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GUEST BLOG / By Edward Jones & Co. -- Despite a turbulent September, equities in Q3 continued a strong rebound from their March lows. We think this bounce in economic activity sets a solid backdrop of support for a new bull market. However, elevated uncertainty tied to the pandemic and presidential election is likely to trigger periodic downswings in equities for the remainder of 2020.
Late-quarter turbulence – International small-cap stocks, which benefited from a weakening dollar over the summer, had the strongest returns for the quarter, up 10.3%. Strong performance in Asian equities also led emerging market stocks to return 9.6% in Q3. China, which makes up roughly a third of the MSCI emerging-market index, contained the virus early and sharply increased fiscal spending.
China is one of the few economies expected to have positive GDP growth in 2020, according to the International Monetary Fund. Despite falling 4% in September, U.S. large-cap stocks continued their steep rally as well – up 8.3% over the quarter and 5.9% for the year.
Keeping a lid on bond returns – Cash returns were mostly flat, and investment grade fixed-income returns were up just 0.6% for the quarter, as the Federal Reserve kept the benchmark federal funds rate near zero. The 10-year yield drifted between 0.5% and 0.7%, far lower than the 1.9% yield at the beginning of the year. In addition to adding $3 trillion to its balance sheet through bond purchases, the Fed pledged to keep rates low for several years.
Elevated volatility likely to continue – We think slower growth, the unpredictable path of the pandemic and the upcoming presidential election will make markets vulnerable to occasional downward swings. But with the recovery in corporate earnings likely already underway, we expect the bull market to continue, aided by accommodative monetary policy and fiscal stimulus spending.
Bottom Line Action-- Given elevated uncertainty tied to the pandemic, we recommend broadly diversifying across asset classes to help buffer your portfolio from downward market swings. Adding high yield bonds, as appropriate, may help enhance fixed-income returns in an environment where rates are likely to stay low for the next few years.
FOURTH QUARTER 2020 ECONOMIC OUTLOOK
We believe the economy has formed a durable bottom, but the pace of growth will slow and the return to pre-pandemic levels will take time. A gradual improvement in the labor market, along with low interest rates and fiscal stimulus, should help sustain the economic recovery into 2021.
--Recovery likely entering a slower phase. Following a record GDP decline in Q2, the economy experienced an initial V-shaped recovery. We believe this strong rebound will give way to slower but sustained growth as fiscal relief is gradually phased out and the initial reopening boost fades. Timely economic activity indicators such as tax collection data, employment and electricity consumption suggest that as of Q3, the economy has recovered almost two thirds of its pandemic-induced losses. That’s a good first step, but there is still a lot of ground to cover, and the next leg of the rebound will likely take longer.
--Labor market holds the key. Provided that medical solutions for the virus continue to progress, we think a gradual improvement in the labor market will drive a durable and self-sustaining recovery heading into 2021. Unemployment remains high, and further employment gains are needed to support the handoff from stimulus to growth and help drive consumer spending, which makes up the lion’s share of the economy.
But consumers are in better shape compared to past recessions, with the personal saving rate elevated (14.1% vs. a 7% average over the last 30 years) and debt ratios low.
A two-track economy until a vaccine arrives – Major industries either remain capacity-constrained or experience weak demand, which is preventing the economy from reaching its full potential. This uneven recovery is evident in the shifting demand patterns from services to goods. As of August, consumer spending in goods was 5% above the February peak, but spending on the far bigger category of services (e.g. restaurants, hotels) remained 7% below peak.
Action for Investors 4Q: We expect gradually improving economic fundamentals and low rates to support rising equities. While the range of economic outcomes remains wide, in our view it’s narrower than in the early stages of the pandemic. This is why we believe an allocation in the middle of the equity/fixedincome range is generally appropriate.
4Q EQUITY OUTLOOK.
The longer-term outlook for stocks is positive in our view, with support from economic growth, corporate earnings and interest rates. In the near term, we expect volatility to remain elevated and markets to consolidate recent gains. We don’t believe the gains experienced since March will be matched in the months ahead, but we do think a durable economic expansion will give legs to the new bull market.
A new bull market emerges – Following a powerful six-month rally, the S&P 500 eclipsed February’s high. We expect a gradual economic recovery, accommodative central bank policy and improving corporate earnings to support this new bull market. Stocks are looking across the valley in economic activity, which likely explains the disconnect between the stock market and the economy. While the virus will largely dictate market outcomes, if history is any guide, gains are not exhausted.
Earnings on track to inflect higher – Corporate earnings have taken a sizable hit, declining 35% in Q2. Earnings are expected to improve in the latter part of 2020 and then rebound strongly in 2021. This severe recession was short lived, which helped corporate profitability hold up better than expected.
In addition, earnings for the two most heavily weighted sectors – technology and health care – remained resilient. As the economic recovery plays out, we expect the equity rally to broaden, potentially driving a rebound in asset classes and sectors that have lagged.
Bottom Line 4Q Equity Outlook:
Markets may take a breather – The quarter ahead looks increasingly challenging amid virus concerns, waning fiscal support and rising U.S.-China tensions. At the same time, full valuations leave little margin for error and are likely to drive more moderate gains. We think the new bull market has legs, but we expect periodic setbacks to produce episodes of volatility (read results of U.S. elections).