Your Quarterly Update on the Financial Markets June 30, 2020 Market Recap The US Economy: “Stocks Lap the Real Economy” The economic contraction for Q2 has yet to be measured, but Annualized Real GDP Growth there is a strong consensus that the number will be astound- ing. Among the more widely followed statistical models, the 6/15 6/18 3.5% 3/20 3.0% -5.0% Atlanta Fed’s GDPNow projection bottomed on June 4th with a 6/20 (e) Q2 annualized growth rate of -53.8%. That unofficial forecast -36.8% improved steadily through June, as data began to reflect both 2015 2016 2017 2018 2019 2020 gradual reopening activities and adaptive behaviors. Following the July 1st release of the ISM Manufacturing Report, the GDPNow model stood at -36.8%. No one knows where the final GDP number will land, but a few things are clear. First, an enormous amount of real value was destroyed by the initial COVID-19 shutdown. Second, that initial event appears to have found a trough at the end of May. However, threats remain from continued propagation of wave 1 through the southern, central, and western US, along with some US Institute for Supply Management (ISM) Indices major population densities worldwide. The probability of 6/20 57.1% subsequent waves remains considerable. 52.6% Against this backdrop, the US stock market posted torrid gains for the quarter, paring year-to-date losses to -3.08%. Index >50 = Expansion 4/20 41.8% Many have pointed out the disconnect, for which there are a 41.5% number of contributing explanations, but truly unprecedent- US Money Supply (M2) 4/20 +6.7% ed monetary expansion by the Federal Reserve is the prima- (Monthly % Change) ry cause. Fundamentally, the stock of a company is worth 5/20 +5.0% the present value of all future earnings of that company. Earnings are depressed now and in the foreseeable future – Previous record: January 1983 +2.8% Data through June 22nd but stock prices are also impacted by the discount rate used 6/20 (e) to translate future earnings to present value. The (some- +2.1% what) unintended consequence of monetary expansion is to 2015 2016 2017 2018 2019 2020 lower that discount rate, inflating the stock market. The mathematics of discounting determines how much in future earnings is recognized in today’s value and how much will be recognized in future years through additional returns. As the discount rate falls, more future earnings accrue to current shareholders. That’s particularly good for tech firms and other high-growth companies, who expect a greater pro- portion of their earnings to occur in the future. However, all other things being equal, a lower discount rate means that less future earnings will accrue to shareholders in subsequent years. In the long run, only real earnings matter. Said differently, you cannot create value by changing inter- Federal Reserve Survey Pre- and Post-Correction est rates, you can only alter how value is distributed be- 2020 Median Longer Run Median tween present and future investors. Valuation gains 12/19 6/20 ∆ 12/19 6/20 ∆ “borrowed” through rate reductions will be “paid back” Change in Real GDP 2.0 -6.5 -8.5 1.9 1.8 -0.1 through forgone returns in the future. In contrast, demand Unemployment 3.5 9.3 +5.8 4.1 4.1 0.0 destruction due to the pandemic represents a real, actual PCE Inflation 1.9 0.8 -1.1 2.0 2.0 0.0 loss of value. The Fed’s bet, apparently, is that the real im- Fed Funds Rate 1.6 0.1 -1.5 2.5 2.5 0.0 pact of the virus on growth and interest rates is temporary (note the lack of change in their long-term projections). Actual/Projected Real GDP Growth This suggests the best-case scenario for stocks is restora- 12/21 tion of real earnings growth (e.g., via a vaccine) accompa- 5.0% nied by rising rates in 2021 – which means most of the 12/14 12/19 Long Run value of a vaccine has already accrued to today’s share- 2.9% 2.3% 1.8% holders. With rates near zero, the ability to borrow addi- tional returns in the event of a contingency is limited. 12/20 -6.5% 2 MARKET RECAP June 2020 The US Bond Market th On May 7 , the 2-year key rate hit its new historical low of 3% US Treasury Yield Curve 0.13%. The previous low of 0.16% was set in September 2011, as markets began to accept a lower-for-longer outlook. The curve is now perfectly flat between the 3-month and 2-year ma- 2% turities, both closing the quarter at 0.16%. Longer-term rates retain a more normal slope, perhaps comforting those who place stock in the predictive power of an inverted curve. The 30-year 1% yield has held in there, resisting a Q2 push back towards its his- torical low of 0.99% set in March. By one perspective, the posi- tive slope and incrementally higher yield versus Q1 point to a 0% more optimistic economic outlook or resumption in risk appe- 3m 2y 5y 10y 30y tites. By a more honest perspective, there is little optimism in a 30-year rate that stands one-and-a-quarter percentage points lower than its prior historical low, established in 2008. With rates, as with the pandemic, there is no light yet at the end of this tunnel. US Bond Index Returns US government debt indices enjoyed positive, but modest gains for the quarter. Meanwhile, credit spreads contracted violently through the first week of June, continuing the trajectory Blmbrg Barclays 2Q20 set in the last week of March. AA spreads declined by nearly 100 bps. June brought some sta- Aggregate 2.90% Short Gov't 0.13% bility to fixed income markets, though high yield spreads widened moderately as signs of in- Interm. Gov't 0.55% creasing coronavirus infections emerged, AA corporate spreads traded below 1% throughout Long Gov't 0.28% the month. The Federal Reserve’s aggressive measures to restore liquidity seem to have had TIPS 4.24% the intended effect. Municipal 2.72% With a large number of “fallen angels” absorbed into below-investment-grade, high yield Interm. Credit 6.67% managers are having to study up on a lot of new names. Along with the spike in issuer credit Long Credit 11.08% downgrades, bankruptcy filings are piling up. Hertz, Gold’s Gym, Neiman Marcus, J.C. Penney, High Yield 10.18% Whiting Petroleum, and J. Crew are among the first major corporate casualties of the pan- (CS) Lev. Loan 9.71% demic. Investors face numerous pitfalls with various industries trading at steep discounts. MBS 0.67% Debt from any retailer is certainly suspect; many started underwater before drowning in the pandemic. However, homebuilders, retailers, lodging, oil producers, live entertainment, and many other industries are teetering as the pandemic draws on without end in clear sight. The common themes are manifold: those sensitive to the pandemic in the narrow sense of relying on foot traffic, in the broad sense of being sensitive to cyclical demand, or simply unable to tolerate such a massive interruption in their operations or supply chain. Outside of issuers that fall victim to those themes, plus the usual smattering of unrelated implosions, many companies have enjoyed a combination of tailwinds this year. Culling the herd in any industry can benefit the survivors. Restaurants that survive the pandemic will likely see demand return to normal before competition does. Retailers however may find the pandemic is simply a catalyst for their eventual demise, much like the Great Recession proved to be for newspapers. Fiscal and monetary stimulus has benefitted many companies that were impervious to, or even helped by, the pandemic. This year, investment grade corporate debt has been issued at more than double the pace of last year. A record of monthly high yield issuance came to market in June. The rise in supply has been driven by a confluence of liquidity needs from companies under stress, an apparent bottoming out in rates, and a resumption in risk appetites. The Secondary Market Corporate Credit Facility (SMCCF) Corporate Yields by Credit Quality started purchasing corporate bond exchange-traded funds AA BBB B 12.39% th (ETFs) on May 12 . In the first week, the SMCCF pur- 10.18% chased $1.6 billion of 15 different ETFs, about one-quarter 8.45% 6.74% of which was high yield. As of June 16th, the facility held 7.05% $6.8 billion in ETFs, with 12% being high yield. An update 3.87% to the program, as expected, expanded these purchases to 2.68% include individual corporate bonds starting June 16th. Only 2.74% 1.56% the first two days of transactions have been disclosed, and Jul-2015 Jun-2016 Jun-2017 Jun-2018 Jun-2019 Jun-2020 they totaled $429 million split among more than 80 issuers, with only 3% high yield. The SMCCF is designed to purchase up to $250 billion in debt, so it is just getting started. The doubly-large Primary Market Corporate Credit Facility (PMCCF) began its purchases on June 29th. 3 MARKET RECAP June 2020 The US Stock Market The US stock market continued its trend of record-setting quarters. US Stock Indices - Total Returns Propelled by unprecedented Fed asset purchases, the S&P 500, the Large-cap Stocks 2Q20 Mid-cap Stocks 2Q20 Dow Jones Industrial Average and the Nasdaq Composite all posted S&P 500 20.54% S&P Midcap 400 24.07% their best quarters in over 20 years amid a broad-based rally.