News & Media
Market Perspectives – Second Quarter, 2020
CitizensTrust – A Division of Citizens Business Bank
Don’t blink, or you might miss the next bear market. That would have been a crazy sentence to write at the beginning of this year, but it sure would have been prophetic.
“U.S. stocks had their worst month since October of 2008 and it was the worst quarter for the S&P 500 and Dow indices since 1987.” That was the first sentence I wrote in last quarter’s Market Perspectives, describing how equity markets had behaved in the first quarter. In fact, it was the worst first quarter ever. Fortunately, here we are three months later discussing the best second quarter since 1938. In terms of an investment time horizon, if you blinked, you missed it.
Global equity markets rose sharply in anticipation that the sharpest economic decline in modern history would be brief. The S&P 500 gained 20.5% in the second quarter after falling 19.6% in the first quarter. A reminder that volatility works both ways. To call it volatile is not enough. The pace on the way down and on the way up were both record setting. From the March lows, it was the best 100 day rally since…1933. Once again, the tech-heavy Nasdaq index was the leader with a 36% gain after “only” declining 14% in the first quarter. The Nasdaq is up 12% YTD. The S&P 500 is down 4% YTD.
During the second quarter, mid and small-cap stocks rose a bit more than the broader market. Mid-cap stocks, as measured by the S&P Mid-Cap ETF, were up 24% for the quarter. Small-cap stocks, as measured by the S&P Small-Cap ETF, were up 22%. International Developed markets, as measured by the EFA ETF, were up 15% and Emerging markets, as measured by the EEM ETF, were up 18%. Globally, stocks recouped a significant portion of their YTD losses with the MSCI World Index rising 19% in the second quarter after falling 21% in the first quarter.
Interest rates began the quarter at the zero bound and the Fed has stated that there is unlikely to be any propensity to move higher until 2022, at the earliest. Longer-term rates and the yield curve were relatively stable throughout the quarter as a result of such Fed commentary. The yield on the 10-year U.S. Treasury began the second quarter at 66 basis points and ended the quarter at 66 basis points.
The most interesting aspect of the fixed income market in the second quarter was the dramatic recovery in interest rate spreads. When investment grade credit spreads “blowout” in response to economic turmoil, it usually takes several quarters to return to the relatively tight levels that represent a confident debt market. This is due to the fact that when the economy is disrupted, the credit default cycle takes time to run its course. This was not the case in 2020. The Federal Reserve stepped in quickly, providing liquidity and purchasing investment grade bonds. This is another form of Quantitative Easing, or QE in Wall Street parlance. The Fed’s balance sheet has grown from $4 trillion at the beginning of the year to over $7 trillion. That is some serious monetary stimulus.
The spread between the average investment grade bond and the ten-year UST is typically between 80 and 200 basis points. This “spread” gets wider during times of financial stress as investors demand more return in order to take risk and lend to corporations. During the financial crisis of 2008/2009, it took over a year for investors to gain enough confidence to drive the Investment Grade spread back below 200 basis points. This year, the Fed stepped in and drove it back to 150 basis points in a matter of weeks.
In record time, the current U.S. recession was confirmed by the National Bureau of Economic Research (NBER) and dated to February of this year. While the current recession is probably going to be brief, we think a “V” shaped recovery that implies a return to previous GDP levels, is highly unlikely.
In hindsight, we now know that the economic shutdown was severe. In the most populous states the duration of the lockdown ran nearly three months. While all states have moved to reopen, the process has been inconsistent and complicated by ever-changing health policies implemented at the state level. Just weeks into this process, many states have reversed course and either shut some businesses back down or delayed their reopening timelines. At this point, the reopening process appears to be an arduous task but fiscal (government) stimulus is temporarily offsetting the negative effects of the shutdown.
On a positive note, fiscal policy, like monetary policy, has been significant and timely. After multiple relief packages, policy makers are working on another trillion dollar plus stimulus bill that would bridge the gap to a fully functioning economy. With over 20 million Americans receiving unemployment benefits, another relief bill will likely be agreed to in bipartisan fashion. This would push the amount of fiscal stimulus beyond 10% of nominal GDP.
The Quarter Ahead
The wishful simplicity of a forced shutdown being lifted and igniting a sharp economic recovery feels incredibly “wishful” at this stage. While re-opening an economy doesn’t sound especially difficult, it is apparently a monumentally complicated task when attempted during a summer of volatile pandemic statistics and election year politics. The policy driven nature of the economic downturn implies that a significant recovery should be achievable, but policy makers have indicated that they will err on the side of caution throughout the reopening process. This will contribute to financial market uncertainty in the months ahead.
The underappreciated news we foresee in the coming quarter is the knowledge we will gain about the virus that has affected all of us in so many ways. In the first quarter we knew nothing. In the second quarter we knew very little and collected a lot of data. In the third quarter, and those following, our knowledge base will grow exponentially. Hundreds of companies are working on solutions, billions of dollars are being spent, and the best scientific minds in the world are putting in countless hours of research. If the Holy Grail is a vaccine, there are over 100 drugs being evaluated and nearly 20 have already entered human trials through a process that is being expedited. This monumental global effort is likely to yield some positive results in the near future. Progress will open the door and allow the natural forces of economic growth to regain their footing.
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