COVID-19 led to a government — Federal and state-mandated recession to mitigate the virus. This commentary reviews how the government-mandated recession will likely increase government involvement in the economy, lead to market leaders further increasing their domination, result in possible political change in Washington, and change investment focus as the economy opens.
Typically, the service industry (over 70% of GDP) buffers cyclical declines experienced by manufacturers (11% of GDP) and other cyclical industries. The government-mandated recession truly brought many service industries, such as restaurants, entertainment, and tourism, to a halt. A survey from Morning Consults shows the difficult path faced by these industries as the economy opens up and they resume operations (see Figure 1). With this near-term headwind, selective investments in product manufacturers and distributors may prove more attractive than services.
To overcome their industry headwinds, service-oriented companies will likely find new and better ways to reach their customers. If correct, one outcome of this pandemic could result in improved productivity for various service industries. With its importance to US GDP, improved service productivity would contribute importantly to overall US economic growth rates.
The recession will likely cause weaker capitalized firms to fall back further competitively. As a result, either market-dominant firms will acquire weaker competitors and suppliers, or they will disappear — most likely disappear. In either case, the “bigs” will further exert their market dominance. In this difficult economic period, investors must carefully determine whether so-called value investments can either regain business traction or become an attractive acquisition candidate. If not, in this difficult economic environment, there may not be sufficient economic “oxygen” to sustain their life.
According to a recent Goldman Sachs study, while the S&P 500 index remains roughly 17% below its all-time high, the typical stock trades about 28% below that high. Very simply, five stocks — big tech — in the S&P 500 now account for approximately 20% of the index. This broad dispersion of returns between the haves and have nots argues for considering a possible narrowing of this difference. Opening the economy could produce just such a change.
One way to take advantage of that possible reversal would use the equal-weighted instead of the cap-weighted S&P 500 index. Historically, the equal-weighted S&P 500 index outperformed the cap-weighted index by over 1% annually (see Figure 2). However, since 2017, the cap-weighted index outperformed based on the strength of tech stocks (see Figures 2 and 3). By using the equal-weighted index, investors would then benefit from a likely broader recovery of stocks when the economy begins to show improvement.
Opening the economy will vary by region and state. While many states experienced a modest impact from the virus, some metropolitan areas felt a heavy rate of infections and, tragically, deaths. According to Quill Intelligence, half of GDP comes from less than 3% of US counties. Despite that small percentage, because of their population densities and other variables, they accounted for 61% of COVID-19 cases in this country.
The timing for opening these key counties will importantly determine the strength and speed of our economic recovery. The most heavily affected regions will likely open slower than other regions. Longer-term, to stimulate their growth, these counties will undoubtedly seek new approaches to overcome economic handicaps exposed by the virus. At the same time, those states that can safely open up earlier and more broadly will gain an economic advantage. Commercial real estate represents one industry that will likely see the most significant impact from the pandemic on densely populated counties. Perhaps it will result in some shifts to office space in their surrounding suburbs.
A recession in a presidential election year turns an economic event into a political one. The current economic difficulties could lead to a possible change in the White House as well as returning one-party control to both houses of Congress. History argues for such a change. Quoting from a recent article in Newsweek, “since 1900, only one president has won re-election with a recession occurring sometime in the last two years of their first term — William McKinley.” Admittedly, the incumbent demonstrates an ability to overcome consensus expectations, as the 2016 election showed. The speed of the economic recovery will likely heavily influence the election result.
With the uncertain speed of the recovery, it seems too early to speculate on the rate of change a new administration would bring to current and new Federal programs. Substantial increases in the Federal deficit now taking place will likely restrain any major new programs. However, higher tax rates, particularly on corporations and higher-income individuals, will mark the future — no matter which party gains control. A new world in Washington would also resume regulatory expansion. Overall, a new administration will likely significantly expand the government’s role in the economy.
Equity markets made a “V” shaped rebound. The economic recovery will not likely match that optimism. At that same time, commodities, and particularly oil, showed a historic drop. The different performance between both markets reflects their investment perspectives. Equity markets tend to discount the longer-term outlook for industries and companies. In comparison, commodity markets reflect immediate supply and demand forces in spot or current prices — not the future.
So far, roughly twenty percent of S&P 500 companies have suspended guidance — likely, more will follow. A good percentage of companies will use this year as a “kitchen sink” year by writing off their past mistakes. The bottom line, this year’s earnings outlook for most companies will give little basis for using traditional stock valuation approaches. Companies will also likely write down their inventory valuations as much as auditors will permit. By doing so, this will help boost 2021 earnings.
Hopefully, the economy will recover sufficiently so that 2021’s first-half earnings compare favorably to this year’s sharp decline. The economic outlook for the second half of 2021 depends on consumers and their “psyche.” Therefore, recovery of consumer spending will depend on successful therapeutic and vaccine developments as well as confidence in testing programs.
We approach financial markets with cautious optimism. Part of that optimism reflects our faith in the dynamism and ingenuity of American business and workers to overcome hurdles brought by the pandemic. At the same time, our caution reflects the unsteady path the economy faces to regain stable growth. With that, our investment recommendation remains 40% equities, 35% alternatives, and 25% fixed income. Reaching that recommended equity asset mix leads to rebuilding equity positions in high-quality companies with strong balance sheets selling at what will likely prove attractive prices. How fast each investor rebuilds depends on their own comfort to do so. In the case of fixed income, we recommended short-term credits to preserve capital, and that continues to be our recommendation.
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