|Craig Fehr, CFA, Edward Jones|
Tuesday, July 7, 2020
AMERICANA / DOW JONES ENDS BEST QUARTER SINCE 1987. WHO FIGURED?
Stocks finished the week higher, capping the shortened July 4th holiday week. The second quarter also saw the Dow Jones having its best quarter on record since 1987, closing up 17.8%. Favorable jobs data came in as confirmed cases of coronavirus reach record highs and some states begin to suspend or reverse reopening plans. We believe
the better-than-expected economic news, coupled with the worsening pandemic, shows an economic recovery is taking shape but there is still some distance to go before the economy can pick up full steam.
Midyear Market Checkup: What's the Prognosis?
We’ve reached the halfway mark in 2020. If you’d glanced at the stock market on Jan. 1 and then not again until June 30, you’d see it was down a modest 4%1. But as we are all well aware, that doesn’t even begin to tell the story of the first six months of this year.
The first half of 2020 contained an all-time high for stocks, a global pandemic, the deepest recession since the 1930s and the sharpest bear market drop on record, followed by a market rally that included the fifth-strongest quarterly gain in the postwar era1.
With all of that packed into the first half of the year, what’s in store for the second half? Here’s our midyear checkup.
The Stock Market
Diagnosis: The U.S. stock market declined 4% overall for the first six months of the year. The path there, however, contained a 35% decline from February’s record high and a 44% rally from March’s low1.
The first-quarter decline made it the fifth-worst quarter since 1950 (’62, ’74, ’87, ’08), while the gain in the second quarter was the third-strongest (’75, ’87)1.
This was the 22nd year in the last 70 years in which the stock market was in negative territory at the midway point1. When the market was down in the first half, the average gain in the second half of the year was 3%1.
Prognosis: Stocks are down, but they’re not out. We don’t anticipate a repeat of the first half in terms of the severity of the drop or the steadiness of the subsequent rally, but we do believe there is a compelling case for equities to trend higher as we advance.
Corporate profits should begin to rebound as the year progresses, offering necessary fundamental support for stocks over time.
While volatility reached extreme levels earlier this year, markets were largely directional in the first half, sliding sharply in February and March, then rising steadily through April and May. While the first half looks similar to a “V,” we think the second half of the year may resemble a “W” trend. A rebound in economic output and corporate earnings, along with ongoing monetary policy stimulus, should provide broad support, but we expect bouts of volatility along the way to be sparked by virus concerns, setbacks in reopening the economy and political uncertainties.
Diagnosis: The U.S. economy endured its first recession in more than a decade, ending the longest economic expansion on record. The economy contracted by 5% in the first quarter, the sixth-largest quarterly decline since 19501. All told, this was the most severe economic downturn since the Great Depression and, in many respects, the most unique given the self-induced shutdown driven by the global pandemic.
Data is signaling the economic rebound began to take shape in recent months. Reports last week showed a sharp rebound in home sales, consumer confidence and manufacturing activity following record declines earlier this year.
This was the 12th recession in the last 70 years, with prior contractions lasting an average of slightly less than a year1. In the previous five instances in which GDP fell by 5% or more in a quarter, GDP rose by an average of 1.6% over the following two quarters1. Once those recessions ended, GDP growth averaged 6% over the subsequent four quarters, reflecting the resiliency of the U.S. economy following downturns1.
Prognosis: We believe the U.S. economy is in the early stages of its recovery. We think the initial rebound will take shape more swiftly given the unique nature of this environment in which the economy is being reopened, unleashing a certain amount of pent-up demand from consumers. We expect positive GDP in the second half of the year. While the economic restart will foster the initial recovery, we don’t expect output to return to pre-pandemic levels swiftly. We think the reopening of the economy will proceed in a “two steps forward, one step back” fashion as new cases and hotspots slow reopening plans and certain industries and regions experience lingering impacts.
We anticipate that, following an initial snap-back in consumption and investment from the depths of the shutdown, the economy should grow at a moderate but sustained pace as we move into 2021 and beyond. While we believe the expansion will be durable, the pace of the recovery will be influenced by progress on a vaccine, which we think will be necessary for household consumption to return to pre-virus levels, as well as any lingering scar tissue on the labor market.
Diagnosis: Unemployment went from a 50-year low (3.5%) in February to the highest level since the Great Depression (14.7%) in April, reflecting the abrupt and widespread economic shutdown.
Last week’s release of the June jobs report revealed encouraging labor market signals as we enter the second half of the year:
After losing an unprecedented 22 million jobs in March and April, the economy has added back 7.5 million payrolls in May and June.
The unemployment rate has fallen to 11.1%.
The leisure and hospitality industry gained 2.1 million jobs, while the retail sector gained 740,000, signaling a recovery in some of the most impacted segments of the economy.
Prognosis: Given the lion’s share (70%) of GDP comes from consumer spending, improvement in the labor market will be paramount to the economic recovery. We think the jump in payrolls over the past two months is an encouraging sign, but it will take time for the damage to heal toward anything that resembles pre-pandemic levels.
The drop in temporary unemployment is a good sign that businesses are bringing back furloughed workers, but it also signals that a large bulk of the rehiring has occurred. Coupled with the moderating pace of declines in weekly initial jobless claims, this suggests to us that the rate of hiring will slow in the second half of the year.
We think the unemployment rate can creep lower toward the end of this year, which should contribute to the overall economic recovery. It should not be lost, however, that unemployment is still above the peak level of the financial crisis (10% in 2009), which is consistent with our view that a full recovery will take shape over the coming years, not months.
Diagnosis: The risk spotlight has shined squarely on the health care crisis and accompanying economic shutdown so far this year.
Uncertainties and risks that rattled markets and the economic outlook, such as the trade war with China, geopolitical concerns and weak global growth, have taken a back seat to pandemic risks for now.
Knock-on effects of market volatility and the temporary economic collapse showed up briefly in the credit markets, with high-yield and municipal bonds experiencing their own episodes of dislocation. Crude oil prices may take the prize for the largest overshoot, as oil prices briefly went negative in
April amid worries of a global downturn.
Prognosis: In the near term, we expect the markets to remain most sensitive to the path for (and headlines surrounding) the economic reopening process.
We have maintained our view that the restart will broadly proceed, but with more setbacks and delays than the market seems to be pricing in. Flare-ups in the south and the potential for a second wave in the fall will be central drivers for the market in the second half.
Other risks will re-enter the picture as we advance this year, posing additional catalysts for market volatility. They include:
--Election uncertainties – History shows us that elections tend to be short-term catalysts for volatility as opposed to a long-term determinant of market performance. That said, the polarized political environment seems likely to prompt episodes of market indigestion as we progress toward November. We don’t think the election outcome will be a binary trigger for a market rally or sell-off, but as the election grows near, we think it’s likely the market will react to proposed policies from each candidate. A Biden win would not immediately reverse all of President Trump’s policies, but we do anticipate candidate Biden to emphasize his differences with proposals related to corporate taxes and certain regulations. The market appears rather complacent on the election uncertainties for now, but we suspect one potential source of volatility will be the prospects for a party sweep across the White House and Congress that could pose the potential for more aggressive, less obstructed policy actions.
--Policy uncertainties – We suspect tougher talk related to the trade relationship with China will re-emerge this year. This was a key instigator of market anxiety through 2018 and 2019. We expect policy support from the Federal Reserve and Washington to remain aggressive, but given the critical nature of these policy responses in keeping the economy functioning, future adjustments to monetary and fiscal policy are also sources of uncertainty.
--Longer-term risks – In addressing the more immediate economic threat, policy actions have created potential longer-term implications, namely excessive liquidity (a bloated Fed balance sheet) and rising federal budget deficits/debt. The former raises the potential for higher inflation down the road, while the latter raises the potential for eventual unfavorable fiscal choices (higher financing costs versus higher taxes/spending cuts). Neither of these scenarios is likely to come to a head in the next few years, but they will be legacy impacts of the pandemic policy responses that markets will grapple with over time. We don’t see runaway inflation or a government default playing out, but we do think inflation and interest rates will eventually rise from current levels.
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