Stocks began the 3rd quarter on a strong note, with the S&P 500 returning about 5.6% for July. We believe that economic data continued to stabilize during the month, and 2nd quarter corporate earnings have thus far come in well ahead of investor expectations. Covid-19 remains a key risk factor for stocks and the economy moving forward. While uncertainty remains elevated, we expect that Congress will soon pass another round of fiscal stimulus, and we believe that the Federal Reserve will maintain its accommodative monetary policies for the foreseeable future.
Most key economic data releases have exceeded consensus expectations over the last several weeks. July ISM surveys (both manufacturing and non-manufacturing) made month-over-month gains, continuing the trend of June’s improvement, and moving back to levels we believe to be consistent with economic expansion. This strength looks to have been confirmed by the Federal Reserve’s regional manufacturing surveys for July which came in at robust levels. Moreover, recent readings on industrial production, durable goods orders, and retail sales have all come in ahead of economists’ projections.
In our opinion the housing market also appears quite healthy. While housing typically lags during recessions, the increased time spent at home due to Covid-19 has motivated many consumers to make meaningful investments in their homes. We have also seen that Covid-19 has led to an increase in demand for houses in the suburbs and more rural areas. These factors, along with the significant decline in mortgage rates, appear to be a boon for the industry. This is not only showing up in the economic data, with metrics such as the NAHB homebuilder survey and existing home sales showing strength, but we are also hearing positive indications from housing suppliers. Paint producers, pool companies, and HVAC systems providers are a few examples of housing-related businesses which have noted the robust condition of their end markets on recent industry conference calls.
Not all the economic data has been positive. A headline grabber was the recently released 2nd quarter GDP, which came in at an historically weak approximate 32.9% annualized decline. However, we were not overly concerned by this reading given that it was widely expected and is also a backward-looking indicator. Clearly the 2nd quarter was an ugly one due to Covid-19-related shutdowns, but it also seems evident that the economy has strengthened considerably since then. Perhaps of greater concern are the weekly unemployment claims numbers, which have remained stubbornly high, and have in fact increased in recent weeks after having been steadily declining since late March. We believe the volatility in weekly unemployment data is likely the result of the jump in new Covid-19 cases which began during the latter part of June and continued to increase through July. It seems evident to us, that Covid-19 continues to impact economic activity. Fortunately, the growth in new cases and hospitalizations appear to have declined during the latter part of July, and we are optimistic that the economy can resume its rebound should this favorable trend prove to be sustainable.
With a large majority of S&P 500 companies having reported their 2nd quarter profits, aggregate earnings are coming in well ahead of what were admittedly very weak expectations. Companies appear to be exceeding top line estimates by a couple of percentage points, but the highlight to us, is on the bottom line where average corporate earnings are beating expectations by over 25 percentage points. Many companies have also noted the positive linearity of the quarter, whereby there was sequential improvement in business conditions each month. Still, many companies have not given forward guidance, highlighting the fact that the environment remains quite challenging to predict due to the lingering pandemic.
As we look forward, we note that conditions remain highly uncertain. Clearly Covid-19 is playing a large role in this uncertainty, but other factors are at play as well. As of this writing, Congress has yet to agree on another Covid-19 relief package. We think that it is crucial that another bill is passed to support the consumer as well as state and local governments, and that economic activity is likely to suffer otherwise. While it is unfortunate that the issue remains unresolved, we do expect that there will be a favorable resolution in the near term.
The election represents another source of uncertainty and volatility for investors. The outlook for tax, regulatory, and other policies will vary materially depending on the outcome. Markets tend to weaken prior to and strengthen in the aftermath of elections. In our view this is likely a function of the greater clarity that investors gain once the election is over and leadership is established.
As a result of these uncertainties, we continue to think that a diversified portfolio is the best approach to navigating capital markets. In our view, the two most likely scenarios for markets going forward include one in which economic activity continues to improve, and another characterized by weakness resulting from the continued spread of Covid-19. Under the first scenario, we would expect that cyclical stocks would be among the winners, while we believe that tech stocks with secular tailwinds, and more traditional defensive holdings would outperform under the 2nd, weaker growth scenario. Given the difficulty of predicting the future course of Covid-19, we maintain our barbell approach whereby we are investing for both outcomes, focusing our efforts on ensuring that our portfolios can do well under either scenario, as opposed to making a large macro bet one way or the other.
As of July 31, 2020
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