Market Perspectives September 2020


Stocks enjoy another banner week amid elevated risks.

Second-quarter earnings data was destined to be catastrophic. However, corporate earnings have been better than many feared, leading to rising investor sentiment and stock prices. The downside, on the other hand, markets may have already priced in many of the positives. In our view, stock prices could be vulnerable to any unexpected news or disappointments.

The economy continues to recover but the next few months could present above average volatility and potentially some downside risks. Nevertheless, we are overweight stocks and believe they will outpace bonds over the coming year.

How is it possible that stocks keep rising? Well, the Fed’s new inflation target of approximately 2% means monetary policy is likely to become even more supportive of the economy and stocks. We believe this higher inflation target could last for several years, thus giving the Fed more flexibility to maintain asset purchase programs.  Of course, inflation may begin moving at a more rapid pace given the weaker dollar, higher commodity prices and (too) aggressive monetary and fiscal policies.

While the Fed is assuring it will remain ultra-accommodative, too much of anything can become risky.  Lest we forget, the recent rise in equity prices has come at the expense of an expanding balance sheet.  Suffice it to say, without the Fed’s support, I don’t believe equity and gold would be trading at current levels.  So, the question on everyone’s mind, is the Fed doing too much and what consequences might we endure if they overshoot?

At least for now, unemployment claims are declining, and we expect the August employment report to show an increase of close to one million new jobs and an unemployment rate that could fall to 10% or below.  This is not a total surprise as the economy and earnings have continued to recover since the outset of COVID-19.  Pandemics are nothing new and, if you live long enough, experiencing another is not out of the question.  Fortunately, they don’t happen very often.  Nevertheless, we think third-quarter GDP growth will show strength, providing additional lift for the economy.

The economy is improving but several disruptive events are at play. The obvious include a pandemic which sparked a sharp recession, civil upheaval, and the presidential election.  These things are monumental and have the potential to create long-lasting effects. Of course, a vaccine or treatment regimen would be a game-changer, but for now, we expect the election will remain focused on measuring the speed at which our economy rebounds. Investors appear to be banking on a vaccine or medical treatment which would allow the economy to get back on track more quickly.  But even with better news on the coronavirus treatment front, the economy will struggle to get back to pre-pandemic conditions since many sectors have been severely damaged.  On the election front, the candidates could not be more different – Trump is pro-business and seems to believe fully a free country is the only way.  Biden hasn’t illustrated or stated his position. He is surrounded by so-called socialists which distorts what could be a reasonably good candidate.

Fundamentally, regardless of who wins the election, America has a spending problem – rising debt and deficit levels could eventually create problems. There is no doubt excessively high budget deficits and debt-to-GDP ratios are unsustainable in the long term and the rate at which we are adding debt and printing money could eventually lead to a calamitous outcome. Monetary policy may provide some additional market support, but future stimulus should be considered a fiscal solution and that is never an easy conversation and rarely becomes policy. The current price of stocks might come under pressure if interest rates rise. Given that earnings expectations have fallen this year, the increase in stock prices is likely the result of two things – price to earnings multiple expansion and government intervention.  In other words, stocks and bonds look overvalued but we think bonds are more overvalued than stocks. Stock prices may continue their climb as the economy recovers and political risks eventually fade but some increased volatility and pullback from current values should not come as a surprise since stocks appear priced for a best-case scenario.

Bottom Line:

The economy is improving and monetary policy support has delivered hugely and asserts it will continue its very accommodative stance.  This set of conditions has provided the necessary stimulus to push stock prices higher, and bond yields lower.  With a dearth of appealing alternatives for investors, more and more money is flowing into equities, potentially creating overbought conditions and the perfect opportunity for profit-taking and downside risk for stocks.  For the short-term, we suggest investors continue to approach the markets with caution. For longer-term investors, staying invested with appropriate levels of risk is a tested strategy that provides consistent results.