• The sequential improvement in global monthly economic data is a welcome signpost, but it is our view that year-over-year data trends more acutely reflect private sector financial conditions. Incrementally higher financial asset valuations may hinge on the breadth and speed of global economies re-opening.
• The Fed’s bold policy response to the economic downturn effectively created a floor for risk assets and a ceiling for both credit spreads and the U.S. dollar. The degree to which foreign developed central banks follow suit may support multiple expansions among foreign-denominated equities relative to U.S. stocks. Low inflation expectations should allow central banks to support further accommodations, while the economic downturn may also pressure elected officials to pass fiscal stimulus.
• Halfway through 2020, multiple known unknowns appear priced into financial assets. As such, the short and intermediate-term outlook for risk assets will likely hinge on economic reality relative to expectations in the second half of 2020 and unknown unknowns that may emerge. Second and third-quarter corporate earnings results should indicate the pace of economic recovery in 2021.
We began the year bearing a cautious view regarding opportunities across the financial markets. Evidence of a maturing economic cycle and somewhat elevated valuations (on the heels of the strong returns generated by markets in 2019) caused us to pause, thoughtfully take stock of the investing landscape and conclude that a focus on risk management trumped striving for return in 2020.
While our forecast certainly did not contemplate the emergence of a global pandemic unleashing, in essence, a ready-made and debilitating economic slowdown, our decision to elevate considerations relating to portfolio risk reaffirms the necessity for investors to be adaptable to evolving economic and investing backdrops.
More recently, markets have taken their cue from nascent data hinting at the potential containment of the virus and society’s ability to, perhaps, nimbly affect an economic re-awakening. Recent returns across risk assets appear indicative of a seemingly unrelenting and robust economic recovery in the second half of the year.
However, we caution investors to remain on guard. Although we are hard-pressed to imagine that the environment confronting investors the last several months will be replicated any time soon, we do expect market conditions will remain tenuous until a more comprehensive resolution to the health crisis is devised.
Financial Market Conditions
The International Monetary Fund (IMF) expects global GDP to shrink 4.9 percent in 2020, which would mark the worst global economic slowdown in nearly 100 years. The IMF forecasts a gradual recovery in the second half of 2020, and 5.4 percent growth in 2021 (down 0.4 percent from its April forecast), anchored on the expectation that global economies will experience a smooth path toward normalcy.
While the sequential improvement in U.S. business activity1 was a welcome signpost that the pace of economic contraction slowed considerably in June, year-over-year trends more acutely reflect the challenging conditions facing the private sector. This trend highlights an important consideration when measuring progress toward a recovery: sequential improvement in economic data is encouraging, but year-over-year comparisons more accurately illustrate the economic reality facing many businesses and households. Economic data tied to household consumption, which historically represents about two-thirds of U.S. GDP growth, underscores that point. Compared to last year, May retail sales fell 6.1 percent, inclusive of a 17.7 percent increase over April. A vital measure of the eventual economic recovery will be the speed by which year-over-year comparisons improve.
We will continue to monitor macroeconomic data but acknowledge the prospect for incrementally higher financial asset valuations in the back half of 2020 may well hinge on the breadth and speed of re-opening. Therefore, we currently prioritize careful and thoughtful risk analysis focused on aligning investors’ portfolio allocations and investment horizons over a reach for potentially higher return.
Evidence validating the efficacy of these curtailments to forge broader economic stability is promising, but very preliminary. We anticipate several speed bumps on the path to a sustained pick-up in the economy.
Global central banks responded to the economic downturn predictably by slashing interest rates and expanding their balance sheets. In a noteworthy move, the Federal Reserve created more than 10 facilities to broaden the range of assets it was willing to buy, including high yield debt. It further indicated that it stood ready to deploy more monetary stimulus if necessary. The bold policy stance paid off. Volatility across financial assets fell, credit spreads narrowed and the U.S. dollar weakened against developed economies and large trading partners.
In the second half of 2020, we expect the Fed to incrementally grow its balance sheet, albeit at a slower pace. Foreign developed and emerging market central banks may also step up policy accommodations to support their economies, which may buoy international equity multiples. Furthermore, synchronized monetary easing may cause investment-grade corporate bond spreads to tighten from current levels.
Accordingly, and in light of wider credit spreads today than at the beginning of 2020, we removed a theme in our 2020 Outlook: Corporate Credit Watch. The premise for our theme at the beginning of 2020 was that slowing economic growth, tight credit spreads and prevalence of BBB-rated corporate debt warranted more tempered allocations to credit and thoughtful utilization of active managers. Although we still favor actively-managed strategies in the asset class, corporate credit spreads potentially offer a more favorable return profile as the economy begins to recover.
1Business activity is measured using Global Markit IHS PMI Composite data through June 2020
Get the latest research directly to your inbox. Subscribe to our DiMeo Schneider Insights today.
View Related Insights
A Strong Start to the Second Half of the Year
Key Observations • Long-dated treasury yields fell to all-time lows, yet risk assets rallied for the fourth straight month bringing …
- Investment Manager Research | Market Commentary