July 2020 Market Commentary: COVID-19 (Coronavirus) and the Changing Economic Landscape
Data Source: Bloomberg
Note: to read full commentary, click here.
July 2020 Highlights:
- Global stocks continued their recovery from the steep 1st quarter sell-off with the S&P 500 now positive for the year. Global markets, as represented by MSCI All-Country World Index or ACWI, were up 5.2% in July led by Emerging Markets (Asian technology) and U.S. stocks (large growth technology). Stocks rallied in the face of global economic declines that saw 2Q U.S. real GDP drop 9.5% (year-over-year).
- Emerging markets outperformed developed market, but it was primarily driven by Pan-Asian stocks (ex-Japan) led by China. MSCI Emerging Markets returned 8.9% and MSCI Pacific ex Japan returned 7.9%. U.S. stocks (S&P 500 +5.6%) also outperformed following strong 2Q earnings releases from many large cap technology companies while Europe (MSCI Europe +3.8%) and Japan (MSCI Japan -1.6%) were notable laggards.
- The month began with a surge in global technology stocks and China-listed stocks. The China Securities Journal, a government-backed publication, emphasized the need for a “healthy” bull market to drive China’s recovery. The MSCI China All Shares Index rose 11.3% for the month. This surge in investor risk appetite partly reversed itself due to continuing fallout over China’s passage of a new security law covering Hong Kong (an action that seemingly violates “one country, two systems.” The U.S. is weighing various sanctions and countermeasures (primarily targeting Chinese technology) while, at the same time, limiting collateral damage to international trade and finances
- China released economic data showing its gross domestic product (GDP) grew 3.2% in the second quarter, perhaps an early indicator of a post-pandemic recovery. However, much of the growth was driven by fixed asset investment and less by domestic consumption which saw retail sales unexpectedly drop by 1.8% from the prior year. There were also reports of China’s Three Gorges Dam experiencing worsening conditions due to heavy rain.
- Investor risk sentiment is expressing itself in seemingly contradictory ways as long duration ‘deflationary’ beneficiaries such as U.S. Treasuries and premium growth stocks performed well alongside pro-cyclical/U.S. dollar depreciation beneficiaries such as precious metals (notably silver which surged to $25/ounce). Precious metals reacted to a sharp depreciation in the U.S. dollar versus its major trading partners.
- These moves could reflect both structural changes in the shape of future economic growth, largely driven by digital media and e-commerce, and an extremely accommodative Federal Reserve who has communicated extremely accommodative policies even if inflationary pressures should resurface down the road. Technology and health care are the only two sectors now reporting year-over-year revenue growth through 2Q2020. The employment landscape appears to be adapting to the new pandemic reality as most of the job gains since February have come from ‘General Merchandise Stores’ (i.e. warehouse clubs and superstores) followed by Couriers (i.e. mobile delivery) and Food/Beverage stores.
- The 2Q earnings decline for S&P 500 earnings has shrunk to a 35.7% drop (from a 44% drop expected at the beginning of the reporting season) thanks to strong earnings releases from bellwether technology and communication companies. Second quarter S&P 500 earnings have come in largely better than expected with sell-side analysts now raising 3Q estimates, the first quarterly raise since 1Q2018 according to Factset. The caveat is that analysts made substantial cuts to their Q3 estimates a couple months ago and are only reversing some of these cuts based on updated company guidance. However, S&P companies are largely confirming a picture of improving conditions with the worst of the economic contraction hopefully behind us.
- The markets continue to rally in the face of an acceleration in global coronavirus positive cases, with renewed breakouts across Europe (Catalonia region of Spain) and Asia (Melbourne, Hong Kong) although hospitalization pressures across the U.S. southern region appear to be easing with a slowing trend in net positive cases. Within the U.S., younger demographics are comprising the bulk of the second wave surge in cases, so the general outlook remains sanguine as the current wave is viewed as more treatable versus the initial March-April wave.
- Global business conditions are showing signs of a rebound, helped by counter-pandemic measures adopted by China (fiscal stimulus, fixed asset investments) and global pandemic relief spending as part of the upcoming European Union budget. European stocks and the euro appreciated over the proposed upcoming EU budget that includes 750 million euros in pandemic relief grants and loans to hard hit southern countries. However, European stocks, particularly banks, weakened subsequent to the budget proposal as a more sober outlook views the relief funding as insufficient to address longer-term debt sustainability problems, particularly Italy’s.
- A broader debate is emerging over how much of the economic contraction resulting from government-imposed quarantines and lockdowns will result in permanent structural ‘changes’ to global economies where many sectors (i.e. traditional retail, travel, leisure, and entertainment) may not see employment recover to pre-COVID levels. For instance, vehicle (general and recreational) sales and home furnishings have largely recovered from March-April declines while the rest of the retail landscape has only partially recovered, as some consumer analysts are interpreting this ‘new normal’ behavior as adapting to a post-COVID consumption characterized by social distancing.
- This month saw U.S. large cap growth stocks pull substantially ahead of small cap and value stocks with this performing gap narrowing throughout the month and then widened again following strong earnings releases from large cap technology bellwethers. Large caps (S&P 500) returned 5.6% while the small caps (S&P 600) returned 4.1%. Growth stocks continue their outperformance over value stocks as S&P Pure Growth returned 6.5% versus 2.3% for Pure Value.
- Among sector performers, a combination of ‘Growth’ sectors (Consumer Discretionary, Communication, Technology, and Healthcare) and ‘Defensive’ sectors (Utilities, Staples) outperformed Financials, Real Estate, and Industrials. Materials performed well benefiting from higher commodity prices (especially precious metals) while Energy was the only negative sector, weighed down by decelerating trends in energy consumption.
- Among factors, Momentum was the only factor to outperform the S&P. High Quality and Minimum Volatility outperformed High Dividend and Value. The latest market advances are increasingly being driven by momentum sentiment resulting in narrower breadth as a handful of large companies are driving an ever increasing percentage of market returns.
- Fixed income posted another strong positive month, helped by the continued recovery in corporate credit and decline in long-term interest rates. The U.S. Bloomberg/Barclays Aggregate Index returned 1.5% for the month benefiting from drop in the 10-Year US Treasury Yield to 0.53%, near the March low of 0.50%. S. High Yield continues to recover from the 1Q20 sell-off, returning 4.7% for the month, as high yield credit spreads broke through 5% for the first time since February.
- The 2-10 Year Term Structure remains positively sloped but continues to flatten as fixed income investors expect the Federal Reserve to exert ‘yield curve control’, pushing rates to near zero all the way out to 5-7 years maturity. This has resulted in a flight to Treasury Inflation Protected Securities as inflation-adjusted (real) yields plunge deeper into negative territory. Is the bond market signaling a stagflation scenario as implied by rising inflation expectations (long-term break-even rates between TIPs versus nominal Treasuries) and anemic economic growth as implied by lower nominal yields?
- Commodities rallied the first week of the month and then flattened out. Copper prices pulled back from intramonth peak levels while the 3-month generic oil price remains range-bound around low $40/barrel. Precious metals (+10.3%) benefited from a weakening U.S. dollar and real interest rates falling further into negative territory. Real estate continues to lag over concerns on how the coronavirus pandemic will affect occupancy rates but showed some signs of recovery later in the month over prospects of federal support for commercial real estate borrowers.
Note: to read full commentary, click here.
By: Benjamin Lavine