Economic Flash: The Markets Forge Ahead: What Could Go Wrong?

June 2020

US Economy: Forced savings.

Due to government aid, US personal income rose an impressive 10.5% in April, yet consumers spent 13.6% less, the biggest monthly drop on record as businesses stayed shuttered. Surveys of US manufacturing and consumer expectations stabilized in May, albeit at recessionary levels.

US Stocks: Optimism abounds.

Although volatility remained high, US equities rallied on increasing optimism about vaccine candidates and progress in reopening the economy. US small-cap stocks performed especially well, as “risk-on” sentiment took hold at month-end. Tech remained strong, with the “big 5” now more than 20% of the value of the S&P 500.

Foreign Stocks: Stimulus boost.

Non-US equities also posted gains in May, with developed markets well-outpacing their emerging peers. Stimulus efforts in both Japan and Europe, where a planned €750 billion recovery fund may set precedent for more effective economic cooperation, were cheered by investors.

Fixed Income: Munis rebound.

Municipal bonds had their best month since 2009, as investors anticipate the federal government will provide additional support for states and municipalities. Net asset flows into municipal bond funds turned positive in the last few weeks of May and liquidity has been broadly restored in the muni market after a severe liquidity crunch in March.

Real Assets: Oil bid up.

The price of WTI (West Texas Intermediate) crude jumped 88% in May, the biggest monthly gain on record but remains roughly 40% below where it began the year. A reduction in lockdown measures and expectations for the global economy to begin recovery led to higher demand for fuel.

Alternatives: Middling returns.

Hedge funds posted modestly positive returns in May and are up modestly over the past 12 months. Relative value strategies continued to outperform as investors capitalized on elevated stock market volatility, whereas trend-following managed futures strategies found themselves whipsawed by the vacillating signals.

Equities Total Return

U.S. Large Cap 4.8% (5.0%) 12.8%
U.S. Small Cap 6.5% (16.0%) (3.5%)
U.S. Growth 6.9% 4.5% 25.0%
U.S. Value 3.4% (16.4%) (2.5%)
Int’l Developed 4.4% (14.3%) (2.8%)
Emerging Markets 0.8% (16.0%) (4.4%)

Fixed Income Total Return

U.S. Agg. Bond 0.5% 5.5% 9.4%
TIPS 0.3% 4.8% 8.0%
U.S. High Yield 4.6% (5.7%) (0.3%)
Int’l Developed 0.1% 0.5% 2.8%
Emerging Markets 0.6% (1.5%) 4.4%
Intermediate Munis 2.8% 1.6% 3.7%
Munis Broad Mkt 3.2% 1.0% 3.7%

Non-Traditional Assets Total Return

Commodities 4.3% (21.2%) (17.1%)
REITs 1.7% (15.3%) (7.3%)
Infrastructure 5.4% (18.3%) (9.0%)
Hedge Funds
Absolute Return 1.4% (2.5%) (0.9%)
Overall HF Market 1.4% (2.8%) 2.9%
Managed Futures (1.1%) (1.4%) 1.9%

Economic Indicators

MAY-20 NOV-19 MAY-19
Equity Volatility 27.5 12.6 18.7
Implied Inflation 1.2% 1.6% 1.7%
Gold Spot $/OZ $1730 $1464 $1306
Oil ($/BBL) $35 $62 $64
U.S. Dollar Index 122.7 116.6 115.9

Glossary of Indices

Our Take

The latest economic data continue to point to what we know: At least in the short-term, COVID-19 has made a big dent in the US economy and a rapid recovery is unlikely. We had previously pointed out that government aid via the paycheck protection program and increased/extended unemployment benefits could only help so much, given that consumers are unable/unwilling to spend freely and many businesses are still on standby. The recent big drop in consumer spending is evidence of this. We continue to question the pace at which consumer activity will rebound and whether that level of demand will be enough to allow many businesses to return to profitability. Given these questions, it does come as a surprise that the S&P 500 is down only 5% year-to-date.

Still, there are signs that a recovery may be beginning as economies locally and globally take incremental steps to reopen. Cell phone activity suggests people are leaving their homes more, mortgage applications have risen, and air travel and hotel data each have come off their recent bottoms. That said, financial markets seem to be relying on optimistic scenarios based on rapid reopening and a quickly delivered vaccine.

What We Are Doing

We are skeptical of the recent stock market rally and think the market is highly susceptible to headline risk, especially concerning disappointments with Covid-19 vaccines and treatments and the prospect of weak corporate earnings for 2nd quarter 2020.

The gains posted by most asset classes in May obscure the rocky path that financial markets took to get where we are now, which suggests the current rally isn’t perhaps all that stable. Resumed trade tensions with China, as well as social unrest in the United States and abroad, add further uncertainty to the outlook.

At this point, we are not likely to significantly increase risk in client portfolios although we are seeing some strategic opportunities in both credit and alternative investments. We are glad to have kept our municipal bond positions generally intact, correctly assessing that it was the short-term lack of liquidity, which has since been restored, that was the primary driver of underperformance. We expect the disparity between Treasury and municipal bond yields will continue to dissipate in the months ahead, which should provide an additional lift for client portfolios.