2020 Global Market & Economy Outlook – Q3 Update

The coronavirus and subsequent government-imposed lockdowns confronted the United States and the world with unprecedented challenges.  Additionally, the ongoing pandemic has weighed heavily on economic activity as investors face the shortest and most severe recession in the post-WWII era. 

The sharp recovery in the domestic markets exemplifies the power of public policy as markets continue their march higher. Monetary support from the Federal Reserve (Fed) included reducing interest rates to zero and a commitment to unlimited purchases of US Treasuries and agency mortgage-backed-securities, amongst various other supportive bond purchasing programs and policy action. Assets on the Federal Reserve’s balance sheet are over $3 trillion higher than they were in February, expanding the current level to more than $7 trillion.  Sentiment surrounding fiscal policy appears less optimistic as enhanced unemployment benefits approach their scheduled July end-date.  The extended benefits have softened the impact of record-level unemployment yet there is resistance in the Senate for an extension.  As negotiations continue, the weak labor market shows little signs of near-term improvement.  In April, more than 20 million people lost jobs and economists continue to revise estimates higher.                                                                                                                     

Current implications for inflation are ambiguous as the coronavirus crisis has led to both supply and demand shocks.  The introduction of the largest stimulus package in history has raised concerns that this excess money supply will lead to rising prices.  More commonly stated as “too much money chasing too few goods”.  This phenomenon may currently be present within certain high-demand consumer goods.  However, a general increase in consumer prices appears unlikely at this time.  Arguably of greater concern in the short to medium-term is deflation, or the reduction of prices of goods.  Recent Consumer Price Index (CPI) data confirmed that the halt in the economy translated to sharp deflationary price pressures, which may ease over the next several quarters.  Deflationary risks are being driven by increasing unemployment and the resulting reduction in wages and consumer demand.  Monetary policymakers may be reluctant to ease accommodative policy so long as the risk of deflation remains.

Overall growth in the U.S. may face continued pressure in the near-term but is likely to gradually recover into year-end as social distancing measures ease.  The current outlook for U.S. GDP reflects a 8% decline this year before expanding 4.5% in 2021. Slower-than-anticipated recoveries in developed foreign economies would exacerbate domestic weakness given the heavily integrated economy. The spread of Covid-19 has led to a projected 4.9% decline in the global economy, with the International Monetary Fund (IMF) noting “extreme uncertainty” around this forecast. Current data suggests global economies are faced with more severe economic downturns than initially expected. This is evidenced by first-quarter GDP results, which surprised on the downside for many advanced economies. Australia, Germany, and Japan were the few exceptions. As we move into the summer months, baseline forecasts suggest global activity is expected to trough in the second quarter. Recent IMF forecasts show economic activity rebounding by 2021, with a projected 5.4% global growth rate.  

Global Equity Markets

In the past two quarters, equity markets experienced both sharp declines and an intense recovery.  Through mid-June, the S&P 500 index experienced 17 daily price swings of +/- 4%.  Historically, the annual occurrence of daily price movements to this magnitude have averaged just above 3 days per year since 1928.  The 30% drawdown in the first quarter was the sharpest on record, occurring in less than 5 weeks. Markets have since recovered, recording their largest 50-day advance, rising nearly 40% entering June.  The second quarter rally has normalized equity valuation levels with major indices setting record highs by mid-June.  The initial recovery was fueled by an emergency stimulus.  Growing optimism of a quick economic recovery as re-openings emerged with prospects of a potential vaccine continued the market’s rebound in the second quarter.   

Following strong performance through late June, investor sentiment has turned neutral, increasing the market's sensitivity to negative economic headlines. This neutral behavior towards risk could produce periods of volatility with large daily price swings.  In the near term, we may begin to see positive economic growth (quarter over quarter) for the third quarter. However, the consensus outlook remains mixed as others weigh concerns of persistently higher unemployment and the potential of further social distancing measures in the areas hardest hit.  Slower economic growth through 2021 would place increased pressure on corporate profit margins.  Globally, the European Central Bank acted in-line with the Federal Reserve, which was second only to Japan.  Attractive valuation levels for non-US markets show higher expected returns in these markets over the next decade calling into focus the need for investors to hold a globally diversified portfolio.

Fixed Income Landscape

The fixed income market was not immune to volatility as equities concluded their longest bull run in United States history. The drawdown sparked a flight to quality as investors rushed into safe-haven assets, purchasing Treasuries and other high-quality bonds.  At the same time, fixed income mutual funds and exchange-traded funds faced historic outflows as an influx of sellers were matched by a shortage of buyers. Investors, both institutional and private alike, scrambled to liquidate their positions. This sudden spike in volatility led bid-ask spreads to widen across the fixed income marketplace as net asset values (NAVs) disconnected from underlying bond prices. High yield securities came under heightened focus as risks from Covid-19 coupled with the collapse in oil prices led to sharp declines in the asset class. Low-quality bond spreads faced dramatic widening, reaching option-adjusted spread (OAS) levels as wide as 1,013 basis points (bps) at the peak of the liquidity-crunch. Dissecting the asset class reveals further disparities. Spreads on Ba-rated notes reached 781bps (7.81%) above Treasuries while the lowest-quality bonds (Caa-rated) widened to 1,761 bps (17.61%). Within investment-grade securities, bid-ask spreads were averaging four to five times higher than just a few weeks prior. The Federal Reserve (Fed) stepped in to address this liquidity crisis on March 23rd with the announcement of the Primary Market Corporate Credit Facility (PMCCF) and the Secondary Market Corporate Credit Facility (SMCCF). The PMCCF provided four-year financing for investment-grade rated companies. The SMCCF was a purchase program for investment-grade corporate bonds. The Fed expanded this program on April 9th with the inclusion of high-yield fixed-income ETFs in addition to the announced stimulus package. The market reacted favorably to this news, which led to the market recovering to near pre-pandemic levels.           

In addition to bond purchasing programs, the Federal Reserve reduced interest rates to near-zero with a target range of 0-0.25%. The Fed continues to maintain a supportive stance, leading Fed Chair Jerome Powell recently stated “We’re not even thinking about thinking about raising rates”, an indication that the central bank has no plans to raise interest rates at this time. 

Coupled with the effects of the U.S. economic downturn, yields are expected to stay low.  An easing of lockdown measures and a recovering economy could pave the way for curve steepening.  In this scenario, 10-Year Treasury yields could reach 1.25% at the end of next year.  This forecast could be challenged by the Fed’s decision surrounding the implementation of yield-curve control.  The Federal Reserve could cap short-term yields at the upper band of the policy range, possibly buying throughout the yield curve to keep long-term yields low. Another method would be capping the long-term interest rate. A combination of capping three-month bills and long-term rates has been implemented in the past during the 1940s as a similar form of yield-curve control. Moreover, if the government distributes another round of fiscal stimulus, the 10-year yield could increase towards the 2.00% level. Alternatively, a resurgence of the virus and further economic slowdowns would place downward pressure on rates. In this scenario, yields could possibly return to all-time lows. ¬¬

Real Assets

Oil prices were not immune as global oil demand and supply became dislocated in the first quarter. Demand was grounded to a halt.  The supply/demand imbalance, along with imbedded costs such as storage, drove oil future contracts into negative territory in April (-$38/barrel).  Prices began to normalize toward the end of April as Saudi Arabia and Russia agreed to production cuts and US rig counts declined.  Crude oil saw price increases nearing 50% in May as demand stabilized.

Gold saw strong demand as measured in fund flows into commodity-backed exchange traded funds.  Research from Goldman Sachs showed the surging demand was driven by developed market investors which offset a drop to near zero in emerging market retail purchases as prices rose.  Fears of increased inflation following heavy doses of fiscal and monetary stimulus and elevated economic uncertainty contributed to investor demand and are expected to persist over the intermediate term.  Their view that inflation could run above the 5-year forecasted rate near 1% with little interest expressed by the Fed to increase rates caused analysts at Goldman to increase its 12-month forecast from $1,800 to $2,000/troy ounce

Published in Wealth Management

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