2Q 2020 Market Summary
Risk assets have rebounded over the past several months in response to monetary and fiscal stimulus, along with signs of improved conditions as the economy slowly re-opens. That said, valuations are now full, and many asset classes are pricing in highly-optimistic scenarios for the future. While we can’t predict the direction of the economy or market in the short-term, we see several potential near-term risks that could slow down the market rally. For example, although the virus is still not contained, the market seems to be pricing in a benign reaction to the recent second wave of infections. Any setbacks to reopening the economy could also slow down financial markets.
We also see the upcoming election cycle as another potential cause of ongoing volatility, though we do not expect a material impact on markets over the long-term regardless of the outcome.
Given heightened levels of uncertainty in the near-term, investors should maintain a disciplined asset allocation strategy that balances both short- and long-term needs and goals. Investors might consider maintaining appropriate levels of liquidity to withstand any shocks in order to potentially take advantage of opportunities those shocks may present. Bonds may still provide a relative level of capital preservation, but fixed income investors will likely realize mediocre returns in the future given today’s low starting point for interest rates. Within equities, investors should maintain diversification across high quality asset classes but avoid areas of economic sensitivity or extreme valuations.
Stocks staged an impressive comeback during the second quarter of 2020. Through the end of June, the S&P 500 Index rebounded 39% from its lows on March 23, and returned 20.5% during the quarter. While the S&P 500 Index is down only -3.1% year-to-date, investors who missed just the five best days of the rally would have experienced a -30% loss so far in 2020, according to Bloomberg.1 This rapid snapback in stock prices highlights the importance of staying invested through periods of market volatility.
While the S&P 500 (representing large cap stocks overall) has recovered much of its year-to-date losses during the second quarter, that has not been the case for many individual companies. The market has clearly differentiated between companies that will struggle due to the pandemic and those that should continue to grow regardless of the economic impact of the virus. While the cap-weighted S&P 500 Index is down only -3.1% on the year, the average stock in the index has fallen by -11%. In the broader Russell 3000 Index, nearly one-third of companies are down more than 30% on the year and nearly half the stocks in the index are down more than 20%.
Large cap growth stocks, especially those in the information technology sector, have posted exceptional relative returns compared to more cyclical value stocks, both prior to and during the emergence of Covid-19. Because growth stocks also outperformed during the first quarter sell-off, the divergence between these two cohorts has widened significantly. Through the first six months of 2020, the Russell 1000 Growth Index returned 9.8%, while the Russell 1000 Value Index fell 16.3%. Similarly, the MSCI EAFE and MSCI Emerging Markets posted returns of 14.9% and 18.1%, respectively during the quarter, but both these indexes were still in the red through the first six months of the year.
Small cap stocks also struggled to keep up with domestic large growth companies. The Russell 2000 Index of smaller companies rose 25.4% during the past quarter but is still down -13% so far in 2020. This is somewhat intuitive, as generally smaller companies have been more cyclically exposed to the Covid-related economic weakness. However, looking back over the past 12 months, the gap between large growth companies (+23.3%) and small value companies (-17.5%) has widened to a remarkable 41% difference in return.
We expect continued volatility in the near-term and believe that stocks in aggregate are full to slightly overvalued following the second quarter rally. At 22 times trailing earnings, the S&P 500 is trading at a price-to-earnings multiple well above its long-term average of around 18 times earnings. Large cap growth stocks are trading at an extreme multiple of 40 times earnings, while cyclical value stocks appear cheap on the surface at around 15 times earnings.
An uncertain economic environment will create challenges for cyclical businesses, as will excessive valuations for some high-flying new economy companies. That said, we continue to see opportunity among high quality companies outside of these two extremes, where prospects for modest earnings growth and valuations are both reasonable.
Bond markets stabilized in the second quarter thanks to monetary stimulus from the Federal Reserve, including the purchase of $2.5 trillion in Treasuries and Agency pass-throughs, as well as aggressive and unprecedented buying of both individual corporate bonds and corporate bond ETFs.
Interest rates were steady during the quarter, but are much lower than the start of the year, and remain extremely low relative to history. Across the yield curve, 1-year Treasury rates were unchanged during the quarter at 0.16%, but down considerably from 1.6% to start the year. Longer-maturity 10-year Treasury rates were down slightly to .65% from 0.70% to start the quarter and 1.92% to start the year. The Bloomberg Barclays U.S. Aggregate Bond Index returned 2.9% during the quarter and 6.1% so far in 2020.
Corporate bonds also benefited from improved expectations and support from the Federal Reserve. The Bloomberg Barclays U.S. Corporate Bond Index returned 9.0% during the quarter, while below investment grade bonds returned 10.2%.
The Bloomberg Commodity Index rebounded 5.1% during the second quarter. The price of a barrel of WTI Intermediate Crude Oil rebounded from $20 to just under $40 at the end of the quarter but experienced extreme volatility during the past three months, including a technical shock in April that drove prices into negative territory for a brief period.
The Dow Jones Commodity Gold index continued its strong performance and returned 12.1% during the quarter. Investors have flocked to gold bullion over the past 12 months due in large part to economic uncertainty and to hedge inflation risk that may arise due to massive global monetary stimulus.