Sellwood’s October 2020 Market Snapshot is available for download.
Third Quarter 2020: Tech Bubble 2.0?
Investors rode a $20-trillion global stimulus tsunami to fresh highs over the summer before renewed concerns put a pause on the rally in September. July and August were a continuation of the rebound from the market bottom in late March, with risk assets, particularly technology-oriented shares, reflating amid better than expected data. September, meanwhile, saw a partial unwinding of the growth trade amidst investor concerns over a stalled economic relief bill in Congress, renewed coronavirus concerns, and market volatility surrounding the upcoming November election. Even with the market pullback, global markets were up 8% in the quarter and are now up 1% for the year.
The capital markets, which had rallied almost nonstop from the March lows until August, began to show signs of excess exuberance. Initial public offerings raised more money than at any point outside the tech bubble, high-yield debt has been issued at record low yields, and day traders poured money into technology darlings, increasingly through the use of options, that have contributed to wild price swings. Additionally, futures markets appear to be increasingly wary of a slow or contested election process, pricing in the most volatile November election period on record.
The September stock market adjustment had no corresponding rally in the bond market. Yields, which sit at record lows, were little changed in September, possibly due to the Federal Reserve’s reassurance that they do not anticipate raising rates over the next two years. The Federal Reserve also announced a new operating framework in which they will allow inflation to “catch-up” for any past misses. Jerome Powell, using the customary Fedspeak, provided few concrete details on how the FOMC might adjust monetary policy to meet the new framework.
Second Quarter 2020: Federal Intervention Masks Underlying Economic Uncertainty
Rising Covid-19 cases, mass unemployment, and stop-start reopenings have hurled uncertainty at the markets and yet, the S&P is down only 3% for the year-to-date ended June 30th. The second quarter rally, with the S&P rebounding 20%, has notably amplified one familiar market trend of the recent past, growth’s continued dominance over value. Whatever your preferred alphabet soup acronym for Facebook, Apple, Amazon, Netflix, Google, and Microsoft, the tech-heavy giants have been the comfort food for investors in the Coronavirus world, pushing the Russell 1000 Growth up a remarkable 10% for the year. U.S. value stocks, as measured using French and Fama data, are in their longest and second sharpest relative drawdown since 1933. Similarly, any portfolio tilts away from the large American tech giants and towards small-cap or international markets have hurt relative performance for the quarter and year. Broad international markets are down approximately 11% for the year while the Russell 2000 is down 13%.
Easing financial conditions in the second quarter helped risky bonds rally as the market responded to the promise of support from the Federal Reserve and Congress. Investment-grade US companies are currently able to raise debt at all-time low yields and many did just that, as new bond issuance hit record levels during the quarter. Yields on safe U.S. Treasury bonds were largely unchanged or slightly down for the quarter, reflecting expectations for a low-growth, low-inflation world in the immediate term. Interestingly, despite the record stimulus, market expectations for inflation remain well below the Federal Reserve’s stated 2% target.
Like always, what is in store for markets the rest of the year is anybody’s best guess, especially with the U.S. entering into election season and governors left grappling with budget holes and rapidly increasing Covid-19 case counts.
Every year, we update our forward-looking Capital Market Assumptions – the building blocks of our asset allocation work on behalf of Sellwood clients – as of December 31. Because equity and bond markets have changed so considerably in the first quarter of this year, we have taken the extraordinary step of updating those assumptions outside our normal calendar. With this update, our asset allocation work for clients will reflect market data as of March 31, 2020.
In the first quarter of 2020, equity values plunged, credit spreads widened, and Treasury bond yields declined substantially. The US stock market registered its fastest 30% decline in history while US corporate bonds lost 7% in March. US Treasury bonds were one of the few investments that provided a positive return as yields fell below 1% across the entire yield curve. Inflation expectations for the next ten years were roughly cut in half, as market participants began to process the likelihood of a looming recession. We believe that these dramatic first-quarter market movements have improved return prospects for public equities by about 0.5% per year over the coming decade, and reduced return prospects for investment-grade bonds by about 0.5% to 1.5% per year over the same horizon.
As stock and bond prices changed in the first quarter, their valuations – which inform future returns – changed as well. The following chart depicts a signature valuation metric for several major asset classes. The blue boxes represent quartiles of each valuation metric’s own history, and the arrow represents the change in that valuation metric from December 31, 2019, to March 31, 2020:
In the first quarter, equities and riskier bonds (corporate and high-yield issues) became substantially cheaper and US Treasury bonds became more expensive. As market participants grappled with an unfolding pandemic and processed its implications for the economy, investment safety became more expensive and risk-taking became more rewarding.
Translated into forward-looking assumptions, recent market changes reveal some interesting opportunities. The following chart depicts the real (after-inflation) changes to our annualized 10-year, forward-looking assumptions for compound return. We assume that the prospective return for long-duration Treasury bonds declined, but every other asset class improved:
If inflation expectations did not change, the recent market decline would also have resulted in higher nominal (before-inflation) expected returns nearly every asset class. Higher recession probabilities, however, caused inflation expectations to decline along with risky assets. Our process incorporates future inflation expectations to derive the “headline” nominal compound return assumption. After taking lower inflation expectations into account, we expect that changing markets in the first quarter reduced future bond returns by between 0.6% and 1.4%, and increased equity returns by about 0.4% to 0.5%.
Forecasting higher equity returns, and lower cash returns, means that we are forecasting a higher equity risk premium than we did at the end of the year. The equity risk premium represents expected future compensation for taking the investment risk of owning stocks, relative to owning riskless cash. Prior to the first quarter of 2020 unfolding, we forecasted nearly the lowest equity risk premium since 2012. Stock markets were priced for nearly everything to go right. After the first quarter, when almost nothing went right, we now estimate that the premium has increased by nearly one percentage point a year for the coming decade. While falling short of representing a generational opportunity, we note that stocks are priced to deliver meaningfully better returns, relative to other opportunities, than they were just three months ago. (As a reference point, our methodology would have forecast an equity risk premium of just 2.0% in December 2007, and 6.7% in December 2008.)
- The first quarter’s market movements were substantial enough, in our view, to meaningfully alter the prospects for investment return over the full coming decade. Accordingly, we have revisited and updated our prospective 10-year Capital Market Assumptions to reflect the new information the market has given us.
- Lower yields for US Treasury bonds reflect an unprecedented premium on safety and have reduced prospects for their future return.
- Future returns for high-quality fixed income outside of US Treasury bonds have benefited from lower valuations on a real (inflation-adjusted) basis, but lower inflation expectations result in lower nominal expected returns.
- Lower valuations for risky assets like global stocks provide support for higher future return.
- Compensation for taking investment risk has increased. Risk is positioned to be more richly rewarded over the coming decade than it was a quarter ago.
- Non-Core fixed income, which we define as below-investment-grade and emerging markets bonds, may present a meaningful, if fleeting, opportunity for return enhancement. US High-yield spreads rose sharply not only in response to the global pandemic, but also in response to an oil price war between Russia and Saudi Arabia.
First Quarter 2020: The End of the Bull Market
The longest bull market in U.S. history peaked in February before swiftly falling into bear market territory, as COVID-19’s impact, along with an oil price war, were felt across the globe. In what is never a good sign of the times, market observers were forced to reference the Great Depression and 2008 global financial crisis in order to find comparisons not only for the market volatility, but also for the swiftness of the decline. The S&P 500 Index declined 34% between its all-time high on February 19th and the quarter’s low, set 33 days later on March 23rd. All in, the S&P 500 ended down almost 20% for the quarter, the sixth-largest quarterly decline since 1927 and the worst since 2008.
Market volatility was persistent during the asset sell-off as investors sold anything with a hint of risk once it became clear that the global economy would be skidding to an unprecedented hard stop for the immediate future. The Federal Reserve moved quickly to provide liquidity and funding support, dusting off a wide range of tools last seen during the tumultuous days during the 2008 financial crisis. Congress acted as well, passing a $2.2 trillion dollar rescue package – nearly three times as large as 2008’s – in the final days of March.
Against this backdrop, bonds either protected or disappointed, depending on their day-to-day liquidity and credit quality. US Treasury yields fell to historic lows as investors sought the safety of US Treasury bonds, which rose by more than 8%. Long bonds, most sensitive to rate changes, performed the best. Anything with risk, meanwhile, declined: high-quality corporate bonds declined by nearly 4%, and high-yield and emerging markets bonds, among the riskiest sectors of the bond market, declined by 13-14%.