Economy and Markets: An Ongoing Disconnect
Recent market performance may not reflect the underlying economic reality.
Key Insights
- Complacent investors may be pricing in too little risk of further economic setbacks, but fears of another Great Depression look overblown.
- Some financial professionals are adding risk, showing interest in higher-quality equity and plus-sector fixed income strategies.
- Other professionals are minimizing downside risks, buying what the Federal Reserve is buying in the investment-grade debt markets.
- Whatever path a financial professional takes, our Portfolio Construction Solutions team can help develop a disciplined approach to maximize the opportunities for success.
Economy and Capital Markets Continue to be Misaligned…
As we’ve discussed in previous insights, capital markets appear to have entered the complacency phase of the Crisis, Response, Improvement, Complacency (CRIC) cycle first proposed in 2001 by Morgan Stanley Analyst Robert Feldman.1 Overall investor sentiment has been positive, suggesting a belief that the worst of the coronavirus pandemic has passed and that the economy will reopen smoothly without further waves of infections.
However, there appears to be an ongoing disconnect between positive market sentiment and the underlying economic reality. As shown in Figure 1 on the following page, U.S. retail sales have fallen sharply since February 2020, indicating a larger downturn than was seen even during the Global Financial Crisis. While government leaders are beginning to lift public health restrictions that have kept Americans homebound, the damage already inflicted on the economy has been extensive. Indeed, many retail stores have been forced to close, and experts expect further waves of retail bankruptcies in the months ahead.
Retail Sales Plummet Amid Coronavirus
(Fig. 1) Seasonally Adjusted U.S. Retail Sales: January 1992 Through April 2020
Source: Federal Reserve Economic Database (Federal Reserve Bank of St. Louis).
…But Comparisons to the Great Depression Appear Exaggerated
In today’s hyperbolic social media world, the coronavirus crisis has been compared with the Great Depression and its aftermath. Does the comparison stand up to scrutiny? A look at unemployment data offers some perspective.
As shown in Figure 2, the unemployment rate rose to 14.7% in April 2020, surpassing the previous postwar high of 10.8% reached during the 1982 recession. May’s official unemployment rate defied most expectations and actually dropped to 13.3%. In contrast, the magnitude and duration of the economic damage during the Great Depression is difficult to comprehend. Unemployment peaked at over 25% and stayed above 15% for extended periods in the following years. In fact, the cumulative amount of time the unemployment rate exceeded 15% from April 1929 to April 1942 equals seven full years.
Is This Another Great Depression?
(Fig. 2) Unemployment: Coronavirus Crisis vs. Great Depression
Source: Federal Reserve Economic Database (Federal Reserve Bank of St. Louis).
While the coronavirus crisis represents a significant economic shock, comparisons with the Great Depression appear more sensational than actual. In today’s volatile environment, we believe it’s essential for investors to lean on hard data instead of emotions.
The bottom line: Positive market performance of late has diverged from negative economic data, even if comparisons with the Great Depression appear exaggerated. Massive economic and monetary stimuli have helped markets rebound, but complacent investors may not be adequately accounting for the risk of future setbacks as the economic recovery unfolds. We caution investors to remember that markets do not move in straight lines, and that a watchful eye is warranted.
What Lies Ahead?
Going forward, economic and financial data will harden and more accurately reflect the prevailing environment. As a result, market volatility is likely to increase as investors consider the broader ramifications.
Against this uncertain backdrop and with limited value coming from backward-looking financial data, we believe active management has an opportunity to shine. T. Rowe Price’s proprietary global research platform and emphasis on frequent interactions with company managements could provide a competitive edge as we move forward in a volatile market environment.
A few of the questions we’re watching on the economic, market, and public health fronts include:
- To what extent will recent civil unrest surrounding social justice impact the November elections? The economic recovery? Capital markets?
- Have investors become too complacent as market performance has rebounded?
- How could a potential second or third wave of coronavirus infections impact the economy and markets?
- With initial positive results on potential vaccines, are investors underestimating how long it will take to clear regulatory hurdles, ramp production, and administer a widespread vaccination program?
Investor Concerns and Approaches Vary
Conversations between our Portfolio Construction Specialists and our partner clients have normalized recently, with an increasing focus on longer-term strategic considerations over shorter-term tactical positioning. As we return to a more normal atmosphere—at least for the time being—financial professionals appear to be reverting to what has worked so far in the current cycle: U.S. growth stocks and large-caps. However, we caution against giving up on diversification. As Figure 3 shows, the performance gap between U.S. growth and value has widened during the recent market recovery, highlighting the potential for a value catch-up trade as the economy gradually recovers.
Is Value Ready for a Catch-Up Trade?
(Fig. 3) 1-Year Index Returns: May 2019 Through May 2020
Past performance cannot guarantee future results.
Source: Financial data and analytics provider FactSet. Copyright 2020 FactSet. All Rights Reserved.
While the tone and direction of our client conversations have evolved, it’s important to continue to think about investment ideas in terms of risk. Financial professionals generally fall into two camps: (1) A majority are optimists looking to take on risk and position portfolios for recovery, and (2) a minority are market pessimists looking to de-risk and minimize the potential for further downside. Whatever camp they fall in, we continue to believe that financial professionals should exercise caution as market pricing may undervalue ongoing economic and public health risks.
- Risk-On Approach
With the strong recovery in most asset classes, investors should be cautious when adding risk to portfolios and could consider a barbell approach. When funding positions in fixed income plus sectors, for example, financial professionals may think about reducing credit risk exposure in short-term bond allocations. In simple terms, investors could lower credit risk in an area with lower return potential like short-term bonds, which may help balance higher risk in an area with higher return potential, such as floating rate bank loans.
Fixed income spread sectors currently look attractive on a risk-adjusted basis due to expectations for monetary and fiscal stimulus to boost liquidity. Spreads for U.S. high yield debt look favorable, and the Federal Reserve is purchasing securities and exchange-traded funds in this space. Floating rate bank loans’ superior position in the capital structure offers an element of stability. At the same time, emerging markets bonds, both government and corporate, feature attractive yields and should benefit as accommodative monetary policies enhance global liquidity.
Among equities, high-quality growth companies with healthy balance sheets, including those consistently able to grow dividend payments, appear more likely to survive the current downturn and emerge in a strong position to thrive when the economy rebounds. U.S. small-cap stocks—growth and value—have led equities in previous recoveries, although small-cap performance can be a bumpy ride. At the same time, global strategies with broad investment mandates hold potential by allowing their managers to invest wherever they find the best opportunities. Investors may also consider adding to strategies with a demonstrated history of producing strong, risk-adjusted returns.
- Risk-Off Approach
Some financial professionals are looking to buy whatever assets the Federal Reserve is buying in the investment-grade debt markets. Short-term and ultra short-term bonds, for example, offer liquidity and higher income potential than money markets—although low yields and high redemption rates pose risks.
For investors concerned about the impact of low interest rates on Treasuries, diversified core fixed income can still act as portfolio ballast in volatile markets. Municipal bonds feature low default rates, low correlation to equities, and favorable valuations versus core taxable bonds. However, municipal risks include the potential for tax revenues to fall just as demand for public services spikes—although we note that states and municipalities can apply for grants under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, and even more federal help for state and local governments may be on the way.
Some financial professionals could look to upgrade the quality of their equity allocation and diversify more broadly. Approaches to diversification include managing specific asset exposures by investment style, market capitalization, and geography. Investors could also consider multiasset funds with built-in diversification across a range of asset categories.
Finally, now may be a good time to review portfolio allocations previously included for their defensive qualities, such as option-based strategies, as the recent environment offered an opportunity to stress test these decisions. Financial professionals can assess whether these strategies actually served their intended purposes and if this measure of protection was worth any impact on performance. For example, a comparison of performance and volatility might be helpful versus a traditional bond and stock portfolio such as 40% equity and 60% fixed income.
Conversations between our Portfolio Construction Specialists and our partner clients have normalized recently, with an increasing focus on longer-term strategic considerations over shorter-term tactical positioning.
Portfolio Construction Solutions for Financial Professionals
Whether you want to maximize growth opportunities in your client portfolios, or minimize further downside risks, the experienced investment professionals on our dedicated Portfolio Construction Solutions team are ready to help you think about your investment decisions in a disciplined and strategic manner. Built on the same foundation that supports our world-class multi-asset capabilities, we offer an integrated suite of services designed to enhance investment outcomes and position your practice for success.
No matter where you are on your portfolio construction journey, we’re ready to help.
Portfolio Construction Solutions from T. Rowe Price
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Important Information
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Information and opinions, including forecasts and forward-looking statements, presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass.
The views contained herein are those of authors as of June 2020 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
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