Mid-Year Review & Outlook 2020

Mid-Year Review & Outlook 2020

As the first half of 2020 draws to a close, I want to use this opportunity to record my thoughts on what has been an eventful 6 months for equity markets and ruminate on how the rest of 2020 will shape up.

Against the backdrop of a rampant and destructive pandemic, the world economy is expected to shrink by 4.9% as per the latest IMF projections. Governments across the world implemented nationwide shutdowns with varying degrees of severity to curb the spread of the virus in order to prevent their healthcare systems from being overwhelmed.

However, the economic implications of such an unprecedented move proved to be costly. Many small and large businesses experienced severe cash flow problems as business operations ground to a halt and this in turn led to large number of layoffs while at the same time governments faced  significant pressure on their budgets due to the rising healthcare costs and the need for a fiscal stimulus to prop up the weakening economies. The economic crisis we are facing is extraordinary because it is very sharp, sudden, and widespread.

Figure 1: IMF Growth Projections

Source: IMF

The US economy is expected to contract by 8% in 2020 and unemployment levels in the country are the highest it has been since World War 2. Many small and medium enterprises are struggling to stay afloat while millions of Americans are struggling to make ends meet. Despite the bleak economic outlook, US equities have bounced back after an initial decline in March due to the panic induced selling caused by COVID-19. The rally has been so strong that the market has not only recovered to pre-coronavirus levels, but it is also positive YTD. The gulf between people’s daily experience and the market has never been greater so what could explain the temporary decoupling of the market from the rest of the economy? I put forward a few of my thoughts on the faster than anticipated recovery of the US markets. 

Possible Explanations for the Rapid Market Recovery:

1) Asymmetric Impact on Large & Small Cap Stocks:

The COVID-19 pandemic has had an asymmetric impact on smaller companies compared to the larger ones. Larger companies tend to have stronger balance sheets with high cash buffers and manageable leverage levels which is crucial in weathering the economic crisis.

Cash is critical in overcoming the short-term economic stress as it is needed to maintain operations and large cap companies tend to have higher cash balances than their small cap counterparts. More importantly, large cap companies can easily access finance due to their relative size. This was clearly visible by the number of new credit lines opened with banks during the pandemic. These large companies have access to high quality collateral that reduces the risk of lending for the banks.

With this in mind, it is important to understand the weightage of large cap stocks on the market indexes. The 2 major market indexes, the DJIA and the S&P 500 both cover big companies. The DJIA measures the performance of large 30 blue chip publicly listed companies in the US and the S&P 500 tracks the largest 500 publicly listed companies. During late stages of the business cycle, such as a recession, there is a general flight to safety and investors tend to go overweight on large cap stocks and underweight on small cap stocks. When the index moves up, it is the expectation that these large cap companies will do well relative to the smaller companies. The indexes do not account for the many small and medium sized non-listed enterprises that employ millions of Americans and they also do not account for the many startup companies that are failing. 

2) The Growing Significance of Technology Stocks:

The technology companies greatly benefited from the government mandated lock downs when compared to some other industries. Amazon, Microsoft, and Apple were the biggest gainers during the pandemic with all 3 companies adding over US$ 200 bn each to their market capitalization. See the diagram below for an overview of their performance during the pandemic: 

Figure 2: The Performance of 3 Largest Gainers During the Pandemic

Source: Information from FT repurposed by the author  

It is also important to remember the relative importance of technology stocks in the market indexes. The S&P 500 divides the companies into 11 sectors and the four most heavily weighted sectors are information technology, healthcare, communication services. These sectors were not negatively impacted as other sectors. 

Figure 3: Market Cap of the 5 Largest Companies as a Share of S&P 500 (Microsoft, Apple, Amazon, Alphabet, Facebook) 

Source: Business Insider

Moreover, as these heavily weighted stocks gain a higher market capitalization due to appreciating prices, they get even higher weightage relative to other stocks.  Therefore, during this crisis the indexes have a natural bias towards the sectors that were not adversely impacted by the pandemic.

3) The Speed and Breadth of The Fed’s Response Reduces Tail Risk:

The Fed moved quickly and decisively to respond to the economic fallout from COVID-19 as they implemented various strategies to mitigate the risk.

The Fed cut the fed funds rate by 1.5 percentage points since March 3^rd and the range now stands at 0% -0.25%, thus bringing down the cost of borrowing on mortgages, auto loans and other forms of borrowings. The Fed has also issued a clear forward guidance by mentioning that rates will be maintained at this ultra-low level until late 2022. Such a clear forward guidance on overnight rates puts a downward pressure on long term rates. The Fed also started a program of quantitative easing by first promising to buy US$ 500 bn in Treasury securities and US$ 200 bn in government-guaranteed mortgage backed securities and then upgrading the program to an unlimited amount to “support the smooth functioning of the market”. Moreover, the Fed was willing to be creative and explore uncharted territories as they began buying ETFs that tracked the corporate bond market and thus infusing it with much needed liquidity at a time of crisis.

Through these actions, the Fed has essentially squeezed all the yield out of the fixed-income markets and if investors want any return, they need to direct their money into equity markets. This has forced some investors to increase their exposure towards equities in their hunt for returns despite the risk.

What is important to note is that every time the market falls, the Fed responds with newer and wider policies to appease the fears of the investors. This is an important point moving forward in the second half of 2020.

 4) Hefty Fiscal Policy Measures to Support the Economy:

Along with the monetary policy, the US government launched a massive fiscal policy called the CARES (Coronavirus Aid, Relief & Economic Safety) Act to provide fast and direct economic assistance for American workers, families, and small businesses. The act authorized US$ 2 trn to combat the battle COVID-19 and mitigate its negative impacts. Some of the policies included direct cash transfers to citizens, loan programs for small businesses and support for hospitals.

While the roll out of this program has been far from perfect there is a clear sign the government is willing to do whatever is necessary to mitigate the risk. The fiscal policy has alleviated some of the hardships faced by households and helped to prop up consumer spending and the business loans have bought businesses some much needed time.

 

Investment Outlook & Strategy

Investment Outlook

There is no rule book for investors in this unprecedented situation. As investors struggle to forecast the short-term and long-term implications on earning due to COVID-19, it is understandable that the markets are volatile. Given the uncertainty plaguing the markets, a prudent approach must be employed with a focus on building a resilient portfolio.

There has been a lot of debate about the shape of the economic recovery with some predicting a V-shape recovery where the economy quickly bounces back. At the other end of the spectrum is a L-shaped recovery where the economy will take a long time to recover. I would take a balance outlook and believe that the economy will see a U-shaped gradual recovery.

Many countries are slowly emerging from their self-imposed lockdowns, but the recovery may not be straightforward. While some households may be eager to spend due to pent up demand, other households would have lost their jobs or seen a pay cut and therefore may prioritize savings. Many households will be hesitant to travel or have extended forms of social contact. Companies which experienced a significant deterioration in cash flows and profitability may prioritize rebuilding their cash positions as a buffer before beginning to rehire or invest.

Since this is a global pandemic, the recovery of the US is not just dependent on how well it manages outbreak but also how other countries manage it as well as it this will impact exports and efficiency of the supply chains.  

As economies reopen, there will be an intense scrutiny on the infected cases as well as economic data and thus the positive and negative news will get amplified and lead to increased volatility in the market.

As we begin to emerge from the downturn, markets naturally look towards improving fundamentals. Investors look for the bottom of the market to re-enter the market and it seems that many investors are using the flattening of the COVID-19 curves as a leading indicator of recovery. However, by analyzing the bounce back, the new price to earnings ratios seem high especially given how fragile the containment of the coronavirus is. As cases seem to grow at a faster pace again in the US, it seems that the flattening of the curve may not be a reliable leading indicator anymore. As a result, I believe the marker will move into a period of volatile consolidation.

With uncertainty high, the focus should be on building resilient portfolios which includes multi-asset diversification with a focus on quality stocks with large economic moats, sustainable earnings, and a manageable level of leverage.

Broad-Based Short-Term Investment Strategy:

1) Don’t Fight the Fed

Since the economic and market fundamentals remain weak, investors may be tempted to short the equity market on the belief that a correction is imminent. While this may be a viable strategy under normal circumstances it is important to remember we are not operating under normal circumstances. One of the key reasons why the market is so distorted is because the Fed has deployed various measures to mitigate the economic risks and this has distorted asset prices. 

Figure 4: The relationship between the Fed's balance sheet and the market

Source: St. Louis Fed

As the diagram above illustrates, the market rebound and the Fed's balance sheet have risen almost simultaneously 

Judging by the actions of the Fed, they respond swiftly to any market downturn with more policies aimed at appeasing the fears of the investors. As short sellers, you are essentially fighting against the entire strength and will of the US Fed and that is not an easy fight to win. In the words of Keynes, “The markets can remain irrational longer than you can remain solvent”.

2) Large Exposure Towards Large Caps

As mentioned earlier, large cap stocks are in a better position to overcome the short-term stress compared to small cap stocks. Given the prolonged market volatility, I believe large cap stocks provide safety in these turbulent times. The prudent approach is to invest in companies with strong balance sheets and positive net cash flow.  As the economic recovery picks up pace and economic fundamentals improve, a more balanced portfolio may be possible by increasing the exposure to small caps but in the meantime for investors hoping to preserve capital, I believe large caps are the best option.

3) Defensive Sectors Over Cyclical Sectors

Another key strategy is to invest in defensive industries such as consumer staples and healthcare which will have resilient earnings during the pandemic. It is important to identify companies with a wide economic moat that will not be eroded during this pandemic. Defensive sectors also provide attractive dividends which could help investors looking for stable returns in the low-yield environment present at the moment.

Review: Revisit my analysis on a historically strong defensive company, Altria Group Inc where I look at the company's short-term and long-term prospects. 

4) Tech Stocks Beyond FAANG

While I believe in the long-term viability of the FAANG stocks, based on their current PE levels, they appear to be overvalued. This is understandable given the low negative economic impact the pandemic has had on this sector relative to other sectors and also the immense media attention that these companies have received.

While FAANG stocks may be overvalued, there is still opportunities within this sector. The increased demand for broadband and connectivity and the rising gaming trend all provide opportunities for various players within the sector.

Conclusion:

While the US stock market rallied due to the massive monetary and fiscal response and due to the impact of the index weightage, the broader economic indicators show a troubled state. Markets have also proven to be turbulent as they react sharply to the infection numbers which are constantly evolving. By remaining invested in quality assets, investors can overcome the short-term volatility as the economy transitions through a U-shape recovery while remaining invested and positioned to participate in the eventual market upside.