There is nothing normal about the nature of this cycle. We have never seen a health crisis morph into an economic crisis by virtue of a government-mandated full-stop shutdown. The S&P 500® index dropped 34% from February 19th to March 23rd – and then rebounded almost as swiftly.
In keeping with the high-speed nature of this crisis, the National Bureau of Economic Research (NBER) recently declared that a recession began in February. It was the fastest decision in the 40-year history of the NBER’s recession declarations. A big question now is how the NBER will determine the end of this recession—the severe depth of it means that certain economic data will likely look dire long after a trough is reached.
With the economy cycling at warp speed, what do we expect for the second half of the year? It’s especially difficult to make forecasts during a global shock like the COVID-19 pandemic, but here’s what we know now:
A clean V-shaped U.S. economic recovery is unlikely
The stock market may have gotten a bit ahead of itself in pricing in a V-shaped recovery. The increase in volatility in June has been related to rising COVID-19 cases in a number of U.S. states. Stocks may continue to be at the mercy of virus-related news—both positive and negative.
In terms of the economy’s recovery shape, we believe the remainder of this year is likely to look more like rolling W’s than a clean V. Even if rising coronavirus cases don’t lead to renewed shutdowns, a slowdown in the recovery should be expected based on the impact of weaker demand and constrained supply. Second-quarter earnings season may be an eye-opener—not just what’s reported for earnings in the quarter, but what companies say about their second half outlooks. Given that one-third of S&P 500 companies have withdrawn earnings-per-share guidance for 2020, any color will be helpful in shaping views about the shape of the recovery.
Longer-term, the U.S. economy may be starting a secular shift from services/consumer-led growth toward more investment-led growth, in areas like health care, technology and supply-chain manufacturing. The expected growth sectors currently employ nearly 40 million people—nearly three times the 13.7 million employed by the expected contraction sectors, such as restaurants and classic retailers. That’s good news, but if the economy is transitioning from having been nearly 70% driven by consumer spending toward investment-based drivers, the ride is likely to be bumpy.
Global market leadership may be shifting
The same countries that saw the deepest downturns in the first quarter also saw the most rapid rebounds in May when the lockdowns began to ease. Although an economic recovery is underway, investors should still exercise caution in the second half of 2020. Global stocks (as represented by the MSCI All Country World Index) already have recovered most of their losses during the second quarter. If the recovery encounters a setback, or slows significantly from the initial bounce, investors may be disappointed and stocks could give back gains.
In the past, cyclicals have typically led the market higher during market rebounds from a bear market and recession. Until the past couple of weeks, defensive stocks had been leading the stock market rebound, suggesting market participants were pricing in a long, slow recovery. However, cyclicals recently have started to outperform. This suggests investors’ expectations may have changed to embrace a brighter economic outlook and a more rapid economic recovery. It’s possible that economic data in the coming weeks will continue to support this optimism, but potential risks abound, including a slower-than-expected recovery, a second virus wave and heightened U.S.-China trade friction.
The fixed income yield curve may steepen
Although fixed income investment returns have been generally positive year to date, yields have swung widely as markets reacted to the sudden halt in economic growth, the Federal Reserve’s rapid short-term interest rate cuts and fiscal stimulus, followed by nascent signs of economic recovery.
The volatility reflects the markets’ efforts to find a path through the economic downturn to the new normal. An enormous gap has opened up between the potential growth rate in the economy and actual growth rate, which signals excess capacity in the economy and tends to put downward pressure on inflation.
The Federal Reserve and Congress have tried to fill the gap with direct funds to households and loans to businesses. Despite the massive relief provided, the outlook still suggests that the economy will take time to recover. Consequently, inflation will likely remain low, and the Fed will maintain an easy policy stance. We expect that short-term interest rates will stay near zero for the next two years or perhaps longer.
However, assuming the economy rebounds in the second half of the year, longer-term yields could move higher. Signs of improving growth combined with an ever-increasing supply of Treasuries will likely result in moderately higher bond yields and a steeper yield curve. With a rising budget deficit, Treasury issuance is increasingly shifting toward longer-dated bonds, adding to the upward pressure on yields and steepening the curve. For the second half of the year, we believe 10-year Treasury yields could drift up to the 1% level.
However, the upside is likely to be limited by ongoing low inflation and the Fed’s determination to hold short-term rates lower for longer. Recent inflation data indicate consumer prices have fallen for three consecutive months and wholesale prices are falling on a year-over-year basis. High unemployment will also likely weigh on inflation.
What investors can consider now
Stay disciplined. Chuck Schwab often says that investing is by its nature an act of optimism, and there is reason for optimism that we will emerge from this crisis and forge a stronger path ahead. But be mindful of the emotions of fear and greed—stay disciplined, especially around diversification and periodic rebalancing. Long-term investment success does not require precisely picking market tops and bottoms. That’s gambling on moments in time, while investing should always be a process over time.
Be ready for a changing market. The recent rotation into cyclicals has started to lift value and international stocks relative to growth and U.S. stocks. If sustained, this new market leadership by sector, style and geography in the second half of the year may catch some investors by surprise after the economic and market cycle of the past 12 years favored technology, growth and U.S. stocks. This suggests that investors who haven’t rebalanced their portfolios in a while should consider doing so. Schwab clients can log in and use the Schwab Portfolio Checkup tool to find out whether their asset allocation still matches the original target. If you’re not sure how to rebalance your portfolio, a Schwab Financial Consultant can help.
Be careful about reaching for yield. For higher yields, fixed income investors will need to take some kind of risk—either duration risk or credit risk or both. In general, we favor limiting duration to reduce the risk of rising long-term rates, and suggest keeping the bulk of fixed income investments in bonds with higher-than-average credit ratings.
© Charles Schwab & Co.
© Charles Schwab
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