Stocks finished modestly higher last week, led by technology and long-term growth stocks. The nonmanufacturing Purchasing Managers’ Index, a measure of business conditions, posted its biggest monthly gain and moved back into expansion, adding to the string of positive economic surprises. However, as new COVID-19 cases rise and several states slow down or roll back reopening measures, the economic recovery is likely to start losing some momentum. Uncertainty around the path of the virus and the political outcome of the U.S. elections will likely linger over the coming months, but low interest rates and monetary and fiscal stimulus should help sustain the economic recovery later this year and into 2021.
Second-Half Outlook: More of the Same?
As the French proverb, or the Bon Jovi song (your choice on where to give credit), says, “The more things change, the more they stay the same”. With 50% of 2020 in the books, our outlook for the second half contains a bit of both, as we think some of this year’s prevailing conditions will persist, while some facets of the investment environment are likely to change as we progress through the remainder of the year.
Your financial goals stretch well beyond this calendar year, so your investment decisions should be guided by your longer-term strategy, not simply the next several months. At the same time, disciplined portfolio positioning and periodic adjustments can help keep you on track toward your goals as we navigate the remainder of this historic year. Here are our views on what the second half of 2020 may have in store:
More of the Same:
- COVID will remain in the driver’s seat.
- The developing pandemic set the course for the market in the first half, and we expect it to remain the primary driver this year.
- The market’s focus will remain set on the economic restart. We maintain our view that the reopening process will continue but won’t proceed in as steady a fashion as the stock market has been pricing in through much of this rally.
- Emerging hotspots in certain U.S. states along with the potential for a second wave in the fall will, in our view, stunt the pace of the recovery, but the rebound that began in May and June should persist through the second half. The focus will remain on the progress toward a vaccine, which we think will be a necessary catalyst for the economy to return to pre-pandemic growth.
- Low interest rates linger on.
- Interest rates fell to record lows this year, having ticked up only slightly as the 10-year Government of Canada benchmark rate remains below 0.60%1.
- The sharp recession produced deflationary pressures on consumer prices which, coupled with aggressive central bank policy, put downward pressure on short- and long-term rates. While we believe the worst of the economic downturn has passed, we don’t expect a meaningful rise in inflation or a shift in BoC or Fed actions. Therefore, we think low rates will continue through this year.
- Coming into this year, corporate debt levels were already at their highest since the late 1980s, while domestic household debt is also historically high when compared to disposable income1. On the other hand, U.S. household debt levels are in better shape, having improved (when compared with incomes and assets) since the financial crisis. The financial strain and credit stress that emerged this year is unlikely to disappear immediately. U.S. Fed (and on a smaller scale, Bank of Canada) credit facilities have softened the blow and will continue to do so, preventing a more destructive credit crisis. However, we do think loan delinquencies and defaults will rise later this year given the disruptions to personal and business incomes. The frothy domestic housing market and stretched consumer debt levels will, in our view, slightly dampen the vigor of the rebound in Canada. For investors, this reinforces the importance of owning diversified and high-quality bond investments in line with investment goals, risk tolerance and time horizon.
- Policy-support spigot will remain wide open.
- Policy responses from both central banks and Ottawa/Washington played a pivotal role in arresting the bear market selloff in March, allowing the market to shift its sights from the budding recession to the eventual recovery.
- The unprecedented economic downturn precipitated an equally-unprecedented amount of monetary and fiscal support. The Fed pulled out all the stops, slashing interest rates, pumping liquidity into the financial markets, establishing lending facilities to get credit to consumers and businesses and backstopping large portions of the bond market to ensure the banking and credit markets continued to function (a key difference from the ’08/’09 financial crisis). Meanwhile, federal policymakers passed the largest sizable fiscal aid packages, providing tax and payroll relief as well as business loans in an effort to bridge the income gap to the other side of the pandemic. While there was no policy that could cure the virus, we think the speed and size of this dual-policy response played a positive role in preventing the economy from falling into a depression.
- At the same time, we don’t expect policy support to dry up over the remainder of the year, even as the economy finds a bit of footing. We think the Fed will keep its foot on the monetary pedal until it sees confirming evidence that the economy and labor market have healed materially. Similarly, we think Congress will pass another round of fiscal relief for households and businesses. This will be particularly important and urgent, given that the initial phase of unemployment relief is set to expire at the end of July.
- Domestically, last week’s release of the “fiscal snapshot” (in lieu of a federal budget release) shed some light on the state of domestic finances. The deficit estimate was larger than expected at C$343 billion representing 15.9% of GDP1. This was driven by the extension of the CERB benefits and wage subsidy program. In our view, this was necessary, and better than the alternative of what would likely have been more severe labour market damage. Canada’s federal debt, while moving higher as a result of the deficit, is still favourable relative to other G7 countries, providing some flexibility and scope to Ottawa to pursue supportive fiscal programs to aid the recovery. Interest rates are low, so the debt is manageable. We would expect more stringent fiscal discipline to return to focus once the economy exhibits signs of a sustainable recovery.
Change of Pace:
- GDP will change its sign.
- While the thrust of the recession occurred primarily in a concentrated span (March and April), the severity of the contraction and the fact that it straddled the end of the first quarter and the beginning of the second quarter produced two quarters of declining GDP.
- We expect the latter half of the year to have “+” signs in front of quarterly GDP results, reflecting the transition from shutdown to reopening. We think the initial rebound will come from a spurt of pent up demand as portions of the economy reopen, aided by government payments that filled the gap created by the largest spike in unemployment since the Great Depression. We anticipate third-quarter GDP to jump sharply, followed by a much more gradual pace of growth from there, likely taking a few years before the economy returns to pre-virus total output.
- The labour market will play a key role in the pace of the rebound, with employment conditions looking different from the polar opposites experienced in the first half of 2020. The year started with the unemployment rates in Canada and the U.S. near historic lows, followed by an instant shutdown-driven spike to the highest unemployment rates since the Great Depression. As we progress this year, we anticipate a more gradual descent. The improvement in unemployment will support the gradual rebound in the economy, but the still-elevated level means the economy has a ways to go to return to full health.
- Last week’s release of the domestic June employment report showed that the Canadian economy added back almost one million jobs in June against an expectation for a 700,000 increase2. The unemployment rate declined to 12.3% down from the record high of 13.7% it hit in May, but it slightly trailed estimates as the participation rate (the labour force as a percent of Canada’s population) increased to 63.8% from 61.4%, a positive sign for the recovery2. Average hourly earnings grew 6.8% over the past year impacted by the mix of jobs2. The cumulative two-month job gains provide confirmation, in our view, that a sustainable economic rebound is underway. More reopening of businesses took place in June, which was reflected in the broad increase in employment across regions and industries, with accommodation/food services and retail leading the job creation. Despite the impressive improvement in conditions over the last two months, the labour market has recovered only about 40% of the three million jobs lost since March, and unemployment remains near record highs2. We expect further ground to be covered in the months ahead, but the pace of the recovery will likely slow as the path of the virus remains uncertain, businesses operate below full capacity because of the pandemic, and pent-up demand fades over time.
- Volatility will come from new sparks.
- The spotlight was almost exclusively on the virus thus far this year, appropriate so. The result was historically-high stock market volatility, including some of the largest daily swings in history as well as the fastest 30% bear market drop on record1. We think volatility will be prevalent over the balance of the year, but likely coming in episodes instead of the persistent decline we experienced in February and March.
- Progress and setbacks related to the virus’ spread and the economic restart won’t be the exclusive headliner as we advance, however. We think U.S. election risk will come into the fore as we advance toward November.
- We’d note that elections raise uncertainties – and markets dislike uncertainty – but they aren’t categorically bad for the markets. Historically, stocks have averaged an 11% return in election years1. Moreover, in the three months leading up to the last 20 presidential elections, stocks only declined five times during that period.
- We’d note that elections raise uncertainties – and markets dislike uncertainty – but they aren’t categorically bad for the markets. Historically, stocks have averaged a 11% return in U.S. election years1. Moreover, in the three months leading up to the last 20 presidential elections, stocks only declined five times during that period.
- We’d advise against making long-term portfolio decisions based on the anticipation of a single election. Experienced has shown us that broader trends in GDP, corporate earnings and interest rates have a more powerful, lasting influence on market performance than do individual elections. That said, given the nature of the coming campaign and politically-polarized environment, we do anticipate the market to exhibit volatility as we move toward the election. Candidate differences on corporate taxes, regulation and expansionary programs will likely be periodic sources of market anxiety as the campaign unfolds.
- Changing letters…as in the alphabet, “w” will follow “V.”
- A quick glance at a year-to-date stock market chart fairly closely resembles a “V,” with stocks perched at an all-time high in mid-February and the S&P 500 currently sitting less than 7% from that mark1. The path in between these two points, however, was anything but subtle, traced by a 35% decline from February to March and then a fairly steady rally of more than 40% from the lows1.
- The left side of the “V” reflected the emerging pandemic and subsequent economic damage, while the right side reflected progress related to the virus and the anticipation of the ultimate recovery. We think the path ahead could resemble more of a lower case “w,” as the recovery proves durable through this year and beyond, but with periodic disappointments and risks as we advance.
- All told, the stock market declined modestly in the first six months of 2020. We think the second half can improve on that number, with ongoing monetary policy stimulus, a rebound in corporate profits and progress toward an eventual vaccine all supporting the longer-term case for gains.
- Investors should remember that:
- Staying invested, versus attempting to jump in and out, is the best way to participate in the longer-term trend;
- The calendar can provide mileposts along the way, but your goals don’t expire in 2020, so make your investment decisions accordingly; and
- Now is a good time for a combination of optimism and realism. Position your portfolio in alignment with your long-term goals, while calibrating your expectations – and diversification – for inevitable bumps along the way.
Craig Fehr, CFA
Angelo Kourkafas, CFA
Source: 1. Bloomberg 2. Statistics Canada
The Stock & Bond Market
|S&P 500 Index||3,185||1.8%||-1.4%|
|10-yr GoC Yield||0.55%||0.0%||-1.2%|
Source: Morningstar, 07/12/2020. Bonds represented by the iShares Core U.S. Aggregate Bond ETF. Past performance does not guarantee future results.
The Week Ahead
Important economic data being released include manufacturing shipments and the Bank of Canada’s interest rate decision on Wednesday. In the U.S., the second-quarter earnings season kicks off on Monday, with 8% of S&P 500 companies reporting earnings throughout the week.
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