable; the chart below helps illustrate this point by showing returns and earnings growth for several key market categories since 2017. Each black bar represents the total return of stocks in that category. Each colored bar shows the growth in their earnings during the same period.
You can see that US growth stocks (which include most tech companies) have enjoyed a 22% annualized return over the past few years despite only achieving a 1% growth in earnings. This low level of earnings growth occurred in spite of their being the beneficiaries of COVID-19 related restructuring. As Jesse Livermore, the author of this chart, stated: “to put the point bluntly, I think we’re being collectively gaslighted by the price action here, and by these irresistible stories of permanently-altered, competition-immune, hyper-profitable future landscapes. Kill Covid and this segment is going to have problems.”
Source: https://twitter.com/Jesse_Livermore/status/1312962302635896833
Fortunately for diversified investors like KCS, the exuberant valuations of these storied growth names have not made their way into other portions of the market, including most of US value and international stocks. We continue to find high quality companies with reasonable growth rates trading at very attractive valuations, and our weightings continue to tilt toward to these names as technology valuations become ever more frothy.
No market trend lasts forever
What could be the catalyst for a rotation away from growth (tech) and toward value (almost everything else)? The trigger that shifts a trend can be difficult to identify ahead of time, but we believe that growth stocks’ heady valuations are underpinned by the belief that interest rates will stay low forever. It’s important to understand how much that belief permeates every facet of the financial markets. Low interest rates help support large government deficits, justify rich valuation multiples (particularly for companies whose earnings growth projections extend far into the future), and cause investors to reach for yield by taking on more risk. At the same time, borrowers everywhere are rightfully taking advantage of low rates.
Governments around the world are issuing trillions in debt, while consumers and companies are refinancing for lower and longer. Nearly every day, we see another company issue new 30-year bonds. Berkshire Hathaway just issued one in the US at 2.45%. In Europe, PepsiCo issued one at 0.45% (for 30 years!). What happens if buyers eventually revolt against this massive new supply of bonds and start demanding higher rates of interest? At some point, we think we will see a rush to the exits as fixed-income investors reevaluate their positioning in these low-yielding assets. And when this happens, interest rates—particularly at the long end—will rise and growth stock valuations will start to tumble.
Another potential catalyst for a shift in market leadership is geopolitics, especially the upcoming US elections. The most likely outcome (despite all the paranoia and nail biting among Democrats) is that Biden will win the presidency and Democrats will keep the house. A Democratic sweep in which the party also wins the Senate is also a distinct possibility.
Unlike many in the wealth management industry, however, we do not subscribe to the view that Democratic control of the federal government would be devastating for the markets. In fact, Moody’s recently published its projections for the economy under several election outcomes. A Democratic sweep was projected to lead to the fastest rates of economic growth and the quickest recovery in unemployment (see the graphs below). Other analyses concur: Goldman Sachs has also said that a Biden win would be better for growth: https://markets.businessinsider.com/news/stocks/stock-market-outlook-biden-blue-wave-boost-growth-goldman-sachs-2020-10-1029649255
Concluding Thoughts
The chart below is similar to the one we showed earlier, but this one shows returns and earnings growth going back to 1976.
Source: https://twitter.com/Jesse_Livermore/status/1312962302635896833
In the long run, most companies around the world tend to demonstrate real fundamental growth in the 5% – 7% range, regardless of location or other factors. Over the past decade, US growth companies have experienced one of the most lopsided tilts in history, similar in magnitude to Japanese equities in the 1980’s or tech stocks in the 1990s. It’s possible that this trend may continue for a while longer, at least until the coronavirus pandemic is finally contained. As Citigroup’s CEO said just a few months before the great recession started in 2007, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
At KCS we believe that investors in some of the more exuberant portions of the market are similarly at risk today. For this reason, we continue to stay diversified, investing throughout the world and in all major market sectors. We don’t take oversized bets on individual companies or even individual sectors, and we don’t weight our holdings by size as do the major indexes. While our approach can sometimes cause KCS portfolios to deviate from index returns, we believe that it serves our clients well when bubbles inevitably burst. Practicing true diversification and avoiding concentration in a handful of “hot” stocks can provide protection against the increased volatility that occurs during times of uncertainty.
Yours truly,
The KCS Investment Team
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