Midyear Outlook: The Longest Expansion, Followed by the Shortest Recession?
July 16, 2020
We are now halfway through 2020, which is shaping up to be a very unpredictable and challenging year. The U.S. has entered a recession as economic activity has severely contracted. Unemployment rose from almost full employment to nearly 15%, which is high but much better than many were predicting. Gross domestic product (GDP) growth could contract by over 30% in the second quarter.
While the economic data declined significantly, investors bid up stock prices close to where they started the year. While there seems to be a disconnect between the economy and the stock market, there is a reasonable explanation. Stock markets are forward-looking. The economic data being released is recording what already happened and a decline was largely anticipated. Some economic readings are coming in better than expected, and worst-case scenarios have not been realized. Global central banks, including the U.S. Federal Reserve, lowered interest rates to nearly zero, and governments around the world committed trillions of dollars to fiscal stimulus. In comparison, the current stimulus significantly exceeds the packages during the 2007-2008 financial crisis and was deployed a lot quicker. Many investors saw a positive effect on markets in 2009 and stayed in the market to avoid being left out this time.
Are investors too optimistic though? One of the most popular metrics investors look at to measure stock prices is the price-to-earnings—or P/E—ratios. In aggregate, equities are over-valued: the prices of stocks compared to their expected earnings are at levels not seen since the dot-com days in the early 2000’s. Future earnings could always surprise equity analysts, and this would cause P/E ratios to fall, but these relatively high valuations remain a concern, and we continue to expect more volatility as earnings and prices adjust to expectations.
Bond investors may be a little less convinced of the possibility of a quick V-shaped recovery. Demand for high-quality government bonds is still high as investors bid up the price of these bonds, pushing down the yields to historically low levels. The benchmark 10-year Treasury yield fell below 0.5% in March and has only climbed modestly since then. Bond investors are not alone in this market, however, as they have competition from the Federal Reserve, which is also buying bonds to keep yields low to stimulate the economy. The 10-year Treasury correlates well with mortgage rates and keeping mortgage rates low enables people to refinance, putting more money in their pockets to spend. Also, it enables people to buy new homes at low rates, and corporations can continue to roll their debt without significant increases in interest expense. At-A-Glance Economic data is recovering off of very low readings after many states and counties started to ease social distancing policies. Stock markets are forward-looking and are pricing in a V-shaped, or quick, recovery after massive fiscal stimulus packages were approved. We think the economic recovery will be more U-shaped and therefore slower, with the economy taking longer to rebound as consumers and officials fear a second wave of the virus. With high expectations and valuations embedded in markets, we continue to expect volatility to remain elevated. While there are risks in equity markets, bond markets also pose risks at low rates. A balanced investment approach focusing on long-term objectives is prudent. So, weak economic data is coming in better than expected and there are trillions of dollars in stimulus on the way with extremely low interest rates on the horizon for the foreseeable future. Investors have largely priced in the good news, so if earnings or economic data miss to the downside, we could see some volatility. Having a strong financial strategy in place can give you confidence through the bouts of elevated volatility we are anticipating. Understanding your specific goals and objectives becomes even more important now. Your financial professional can help keep you on track and keep your sights on your long-term plans.
This report is created by Cetera Investment Management LLC
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