Stocks finished lower during October, as the S&P 500 declined about 3% for the month. While the economy continues to heal, markets have been buffeted by the sharp increase in coronavirus cases in the U.S. and Europe, and the lack of progress on a new stimulus bill. Moreover, the period leading up to an election can be volatile even in less uncertain times. Nevertheless, we see reasons for optimism. A stimulus bill may be easier to pass following the election, the Federal Reserve may step up its accommodation, and numerous phase III trials are currently underway in the race to discover an effective vaccine for COVID-19.
Economic data continued to firm in recent weeks. Third quarter GDP rebounded at a 33.1% annualized pace, coming off an historically weak, pandemic-plagued second quarter. The housing market remains quite strong. While both new and pending home sales cooled slightly in September, the NAHB homebuilder survey notched another record high and the latest reading of single-family starts and permits hit levels not seen since 2007. Durable goods orders for September beat consensus expectations and now sit above pre-pandemic levels. The labor market has also shown signs of improvement, with initial unemployment claims recently falling to the lowest level in several months, though they do remain quite high by historical standards.
One aspect of the third quarter recovery that we were particularly encouraged by was the strength in newly formed businesses. New businesses formation in the U.S. increased by 77% to a record level during the quarter. We attribute this to a confluence of factors, including the skyrocketing unemployment in the wake of the pandemic, the on average $1,200 payments received by many households as part of the CARES act, and the abundance of online tools currently available to assist the would-be entrepreneur in starting a business. We see this as confirmation of the resiliency of the U.S. economy, and expect that it should help to support economic activity moving forward.
Third quarter earnings season looks to be off to a strong start. With approximately 60% of the S&P 500 having reported as of this writing, 81% of companies have exceeded earnings expectations. While aggregate earnings per share are down 12.5% on a year-over-year basis, this compares quite favorably with analysts’ forecasts for declines of greater than 20%. Most importantly, as investors base stock values on future cash flows, earnings expectations for the coming year have been trending higher.
Elections can be key sources of uncertainty for capital markets. We have noted that historically stocks tend to weaken prior to, and strengthen following, elections as investors gain more clarity and insight into the political landscape. The biggest risk factor pertaining to the election might be the potential for a significantly delayed result. In our view, markets are likely to shrug off a few additional days of uncertainty, but a longer delay could derail stocks as was the case following the 2000 Presidential contest during which the S&P 500 declined by about 8.4% from November 7th through December 15th when Al Gore ultimately conceded. We do note, however, that the implied future volatility in both equity and foreign exchange derivatives has come down over the last month, suggesting that investors are becoming less concerned about the immediate aftermath of the election.
Another risk facing investors is the lack of progress on a new stimulus bill, particularly in light of the worsening coronavirus conditions across much of the country. The decline in the personal savings rate in recent months suggests that more stimulus will likely be needed to sustain consumption, a key cog of the U.S. economy. We remain optimistic, however, that the prospects for getting a deal done should brighten once the election results are in, and the negotiating parties know better where they stand. Should the pandemic conditions deteriorate further, it would likely put more pressure on politicians to reach an agreement.
Uncertainty may be reaching a crescendo, as investors wrestle with a new wave of infections across the country and the polarizing political landscape. However, we see multiple countervailing factors which keep us from taking too bearish an outlook. There are currently multiple phase III trials underway as pharmaceutical companies continue to work towards developing a vaccine for COVID-19. We would expect that approval of a highly efficacious vaccine would go a long way towards boosting investor spirits as it would considerably lessen a major risk to economic activity and provide light at the end of a long tunnel. We also think that the initial wave of the pandemic which hit the U.S. in the spring has given policy makers and corporations some experience in managing through lockdown conditions, perhaps enabling future restrictions to be more targeted and less detrimental to corporate profitability. Similarly, hospitals appear to be having more success treating patients.
Another key support valve for markets, in our view, is the Federal Reserve, which we believe has more dry powder at its disposal to help to boost the economy. We think that more can be done to backstop credit markets through the Federal Reserve’s various lending facilities, and asset purchases can be ramped up should conditions warrant such actions. Moreover, as noted above, we do expect that ultimately another fiscal stimulus bill will get passed. As we manage through these various crosscurrents, we continue to believe that a balanced portfolio is the best approach. We therefore continue to bifurcate our portfolios with allocations to companies that could do well in lockdown scenarios, as well as to those that we would expect to outperform under better growth conditions.
As of October 31, 2020
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