Recent Developments: After a rollercoaster ride in the spring and summer, the U.S. economy appears to be entering a flatter stretch of renewal ahead of the pivotal 2020 presidential election. The thundering economic rebound following a historic recession in the wake of the coronavirus pandemic has shifted into a more lukewarm recovery. Consumer spending has slowed, business investment has softened, and the number of people going back to work has tapered off.
The end of massive federal aid for the unemployed and small businesses also appears to have tapped the brakes on the speed of the recovery. The economy did not suffer as badly as many predicted when federal aid dried up, but incomes for millions of Americans were sharply reduced and some businesses were left high and dry. The odds of additional government help before the November election seems more and more unlikely. Democrats and Republicans have been sharply divided over how much to spend and have made no headway in negotiations since the last aid package expired in July.
So, what is going to get the economy moving faster or keep it growing?
States have begun to ease coronavirus restrictions and give businesses more leeway to operate. The Federal Reserve, for its part, made it quite clear that it plans to keep U.S. interest rates at a record low for at least three more years — if not longer. And most importantly, people have begun to go back to work. Not as fast as they did earlier in the recovery, but the economy is still adding more jobs than it is losing.
If that is the case, the U.S. is unlikely to slip back into another economic malaise.
Outlook: The U.S. economy continued its steady recovery from the sharp declines in the second quarter as demand and output strengthened. U.S. service-sector and manufacturing companies reported solid growth in September, a positive signal for overall economic growth in the third quarter.
The question now turns to whether the economy’s strong performance can be sustained into the fourth quarter. Coronavirus infection rates remain high in the U.S., and mounting uncertainty over the presidential election could further push down business optimism. The path ahead continues to be highly uncertain. A full recovery is likely to come only when people are confident that it is safe to re-engage in a broad range of activities.
Assuming no major second wave of the virus leads to another round of shutdowns, it is reasonable to expect the American economy to recover much of what was lost to the pandemic over the past year. While growth appears likely to slow after its initial burst on reopening, it should pick up again once a vaccine is available. As a result, GDP is expected to regain its pre-recession level by the first quarter of 2022.
Based on the Federal Reserve Bank of Philadelphia’s U.S. Coincident Index, the gauge of U.S. economic activity registers an August 2020 reading at the 100th percentile from January 1979 to August 2020. Source: Capital Market Consultants, Inc.
Recent Developments: Despite the ongoing pandemic, U.S. equity markets continued to rebound during the first two months of the quarter. Market volatility spiked in the final month of the quarter as investors focused on the reacceleration of positive COVID-19 tests along with indicators that a vaccine will likely not be available until the summer of 2021 or later. Throughout the quarter, the rising stock market has been at least partially driven by the federal government’s aggressive efforts to ensure that the capital markets remain liquid and investors stay confident.
Overseas, investor optimism rebounded with less vigor than in the U.S., especially in Europe where the economy contracted even more severely during the COVID-19 shutdowns. Additionally, a new spike in cases in Europe is fanning fears of a second wave of the pandemic. As in the U.S., central bank accommodation and government stimulus have played an important role in stabilizing international economies. Corporate earnings growth was sharply negative during the quarter, but generally better than expected. Emerging market stocks registered a strong return in the third quarter, boosted by optimism toward progress on a COVID-19 vaccine and the ongoing economic recovery.
In fixed income markets, the overall environment was largely "risk-on" during the quarter, although September was more muted amid rising COVID-19 infection rates and renewed lockdowns in some countries. Government bond yields were mixed, with the U.S. 10-year yield rising 3 bps, the UK 10-year yield increasing 6 bps, and the German 10-year yield falling 7 bps. Corporate bonds outperformed government issues with U.S. high yield issues gaining 4.6%. International bonds outpaced domestic issues as foreign currencies exhibited strength, relative to the U.S. dollar.
Outlook: In the U.S., supportive monetary and fiscal policies, the potential of a COVID-19 vaccine, and favorable fundamentals anchored by modest inflation are among factors supportive of equities. However, after the dramatic rebound from the March 23rd lows, an equity market pullback would not be surprising. Volatility is expected to remain elevated into the new year for as long as the duration and the impact of COVID-19 remain uncertain. Uncertainties surround the U.S. election, particularly as they may impact tax policy, government regulation, and the re-escalation of U.S.-China trade tensions.
If the post-coronavirus economic recovery favors undervalued cyclical value stocks over expensive technology and growth stocks, developed international equities should perform well as major foreign stock indexes are overweight cyclical value stocks, relative to the U.S. In Europe, economic indicators have rebounded through the September quarter following the easing of lockdowns. COVID-19 infections have been rising, but hospitalization and death rates remain low. The prospect of nationwide shutdowns appears low. In Japan, the economy continues to lag the recovery of other major regions. Prime Minister Yoshihide Suga is expected to provide further fiscal support before the year-end. Despite this support, the Japanese economy may remain a laggard in the recovery, due to constrained monetary policy and deflationary dynamics. In the UK, Brexit dominates the outlook, and the risk of a hard exit is high.
In emerging markets, uncertainties surrounding global trade policies will likely remain a headwind until investors get clarity about the state of trade negotiations after the U.S. election. COVID-19 is also a headwind as many emerging market economies are still battling to contain the virus outbreak and lack policy space to cushion the blow. Rhetoric has been escalating between the U.S. and China. Relative to the U.S., there is value in emerging market equities, and China’s early exit from lockdown measures as well as stimulus support should benefit the asset class. It is becoming clear that the lifting of lockdowns and government stimulus are the most important elements in determining how economies recover from the current health crisis. Unfortunately, the pandemic has caused almost all developing countries to experience a deterioration of budget balances and rising debt-to-GDP ratios. This weaker fiscal position makes emerging markets more vulnerable.
For fixed-income investors, the environment remains relatively challenging with yields on 10-year Treasuries ending the quarter around 0.68%. Given the Fed's commitment to a "lower for longer" rate policy, the yield on the 10-year Treasury is expected to remain below 1.0% for the foreseeable future. The fall election may prove to be a catalyst for rate moves, particularly if a Democratic sweep becomes reality. Markets would likely perceive this to be a risk-off event, driving yields lower. U.S. investment-grade credit issues have seen spreads narrow. Valuations in this asset class appear a bit rich. Investment-grade corporate credit spreads are expected to remain range-bound in the near term. U.S. high yield bonds face significant economic headwinds and high yield credit spreads may feel the pressure of increasing defaults, downgrades, and bankruptcies. Caution is thus warranted. In emerging markets, the pandemic continues to weigh on fundamentals, but dovish central bank policies remain supportive. Broadly speaking, high quality fixed income should continue to play a useful role in managing overall portfolio risk.
Based on the S&P 500 trailing twelve month Price-to-Earnings ratio, the gauge of U.S. equity valuation registers a current reading at the 3rd percentile from January 1957 to October 8, 2020. Source: Capital Market Consultants, Inc.
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About the indices presented above:
Standard & Poor's 500 (S&P 500®) Index is a market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the Nasdaq.
The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
The MSCI ACWI (All Country World Index) is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world.
The MSCI EAFE Index is an equity index which captures large and mid cap representation across Developed Markets countries around the world, excluding the US and Canada.
The MSCI Emerging Markets Index (EM) captures large and mid cap representation across 24 Emerging Markets (EM) countries.
The Bloomberg Barclays Global Aggregate Bond Index measures global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
The Bloomberg Barclays US Aggregate Bond Index measures the performance of the U.S. investment grade bond market. The index invests in a wide spectrum of public, investment-grade, taxable, fixed income securities in the United States – including government, corporate, and international dollar-denominated bonds, as well as mortgage-backed and asset-backed securities, all with maturities of more than 1 year.
The Bloomberg Barclays US Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets. It is composed of the US Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities.
The Bloomberg Barclays US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
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