As we reflect on the first half of 2020, we are reminded of the fact that the economy and financial markets are not always in sync. While the rapid decline in asset prices during the first quarter was logical to reflect a lower profit outlook and heightened risks, the rapid rebound during the second quarter seems out of step with the economy.
However, policy makers’ efforts to bridge the gap in economic activity has reduced downside risk, which allows investors to look further into the future to identify the value of a business when valuing stocks and bonds.
Second quarter GDP is expected to post the largest decline ever as the economy plummeted during the self-prescribed recession. The number of unemployed persons skyrocketed with the unemployment rate quickly jumping to a record high of 14.7% in April, well above the 10% peak reached during the Global Financial Crisis.
Investors appear to be pricing in a favorable economic and profit backdrop in 2022 and beyond. At midyear, stocks have recouped much of their decline with the S&P 500 down just 3%. Bonds have recorded an impressive 5% return year-to-date. Both have benefited from central bank and fiscal stimulus, which has reduced economic risks and provided a support to “normal” market functioning.
Significant improvement is expected in the third quarter as lockdowns are eased, but the pace of growth will likely moderate after a strong initial bounce. U.S. output may not exceed its prior peak until early 2022. Employment should improve over the coming months as businesses reopen, but the unemployment rate could remain near double-digit levels as we enter 2021.
Positioning in an Out-of-Sync Moment
Uncertainty over the pace of recovery and rich valuations that seem to be pricing in a return to 2019 profit levels by the end of 2021 lead us to underweight stocks. Investor complacency and a momentum-based market makes stocks vulnerable to disappointment, in our opinion. Long-term returns for stocks are likely to outperform bonds; however, stock returns are likely to be below average. We recommend tilting portfolios toward the U.S. and quality, growth-oriented companies.
For bonds, weak growth, low inflation and the central bank’s commitment to low rates are positive in the near term. (However, low interest rates mean low expected returns over the long run.) We see investment grade corporate bonds and high yield bonds as more attractive than U.S. Treasury bonds in the current environment.
We also see higher-quality municipal bonds as offering good relative value. We are avoiding the most economically sensitive, such as municipalities and projects that derive revenue related to travel, public gatherings and senior living.
We like general obligation bonds from strong communities and schools—but not if they have pension problems or high debt or unbalanced budgets or shrinking populations. We like many large colleges, but only if they have strong budget performance and a stable to rising enrollment trend. Among housing bonds, we look for strong federal and state support. And sales tax bond revenues have held up better than initially feared; we like these where we see strong wealth levels and a stable to growing population.
Apart from traditional stock and bond allocations, some investors may benefit from weightings to alternative investments—particularly strategies that offer returns with a low correlation to traditional assets. Alternative income investments, such as real estate and private debt, may also be good substitutes for an equivalent risk level of stocks and bonds.