Q3 2020 Investment Outlook

Executive Summary

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 rebound during the second quarter seems out of step with the economic reality.

However, policymakers’ 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 and the price of its stock and bonds. As a result, asset prices recorded significant gains during the second quarter as investors have been increasingly willing to look beyond the impact of the pandemic.

Still, the scale of markets’ recovery gives us pause, and given the disconnect we have generally positioned portfolios in the following manner:

• Uncertainty over the pace of recovery and rich valuations lead us to underweight stocks. Investor complacency and a momentum-based market make stocks vulnerable to disappointment, in our opinion. While long-term returns for stocks are likely to outperform bonds, they are likely to be below average given high valuations. 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.
• Apart from traditional stock and bond allocations, some investors may benefit from weightings to alternative investments—particularly complementary strategies that offer returns with a low correlation to traditional assets. Alternative income investments, such as real estate and private debt, may be good substitutes for an equivalent risk level of stocks and bonds.

Economic Outlook

• 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.
• The economic plunge resulting from efforts to contain COVID-19 was met with an unprecedented policy response. The level of fiscal and monetary support provided by policymakers in the U.S. is estimated to total more than 44% of GDP, with additional measures being considered.
• The support packages appear to be delivering on what they were intended to do—bridging the gap in economic activity caused by the shutdowns and restoring confidence. While financial conditions have improved and economic “green shoots” are appearing, the trajectory of the recovery remains dependent in part on how the pandemic unfolds as businesses begin to reopen.

U.S. Equity Outlook

• Equities recorded their best quarter since 1998, with the S&P 500 Index gaining 20.5% during the period. The 44% gain from the bottom recouped about 75% of the decline that ended on March 23. U.S. large-cap growth stocks led global markets higher.
• Investors have been attracted to their strong balance sheets and secular growth in a slow-growth, low-interest-rate environment. Other factors contributing to large-cap growth outperformance include price momentum and sheer size, given these companies are the largest weights in many indices.
• S&P 500 earnings are expected to decline 23% in 2020 followed by a 31% increase in 2021, which would return earnings to 2019 levels. The price-to-earnings (PE) ratio for the S&P 500 was 21.7x forward earnings as of June 30.

U.S. Fixed Income Outlook

• Taxable bonds posted strong 2.1% returns during the quarter and are now up 4.7% year to date. Investment grade and high yield bonds fared even better gaining 9% and 10% respectively as credit spreads narrowed back toward long-term averages. 
• Tax-exempt bonds returned 2.9% during the quarter and are up 2.5% year to date as concerns over tax revenues begin to fade along with the reopening of the economy.
• Global central bankers have gone all out to support financial markets. The balance sheet of the Federal Reserve has increased from $4 trillion to $7 trillion this year, and the European Central Bank has entered into a 1.35 trillion euro bond-buying program.