Monday Market Review September 7, 2020
Economic data last week included mixed but generally pointed to expansion for manufacturing and services releases, as well as a better-than-expected employment situation report for August.
U.S. and foreign equities both fell back last week, as growth stock strength reversed. Bonds ticked up slightly, although stronger economic data sustained interest rates. Commodities fell broadly, led by lower pricing for crude oil and demand continues to remain weak.
U.S. stocks fell back last week, as early strength gave way to sharp pullbacks on Thursday and part of Friday, as discussed earlier. By sector, only utilities and (oddly) materials provided positive returns; energy and technology led the market downward, with negative results of over -4%. Real experienced minimal losses, which outperformed equities broadly.
Foreign stocks in both developed and emerging markets declined in similar magnitude with U.S. equities. There are signs that additional European stimulus could be in the works from a variety of angles, both broadly by the ECB and specifically by individual nations, such as France. However, this positive sentiment has been soured by a slimmer probability of a productive Brexit deal by year-end.
U.S. bonds ticked up slightly, although a yield recovery by Friday tempered larger gains one would expect when equity markets fell back. This was perhaps due to better economic expectations following a strong jobs report. Both U.S. treasuries and investment-grade corporate bonds gained a quarter-percent, while high yield and bank loans each lost ground. Foreign debt was held back by a sharp rally in the U.S. dollar last week, with developed market debt reporting net losses and emerging market bonds little changed.
Commodities generally fell back last week, not helped by negative risk asset markets and a strong dollar. Energy and precious metals led the decline, while industrial metals and agriculture were little changed. The price of crude oil fell by only a few dollars, but amounted to -7%, to just under $40/barrel. The Saudis cut prices for October with signs that broader energy demand remains under pressure.
Question of the Week
What would be the impact of a Biden Presidential election win, potentially including a Democratic takeover of the Senate?
The impact of a potential new President on stock market returns is always a key question in the weeks prior to a general election. It’s important to keep in mind that, despite frequent worries around this time of year, and that financial markets may react in the shorter-term term to poll results and election outcomes (especially surprises), the longer-term effects of any administration’s policies appear to be disconnected from financial market results. Instead, stocks especially tend to follow earnings, which follow economic growth trends. Nevertheless, there are always policy distinctions that could affect various industries to some extent.
In contrast to election season norms in prior decades, polarization between the two parties has become more pronounced, with more extreme positions on both sides forcing candidates away from traditional ‘centrist’ policy often adopted during general election campaigns. A Biden victory has the potential of moving policy toward a more progressive stance, although this is not as simple of a story as in past years, with the current administration having taken a variety of unconventional stances in its own right.
The potential retaking of the Senate by Democrats, in addition to their already holding power in the House, would heighten the risk of more progressive policies being voted in—with minimal opposition. On the other hand, Republicans successfully retaining the Senate would continue to act as an effective counterbalance against legislation from the House, potentially resulting in a policy log jam for the next four years. (Some see this as a best-case scenario, although doing little to alleviate the high current levels of political disagreement.)
The following represent a few areas that could be most impacted by a new Democratic administration, through either new legislation, reversals of prior policies, or no change:
Taxes. It is assumed that the corporate and personal tax cuts put into place in the current regime could be reversed—partially or fully—towards prior levels. Personal income tax policy rhetoric during the campaign has been aimed at the ultra-wealthy, but with high budget deficits and an unprecedented level of fiscal debt, higher tax rates for even middle-income Americans have been feared. This includes higher capital gains tax rates, seen as benefiting the wealthy the most, as they own the majority of financial assets. ‘Wealth taxes’ based on assets are out there as a wildcard as well (although targeted at billionaires). Even if corporate rates do not return to prior max levels of 35%, they are likely not to remain at 21%, either. Most directly, higher tax rates for companies directly erode multi-year earnings projections, which could result in lower stock valuation assessments.
Environment. This multi-faceted policy area includes not only ‘green’ legislation (likely to be promoted by a Biden administration), but also important carryover effects related to the energy industry broadly. It would likely be unfavorable for traditional petroleum- and coal-based energy production (and emissions), including limitations for drilling, and increased regulation of impacts. Conversely, alternative energy sources would likely be promoted—including wind and solar—as well as the potential taxation of carbon emissions.
U.S.-China relations and trade. This is a more challenging policy point, as both parties have adopted a hard line on China—for a variety of different reasons. The current administration has taken a more confrontational approach. This has been unique relative to prior regimes, which, at least at the surface, had attempted to avoid outright hostile language and direct economic sanctions. While the two parties agree in principle for a tougher stance, Republicans have focused this effort on corporate intellectual property, while Democrats have also included human rights concerns; specifically, based on the treatment of several ethnic and religious minority groups within the country. This remains a wildcard to some degree, but the majority of Americans and politicians now favor a tougher stance toward China—a rare point of policy agreement.
Antitrust legislation. This wouldn’t normally surface as a key policy platform, but the rise of several technology behemoths has raised questions over the competitive environment and growing economic power of these firms. In prior decades, pro-business conservative politicians have been more reluctant to attack oligopolistic entities, while populist/progressive movements had been responsible for breaking up dominant ‘Robber Baron’ firms—such as Rockefeller’s Standard Oil in the early 1900’s. In recent years, though, the more progressively-minded tech giants have been supportive of the Democratic agenda and drawing the ire of Republicans—creating a role reversal. The pressure on these firms may continue to some degree, depending on who’s in charge. Some of this oligopolistic power is due to the structures of the industries. They’ve remained among the most fundamentally solid from a financial standpoint during the pandemic, which has rewarded investors. Of course, many small businesses have not fared nearly as well, fanning the flames of resentment.
Workers. Republican policies over the years have generally been focused on letting ‘laissez faire’ (free market) forces determine market competition and pricing dynamics—favored by many mainstream economists. Biden policies would likely offer more worker-friendly populist concessions, such as a higher minimum wage, better health coverage, paid leave, student loan relief, etc. On one hand, additional benefits and pay cut into company profit margins. On the other hand, more money in the pockets of consumers could be a catalyst for broader personal spending and consumption growth broadly, which benefits the broader economy in its own way.
Healthcare. The formation of the Affordable Care Act (‘Obamacare’) was followed by an immediate battle for repeal by Republicans and expansion by Democrats. This fight is likely to continue, with any enhancements in coverage (like ‘Medicare For All’) or other changes aimed at high prescription drug prices (also favored by the current administration, despite potential impact on corporate profits). Some pharmaceutical firms have acted to pre-emptively curb pricing for some drugs in efforts to stem the criticism and potentially unfavorable legislation. These firms counter that such high prices act as the funding mechanism for continued research and development on new therapeutics, which many politicians have accepted. The convoluted health care system, though, continues to overwhelm attempts at reform, which has led to a lower financial market probability for radical change in the near-term.
Defense. In prior years, a strong defense budget and global projection of power has been a Republican party tenet. Lately, this has taken a bit of an opposite turn with conservatives moving more towards a stance of isolation, and progressives seeking to maintain greater globalism. This may be an area with little net change, absent geopolitical surprises (which can be counted on).
Immigration. This doesn’t seem like a market-related topic at first glance, but movement of people across borders affects demographics, which, in turn, affects the size of the labor force and productivity—and ultimately economic growth. This has been a divisive issue throughout America’s history, and each side currently has a mixed relationship with it. Generally, economists argue that a more lenient immigration policy provides a larger pool of workers, which results in not only higher production but also higher consumption. Companies have often silently been in favor of these less restrictive policies, which brings in a higher supply of workers, which lowers wages and boosts profits. On the other side, and often in conflict with other elements of the party, Democratic politicians have tended to have strong support from unionized U.S. workers, which often oppose globalism and foreign worker competition—in efforts to retain jobs and sustain higher wages domestically. Realistically, on net, there could be few extreme changes due to these continual conflicts.
Fiscal policy. In decades of old, Republicans were seen as the fiscally spendthrift party, while Democrats were cast in debates as ‘tax-and-spend.’ But even prior to the Covid recession, these traditional labels were less applicable, with higher spending proposed on all sides. Due to economic woes from the pandemic likely carrying over into 2021, and perhaps 2022, as well as increasing acceptance of policies such as Modern Monetary Theory (MMT), it appears the accepted spending may continue regardless of the party in office. However, at the fringes, Democrats have proposed more direct relief to workers, and Republicans to small businesses, in keeping with other distinct policy preferences.
Monetary policy. This should be unaffected by politics, and largely has been over the years. Of course, there have been notable and theatrical exceptions, such as the Fed Chair being physically bullied at LBJ’s Texas ranch in the 1960’s, and the current President’s urging of low rates via social media. A Biden presidency could likely feature more restraint, and a conventional ‘hands off’ approach. However, the Fed could be increasingly impacted by the large Federal deficit and rising debt load, which affects both interest payment obligations as well as credit rating—which affect rates outside of the Fed’s control.
In short, by looking at individual industries, the outlook may not appear to change that much, aside from policy preferences one way or another. The key differences relate to tax policy, the broader regulatory environment, and fiscal spending policies.
It’s important to remember that an elected President has very little effect on market results, historically. In fact, some of the stronger periods of market performance have been under Democratic administrations, contrary to popular assumption.
What causes sudden market declines like we saw this week, seemingly out of nowhere?
There often isn’t a concrete reason. It’s important to remember that stocks trade in a market like any other good: when there are more buyers than sellers, prices move higher; when buyers dry up, this can reverse quickly. It’s been argued that certain large cap growth stocks have become frothy in valuation—particularly in the technology sector—as investors have crowded into profitable segments that are ‘working’ despite mixed results in other segments of the market. Some adjustments by options hedgers were blamed at one time. Some are blaming day-trading follies by fickle retail investors, who presumably either have more time on their hands, or usually engage in sports betting as an outlet for speculating, but regardless, may not be as focused on fundamentals as are institutional investors. Or, perhaps the overall economic news has been just ‘too good, too soon,’ with Wall Street conditions looking very different from those on Main Street, the latter of which is still facing significant struggles which aren’t fading as quickly as hopes for ongoing government stimulus and a vaccine release remain high.
The S&P’s declines last week, on Thursday of -3.5%, followed by another -2.5% at one point on Friday (before recovering), were unexpected, but not overly surprising considering the strength of equities in recent weeks. September has the reputation of being one of the most volatile months of the year, with the added element of continued pandemic-related uncertainty. Ironically, this decline coincided with news that the CDC had ordered states to begin preparations for vaccine distribution as soon as November.
Another factor is recency bias—the phenomenon that we can become detached from normal market behavior during long stretches of low volatility. For the last five decades, the average daily move for the S&P has been +/- 0.7%, with a standard deviation of 0.8%. This implies that a daily price change of two standard deviations (or +/- 2.3%) has about a 4.6% probability of happening on any given day (so half of this, or about a 2.3% chance for a down day of that magnitude). Volatility has a tendency of clustering, as it has this year, while summer 2020 has been tame but steadily higher. Based on a variety of overall market metrics, despite concentration to the largest tech firms reaching high levels, broader indicators point to non-frothy valuations using earnings expectations for the coming few years—reflecting a post-Covid ‘normal’ environment. In ‘normal’ conditions, it’s reasonable for investors to continue to expect ‘normal’-like returns.
(+) The ISM manufacturing index for August rose by 1.8 points to a solidly-expansionary 56.0, beating consensus forecasts calling for little change at 54.8. Within the report, 15 of 18 categories saw improvement, with new orders rising by 6 points to a 16-year high (at a level of nearly 68—strongly expansionary), production and supplier deliveries rose to further expansionary levels, as did prices paid. On the other hand, employment rose but remained in contraction.
(0) The ISM non-manufacturing index for August fell by -1.2 points to a still-expansionary 56.9, which was just below the median consensus forecast calling for 57.0. Declines were seen in several underlying segments, including business activity and new orders, although each remain in expansion. Prices paid and supplier deliveries rose further into expansion. Employment rose by a few points, but fell just below the neutral range in contractionary territory. Both manufacturing and services have strengthened sharply in recent months.
(0) Construction spending for July rose by only 0.1%, below the forecasted gain of 1.0%, although prior-month data was revised higher by several tenths of a percent. Private spending rose slightly overall, with a gain in residential offsetting a decline in non-residential. Public spending levels declined overall, although experiencing a similar residential/non-residential pattern.
(-) The trade balance for July experienced a rise in the deficit of -$10.1 bil. to -$63.6 bil., surpassing forecasts of -$58.0 bil. Volumes have continued to pick up relative to the pandemic shutdown-induced depths (up 10% for July—the largest monthly increase in nearly 30 years). Overall imports rose by 11%; exports increased 8%, with balance in the petroleum and non-petroleum segments.
(0/-) Initial jobless claims for the Aug. 29 ending week fell by -130k to 881k, below the median forecast of 950k. Continuing claims for the Aug. 22 week came in down -1.238 mil. to 13.254 mil., a bit below the 14.000 mil. expected. There were some methodological adjustments made in the seasonal formula, which skewed some of the numbers last week. Claims fell most sharply in FL and GA, while CA saw an increase of over 40k claims, perhaps due to wildfire issues more than the pandemic.
(-) The ADP employment report for August showed a gain of 428k, falling well short of the 1.000 mil. jobs expected, with a noted slowdown in hiring noted during the month, although July’s numbers were revised up by over 40k. Services jobs gained 388k, a third of which were in leisure/hospitality. Goods production jobs saw a 40k increase, the bulk of which were in construction.
(0) The August employment situation report came in a lot stronger than expected on several fronts, although the overall labor environment obviously remains challenged. Nonfarm payrolls rose by 1.371 mil., beating estimates calling for 1.350 mil. Leading segments were government (344k), retail (249k), and professional services (197k), although the report was generally strong across the board. Over the last four months, it appears that around half the jobs that were lost earlier in the year have been recovered (based on how job loss is defined), with a ratio higher than this for service jobs such as restaurants and retail stores.
The unemployment rate fell by -1.8% to 8.4%, below expectations of a lesser drop to 9.8%. The labor force participation rate rose by 0.3% to 61.7%. While still higher than in February, pre-pandemic, this represents a rapid and deep recovery, while there remain a handful of measurement issues. For instance, the group classified as ‘employed, not at work, other’ fell a few percentage points to 9.1%, with the ratio of unemployed workers classified as being on temporary layoff declined 10 percentage points to 46% in August. The household survey included a jobs gain of 3.8 mil., with 6 mil. workers considered to be on ‘temporary layoff’. The U-6 level of underemployment fell by -2.3% to 14.2%, including a decline of those working part-time for economic reasons.
Average hourly earnings rose 0.4% in August, surpassing estimates of no change, which kept the year-over-year rate of change relatively high at 4.7%. Average weekly hours ticked up 0.1 to 34.6, indicating higher activity levels.
Earlier in the week, the final nonfarm productivity metric for Q2 was revised up by nearly 3% to an annualized rate of 10.1%, surpassing expectations calling for 7.5%. Final unit labor cost results for Q2 was revised downward by over -3% to an annualized increase of 9.0%, below the 12.0% level expected. Year-over-year, unit labor costs were also downgraded by nearly a percent to 4.9%. These figures have been skewed by the unusual pandemic environment this year.
Have a good week.
Ryan M. Long, CFA
Director of Investments
FocusPoint Solutions, Inc.
Sources: FocusPoint Solutions, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Citigroup, Deutsche Bank, FactSet, Financial Times, First Trust, Goldman Sachs, Invesco, JPMorgan Asset Management, Marketfield Asset Management, Morgan Stanley, MSCI, Morningstar, Northern Trust, PIMCO, Standard & Poor’s, StockCharts.com, The Conference Board, Thomson Reuters, T. Rowe Price, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wall Street Journal, The Washington Post. Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends. Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.
The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness. All information and opinions expressed are subject to change without notice. Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product. FocusPoint Solutions, Inc. is a registered investment advisor.
Notes key: (+) positive/encouraging development, (0) neutral/inconclusive/no net effect, (-) negative/discouraging development.