October 14, 2020

Economic trends

Economy

The U.S. economy contracted at an annualized rate of 31 percent during the second quarter given the outbreak of COVID-19 and the associated stay-at-home orders. In response, the U.S. government enacted aid packages which the Congressional Budget Office estimates to cost $2.4 trillion and the Federal Reserve has done more since March than it did during the entirety of the 2008 financial crisis. These stimulus and aid programs are designed to create a bridge over the economic contraction until such time that medical solutions to the COVID-19 outbreak allow economies to open to a much more significant degree.

The economy has rebounded strongly from its lows and is expected to grow at an annualized rate of 15 percent in the second half of 2020. Notably, a dramatic rebound in consumer spending and investment are expected to be the primary drivers of the expansion. While conditions are improving, the economy remains far below its pre-COVID-19 peak and it will take some time to return to that level.

Inflation

Inflation has increased in recent months but remains subdued. In August, the Consumer Price Index increased 1.3 percent, up from 1.0 percent in July and close to zero in May. Looking forward, we expect inflation to follow the trajectory of the economy. If activity increases as expected, price levels should continue to rise as well. For the foreseeable future, we expect inflation to remain contained, but with an upward bias. 

Last quarter, the Federal Reserve announced a significant shift in its monetary policy framework. Under the new framework, our central bank will target an average inflation rate of two percent rather than setting a threshold for inflation at that level. This is significant as the Federal Reserve will no longer be required to raise interest rates when inflation rises above the two percent threshold. It also implies the central bank no longer needs to make pre-emptive rate increases when unemployment rates are low and the economy is strong. 

U.S. Dollar

As COVID-19 spread throughout the world and economies closed, the U.S. dollar benefitted from its status as the world’s reserve currency and it rose to historically high levels. However, over the course of the summer, the global economy began to recover, and our currency declined from its near-term peak. From a historical perspective it remains at a relatively high level reflecting the risks countries face as they attempt to restore their economies to full employment and return to more normal lifestyles. Looking forward, we expect our currency to remain elevated given a high probability of an uneven global economic recovery.

Asset class

Cash/money market instruments

Cash rates have stabilized within a narrow band over the last quarter and are anticipated to remain steady. Monetary support by the Federal Reserve is expected to remain extended as Fed Funds Futures do not project a change in rates until 2022 at the earliest. In addition, the traditional dual mandate of maximizing employment and stable pricing has been reprioritized. With the introduction of average inflation targeting, the Federal Reserve seeks to prioritize economic growth and full employment above price stability. Recent actions by the Federal Reserve reinforce its commitment to maintain a loose monetary policy, yet it is widely acknowledged that a large portion of the Fed’s toolkit has been depleted. We anticipate short term rates to remain stable and approximate current levels in the coming months.

Intermediate government/credit bonds

Easy monetary policy combined with the Federal Reserve’s backing of credit markets, has limited the volatility of intermediate term bonds. The 5-year U.S. Treasury has traded in a narrow range over the last three months and corporate bond spreads remain low. There are some encouraging early signs of an economic recovery, but the nascent rebound remains vulnerable. While the situation is fluid, we anticipate intermediate term bonds to remain within their recent range.

Tax-exempt municipal bonds

State and local governments have been under fiscal pressure as they try to navigate through the Covid-19 pandemic. Fortunately, some of the feared catastrophic declines in revenues have not been realized. Data from the Bureau of Economic Analysis through June 30 indicate that overall tax revenue for all 50 states is down just 2.6 percent year-over-year. Though there are exceptions, it appears that revenue conditions are stabilizing and manageable for most state and local governments.

U.S. equity

The U.S. equity market has rebounded in dramatic fashion from the lows of last March. This growth has been fueled by a number of drivers including an unprecedented level of government aid, unusually aggressive monetary policies, and optimism regarding the eventual development of vaccines and other medical solutions that will allow us to return to more normal lifestyles. Of course, earnings have also been a driver of returns and last quarter they were better than expected. Perhaps just as important, management from many companies noted sustained improvement in the second quarter with each month showing improving trends as we progressed into the summer.

While stocks have rebounded, the market has been bifurcated. This year, stocks of large, growth-oriented companies have significantly outperformed those in the Value category. This makes sense in a world focused on COVID-19 as technology, biotech, health care and e-commerce companies are taking on increased levels of importance. In contrast, stocks of companies with high debt levels, those in cyclical businesses and small-cap stocks have not performed as well given the lack of clear visibility on the depth and duration of the economic contraction.

Looking forward, we expect a heightened level of volatility given the upcoming presidential election, uncertainty regarding the implementation of another government aid package and the pending trial results for several vaccines. In aggregate this is a fluid situation, but we expect the rebound in earnings and economic growth to continue. In order to confirm our view, we will be monitoring developments in the medical field closely as they have the potential to accelerate the return to more normal lifestyles while also allowing for a robust economic recovery. We will also be following the progression of the virus and how governments handle any increases in cases, the economic and earnings data, as well as the course of stimulus efforts from our government.

International equity

The re-opening process has occurred worldwide with countries in various stages of their recovery. In general, Asian countries were the first to emerge from the lockdowns and Europe started their re-emergence in May. Accordingly, foreign markets participated in the rally last summer and rebounded strongly as economies re-opened.

International economies face a similar challenge relative to our experience here in the U.S. In the near-term, aggressive monetary policies and government aid programs are providing support for international equity markets. However, the longer-term outlook is dependent upon the extent to which economies remain open and move closer towards full employment. While there are many country specific variables, in aggregate, the situation is fluid and ultimately is dependent upon the same primary factors driving the U.S. markets: development of medical solutions, the progression of the virus and how governments handle outbreaks, economic and earnings data, as well as stimulus efforts from local governments. 

Commodity

Commodity prices, in the aggregate, have declined this year. The closure of economies around the world resulted in a significant drop in demand for cyclical commodities. In addition, Russia and Saudi Arabia engaged in an oil price war earlier this year that exacerbated the issue, resulting in a sharp decline in oil prices. In contrast, gold has performed well given strong demand for safe-haven assets and a hedge against inflation.

Looking forward, we expect commodity prices to have an upward bias. As the economy recovers, we expect price levels to increase driven by rising demand for cyclical commodities. Demand for precious metals should also remain high given the aggressive monetary policies and the threat of inflation in the years to come.

Potential opportunities & threats

Opportunities

New opportunities/new markets – The outbreak of COVID-19 has presented a unique set of challenges. It also provides businesses with a unique opportunity to differentiate and develop new markets. By some estimates, technology has been pulled forward two to three years and new products and services are in high demand. Prevalent themes include the increased use of technology, home improvement, home ownership, products and services that facilitate working from home, and a significant increase in the use of online retail relative to shopping in stores.  

The emergence of new technologies – The convergence of cloud computing, significant increases in computing power and the advent of the smartphone have created a connected world in which new technologies change the way we live. This convergence has created a number of investment opportunities centered around long-term themes in which disruptive companies can capture high levels of market share in a relatively short period of time.

The evolution of finance — Technological advancements are disrupting traditional methods of banking, finance and transfers of cash. For example, we are experiencing a global shift from paper currency to electronic payments fueled by the popularity of credit and debit cards. Electronic bill paying services and companies that facilitate cash transfers are also experiencing strong demand. This shift is still in its early stages and is expected to have a long runway as it is occurring across both the developed and the developing economies.

Risks

Failure to develop medical solutions to combat COVID-19 – In the coming months several vaccines will complete phase three trials. In addition, advances in testing and therapeutic drugs are also expected. Failure to return to more normal lifestyles will extend the current environment characterized by elevated levels of unemployment and a bifurcated economy in which some industries are struggling for survival. 

Debt-related issues — Sovereign debt levels were rising prior to the outbreak of COVID-19. However, in the wake of the virus government debt has increased significantly. In the U.S., government debt has increased by 14  percent this year. In addition, our government may pass additional stimulus measures that will meaningfully increase that figure.

Trade disputes & rising protectionist sentiment—Trade tensions between the U.S. and China de-escalated as we closed out 2019. However, tensions remain elevated and it appears no further trade deals will be completed in the foreseeable future.

Increasing government regulation of technology companies—Several of the leading technology companies have established dominant market positions and have few competitors. As the power of these companies continues to increase, government regulators are placing them under greater scrutiny by assessing their privacy policies, acquisition plans and competitive practices.

Geopolitical risks—Conflicts in many parts of the world have escalated or have near-term catalysts that may result in a change in dynamics. We continue to monitor events across the Middle East and the South China Sea. 

Cybersecurity — Cybersecurity remains a significant issue as evidenced by persistent attacks on both the international money transfer system, SWIFT, and on systemically important financial institutions.