2020 is making it harder to talk about “markets” as if they are a common entity and not thousands of individual companies facing dramatically different challenges and opportunities. I could say that “the market” is up through the third quarter, but that would be a poor description of the year so far.
What has really happened is that a handful of very large tech-oriented US stocks have had a great year while the other 99% of publicly-traded companies around the world have had a year ranging from unexceptional to awful. The dispersion of returns between the best and worst sectors, sizes and styles, just in the US, has been enormous. Through September 30, the Russell Large Growth index was up 24.3% for the year while the Russell Small Value index was down 21.5%.
All US stocks taken together—large and small, growth and value—are up about 5%. Not a bad year given all the headlines. It reminds me of a joke about a statistician who put his head in an oven and his feet in a freezer, saying, “On average, I feel fine.”
Six months ago, all investors cared about was COVID. Judging by what we see from the financial media, uncertainty around COVID has been replaced with uncertainty around the election. Ultimately, future earnings are all that matter. The biggest determinant of earnings in the near-term will be the speed at which we move past COVID and get the economy permanently reopened. As such, the development of a vaccine is the literal shot in the arm the economy needs. We believe it’s coming, but we don’t know the timeline or effectiveness, or how quickly it can be distributed, or if people will even take it. But its arrival will be the catalyst for economic resurgence.
Until then, we must deal with the headwinds. The two key drivers of growth into summer appear to be fading: the benefits from reopening segments of the economy and the benefits from increased unemployment, jobs protection and business assistance. The former appears unlikely to continue without a proven vaccine and the latter is being held back by political uncertainty. There appears to be only a small chance of a new fiscal spending plan being enacted before the election.
The bears point to a resurgence in infection rates, slowing economic indicators, and the prospects for higher corporate tax rates next year if Biden wins. The bulls argue that massive monetary and fiscal support is here to stay and any weakness will prove temporary once we get a vaccine. I think there’s truth on both sides, and I expect that markets are likely to remain choppy for a while.
The longer-term concern is inflation. The Fed recently revised their inflation target and will now aim to achieve average inflation “moderately above 2 percent for some time.” What does ‘moderately above’ mean, and how long will they let it run before changing policy? I think the Fed will tolerate very high levels of inflation for one reason: they do not want to raise interest rates. At this rate of borrowing, a 10-year Treasury rate above 2% will crush the budget.
The Fed will follow the path of least embarrassment, which means they’ll be slow to act. If rates move 1% higher, we’ll have a debt-to-GDP of 250% in 30 years. If rates move 1% lower, we’ll only have debt-to-GDP of 150%. So there is a powerful incentive for the Fed to keep interest rates low that has nothing to do with monetary policy. And near-zero interest rates combined with multi-trillion dollar deficits is inflationary. No offense to the Modern Monetary Theorists, but I don’t see how our current fiscal and monetary policies acting together cannot be inflationary. Once the virus is behind us, the combination of pent-up demand and outsized government spending could certainly make the economy run hot.
As for the implications, the tech sector would likely underperform in a high inflation environment. Value should outperform, as should the usual suspects: small caps, banks, energy, TIPS and commodities. Inflation is synonymous with a weaking dollar. In prior periods when the dollar was weak, the best performing markets were foreign and emerging stocks.
We currently have exposure to large cap value, international and emerging markets, and small cap stocks. None of these positions have helped in 2020. Still, if inflation continues to beat expectations, we may tilt our US stock exposure toward value and add more international and emerging market exposure. But if inflation doesn’t happen, we’ll collect the dividends on what we currently hold and move forward. Rotations like this are a process, not an event; they can take months or years. For now, US growth remains the dominant trend and the largest concentration in our strategy.
But as happens near the end of such growth periods, the largest companies come up against two problems, the first being the base effect: their capitalization becomes so large that it becomes difficult to move the needle. The other is regulation. People, including government agencies, start to take a closer look. This summer, the heads of major tech firms were brought before Congress to testify on antitrust issues. Will the government break up Facebook and Amazon, or regulate social networks and search engines as public utilities? It’s improbable, but not impossible. Taken together with other trends like higher inflation or higher interest rates, the shift toward value could gain momentum.
A quick note on fixed income: there are hardly any opportunities in bonds right now. Rates are so low that most Treasury bonds are at negative yields after inflation. Treasurys may offer temporary safety in the event of an equity market sell-off, but can hardly be counted on to provide much return over the long-term.
And while the Fed has done a great job providing liquidity to the credit markets through its various programs, no amount of buying will improve the solvency of the underlying issuer. We expect to see a lot of ‘extend and pretend’ loan restructuring, because “a rolling loan gathers no loss.” But the loans will come due eventually, and bondholders will either be made whole or they’ll get in line at the asset sale. So while a lot of managers are doubling down on lower-quality junk bonds, we still favor the “fallen angel” trade, balanced with positions in high-quality corporate and government bonds.
Finally, a word on the upcoming election. The election is like a vortex. We can’t know what’s on the other side until we go through it. Regardless of your preferred candidate, the reaction function of the market has to do with uncertainty, not politics. On the other side of the election, we won’t have the election to worry about. We’ll have certainty, for better or worse.
And while elections are always contentious, markets have gone up under most presidents, even in those times when one party controls the White House and Congress (see attached chart from Fidelity). The economy—and therefore the stock market—is incredibly dynamic and impacted by many factors beyond tax rates and political leadership. For those concerned about a political sweep, mid-term elections tend to equalize any lopsidedness of the first two years. The lesson is that it’s hard to make investment policy out of politics.
I expect we’ll see plenty of volatility between now and the end of the year as we move through the election and the pandemic, so it’s important to keep long-term goals in mind. What’s required at this moment is patience and a high tolerance for near-term uncertainty, especially when it comes to politics.
Our primary task is to manage risk in your portfolio, which is why we diversify among investment styles, geography, and asset class. A diversified portfolio means the various parts move asynchronously between and among each other, with some parts doing well and others lagging. Rarely has this dispersion been as pronounced as in 2020. Whether it’s COVID, a vaccine, rising inflation, rotation from tech leadership to something else, we’ll continue to monitor the data and look for sustainable trends.
Let us know if you have questions or comments.
 Russell 3000 Total Return through September 30
 CBO estimates
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