2020: Third quarter economic market analysis
Each quarter, our economic and investment team creates a comprehensive overview of market conditions. Below is summary of our 2020 third quarter economic market analysis. You can access and download the complete report here.
Assessing the third quarter of 2020 and looking ahead
The economy continued its reopening process throughout the third quarter. The labor market is healing, workers are being called back to work and the unemployment rate is improving. Consumers were supported by jobs and fiscal stimulus, resulting in robust consumption. The COVID-19 global pandemic continues, but the data suggests there is light at the end of the tunnel. In the second quarter, U.S. GDP contracted by 31%, which was unprecedented — something the economy had not seen in either the Great Recession or the Depression. In the third quarter, we expect to see another unprecedented event, this time a significant recovery, with U.S. GDP up 25% (some estimates are as high as 35%) — again, something the economy had not seen in either the Great Recession or the Depression.
The third quarter economic data indicates there is light at the end of the tunnel. There are risks that remain, such as COVID-19 outbreaks, the termination of numerous stimulus programs and the uncertainty of new stimulus programs.
- Economic activity: As global economies reopened in the third quarter and fiscal stimulus supported consumers’ consumption behaviors, economic activity robustly rebounded. We expect Q3 gross domestic product (GDP) to improve by 25%; the risk could be to the upside. However, if there is a resurgence in COVID-19 cases and stimulus programs are not replaced or extended, a household fiscal cliff may develop and consumption may plateau, putting Q4 GDP in jeopardy.
- Initial unemployment claims: The labor market, a proxy for economic conditions, is healing. Unemployment peaked in April at 7% as economies shut down and swiftly recovered by the end of the third quarter, down to 7.9%. The initial unemployment claims figure gives us clues to the direction of the future unemployment rate. Claims peaked in late March at 6.6 million and have recovered to approximately 850,000, still at an elevated level. To put in perspective, during the Great Recession, initial unemployment claims peaked at 665,000.
- Consumer confidence: Confidence improved across all demographic groups. The Conference Board’s Consumer Confidence index jumped in September, the largest improvement since 2003, led by consumer expectations due to an improved outlook in the labor market and business The increase in confidence and purchasing plans bodes well for consumer spending growth in the near term. Stimulus, stock market gains and housing prices all boosted confidence. As stimulus programs expire and are potentially replaced with less generous plans, confidence may stall. Spiking COVID-19 cases may also curb confidence, yet positive news on a vaccine will stabilize sentiment. Consumer confidence data indicates that perhaps consumers are seeing a light at the end of the tunnel.
- Monetary and fiscal stimulus: The fiscal response to COVID-19 has been unprecedented as the total fiscal stimulus has amounted to approximately 13% of GDP compared to the great financial crises at around 7% of GDP. Fiscal stimulus has supported consumption in the third quarter. However, many of the benefits have expired, presenting some risk to the recovery. More stimulus will be required to support growth. Many stimulus beneficiaries increased their savings in the third quarter, providing liquidity for consumption in the event of no additional stimulus. The Federal Reserve (Fed) has ensured the public that low interest rates will remain a long-term strategy. Moreover, the Fed has engaged in aggressive quantitative easing, ballooning its balance sheet from approximately $4 trillion in February to just over $7 trillion today, which has helped risk assets.
- Risks: Numerous uncertainties remain: the COVID-19 virus, reversing reopening plans, changing stimulus plans, high-unemployment, trade tensions with China, a presidential election and dislocations in the financial markets.
Even with a robust recovery in the second half of the year, 2020 annual GDP will contract between 3 and 4%. The economic rebound in the second half of the year is expected to continue into 2021. COVID-19 continues to be a point of uncertainty. We expect the Fed to take no further action in 2020, leaving short rates at virtually zero. We expect the S&P 500 to remain in a trading range between 3200-3600.
Equity market analysis
In the third quarter, the S&P 500 rose 8.9%, reaching new all time highs. Many of the themes in the second quarter carried over to the third quarter. The market rallied due to the reopening of the economy, the anticipation of continued fiscal stimulus and a potential vaccine/therapeutics on the horizon to combat the virus. Positive vaccine news and a gradual reopening of the economy have given investors increased visibility into a corporate earnings recovery in 2021. The stock market, a leading indicator, clearly sees some light at the end of the tunnel.
The impact of the presidential election
While elections can create short-term volatility in the markets, over the long-term, they have limited impact on returns. Over the last 75 years, the market has returned on average 11% per year and has done well under both Democrat and Republican administrations.
The Democrats’ proposal to increase tax rates will negatively impact corporate earnings growth rates. However, the aggressive fiscal stimulus proposal proposed by Democrats should offset some of this earnings impact. We believe we may see some volatility in markets if taxes are increased, but longer-term, the benefits of fiscal stimulus will lead to more consumption and higher markets.
The Republican proposal includes lower taxes and less aggressive fiscal stimulus. Again, this perhaps may result in mixed outcomes: lower taxes may be beneficial for corporate earnings, yet without stimulus, consumption may decline in the short term.
COVID-19 impact on the stock market
COVID-19 still represents a significant risk to earnings and the stock market. However, there is light at the end of the tunnel due to the following:
- While cases are ticking higher, the increase in hospitalizations and deaths remain under control
- In the short run, better therapeutic options are lowering the death rate
- In the longer term, a vaccine is likely to be widely distributed by the middle 2021, which will help the economy return to normal
Traditional valuation metrics, such as the price to earnings (P/E) ratio, indicate the market is overvalued. The S&P 500 trades at 22x forward earnings vs. a long-term average of 16x. However, the dividend yield on the S&P 500 is 1.7% vs. a 10 year treasury yield of 0.8%, which makes owning equities attractive relative to bonds (a dividend yield higher than the 10 year treasury yield indicates stocks are cheaper than bonds).
Our revised S&P 500 forecast is 3300 for 2020. Our 2020 forecast represents approximately 22 times our 2021 EPS estimate of $150. While a higher multiple is justified due to the Fed and low interest rates, our short-term forecast is for the market to be in a trading range of 3200-3600. Our 2021 S&P 500 price target is 3600.
Bond market analysis of third quarter 2020
The third quarter was much quieter than the first half of the year. Interest rates moved mostly sideways. The Fed’s ongoing pledge to do whatever it takes to keep financial conditions accommodative kept investors hungry for risk assets. This drove up equity prices and kept the tailwind in place for the corporate and high yield sectors. Returns were solid, but have begun to lose momentum as rates have fallen nearly to zero and corporate spreads have made a full recovery.
The Fed has effectively gone “all in” by expressing an intention to hold overnight rates near zero through 2023. They’ve also hinted that they will use open market purchases to ensure that longer rates remain near the current historical lows. This has pushed mortgage rates to all-time lows — which has helped keep the housing market moving along at a very brisk pace. Additionally, another huge wave of mortgage refinancing has put extra discretionary cash into consumers’ pockets, which is clearly some light at the end of the tunnel.
The massive level of Federal stimulus has never been seen before and has resulted in an unprecedented growth in the money supply. Zero rates, massive money supply growth and massive growth in the Federal debt burden have ignited a heated debate over the likelihood and timing of a resurgence in inflation (see page 10). While there are numerous dis-inflationary forces that are keeping headline inflation dormant at this time, we believe that a modest resurgence is likely — albeit at least 2-3 years in the future. The debate will continue to simmer, but the inflation figures are likely to remain subdued for long enough to be outside of the current actionable time horizon (12-24 months).
High yield continued its run of strong performance, spurred onward by ongoing stimulus commitments from the Federal Open Markets Committee (FOMC). With the Fed keeping monetary policy at “full throttle” and Congress assumed to be closing in on another round of Fiscal stimulus, the high yield markets are likely to enjoy enough of a tailwind to help drive a reasonably attractive return stream for the next 6-12 months. As with the rest of the bond market, the return stream is losing momentum, but simply collecting the coupon yield of 4.5% should make it a strong alternative relative to other sectors of the market.
Bond market forecast
We believe the Fed will stand firm on its pledge to keep rates anchored near zero — at least through 2021, perhaps longer. Given the many uncertainties around the upcoming political environment and the reopening of the economy (post-COVID-19), longer-term rates are unlikely to move meaningfully higher. This should allow fixed income investors to at least collect their portfolio yield. However, this also means that the decades-long run of 5-10% returns from bonds has likely come to a close. We are much more likely to be facing several years of returns in the 1.0% range.
Download the complete 2020 Q3 Economic Market Analysis
To access more of our Q3 economic market analysis, please download the complete overview. In addition to our overall forecast and evaluations of the equity and bond markets, you can explore our notes on:
- Labor market updates
- Consumer and business confidence
- GDP and fiscal stimulus
- Fed and market valuations
- Election and COVID-19 trends
- Money supply and inflation
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