Friday, October 16, 2020

3rd Quarter Update – 2020 The Longest Year

What’s influencing markets:

  •  Market Update – Stocks up significantly in 3rd Quarter
  • Economic Rebound since March – Household net worth at a new record
  • Supportive Monetary and Fiscal Policy - Low interest rates, QE and lots of spending
  • Election risk diminished  
  • Planning Opportunities for 2020

It was the evening of March 12th and we were having what turned out to be the final soccer practice of the season. I have been coaching my daughter’s soccer team for years albeit with little knowledge of the intricacies of soccer. We missed the memo that the soccer league was cancelling activities, so we were the only team on the pitch that evening. 

Schools were closing and spring break was on the horizon so we thought maybe the kids would be home for a month before heading back to school to finish up the school year. I also thought soccer leagues might be suspended and then resume after the pandemic wrapped up in a month or so. That was a little na├»ve!  

Many adults continue to work remotely, and many kids are still homeschooling. And while there are still many people and businesses suffering right now, the overall economy has been able to recover much of what was lost early on in COVID. An upside-down world has evolved its everyday functions as a health crisis turned into an economic crisis. While government response cannot solve every problem, the policy responses to rescue the health and economy of citizens worldwide have been powerful and unprecedented. 

Market Update

During the third quarter of 2020, the equity markets continued to recover from the drawdown earlier in the year. Remarkably, and as the chart below indicates, large technology stocks did the heavy lifting for the markets, yet again, as indicated by the Nasdaq 100 outperformance during the quarter. While we do not expect the large cap U.S. growth stocks to outperform every quarter and every calendar year, the momentum and investment performance by that category has been striking.

The S&P 500 value of 3363 on September 30th is currently trading at 26 times estimated 2020 earnings of $130 and roughly 20 times projected earnings of $166 for 2021. Those valuations are a bit lofty, but not unreasonable when compared to a 10-year Treasury bond paying 0.68% annual interest. The returns generated by stocks and bonds might have exceeded expectations given the challenges faced by the economy this year.   


 

Economy

A robust economic rebound from the 2nd quarter when we saw a historic GDP drop is helping stocks continue to recover. The latest estimate from the Atlanta Fed is that GDP growth will increase 35% for the 3rd quarter 2020. This follows a 31.4% drop in real GDP during the second quarter. These are annualized figures so the actual change in economic activity is less than a 10% drop of roughly $2 trillion in economic activity for an economic base lever of $22 trillion. Depending on how the 4th quarter 2020 develops, the U.S. economy may only see a slight decrease on total economic output for the year of 2020. That would be an enormous success compared to what seemed possible in March and April of this year.

Of course, millions of workers remain without jobs. As the pandemic emerged and the shutdown began about 20 million jobs were lost, and at this point the economy has only recovered about 50% of those lost jobs. The unemployment rate, after spiking to 14.7%, declined to 7.9% in September.


 

An indication of American ingenuity and the resilience of the economy is the fact that new business applications and permits are rising faster than in recent years.  The stay at home economy is fundamentally changing the way we live our lives, so while some businesses may have difficulty sustaining, a whole new collection of business opportunities are presenting themselves. This is especially true in this unusual economy as new opportunities to serve a void are abundant as evidenced by the surge in new business permits.  

 

 

The improvement from the bottom instructs what is happening with asset prices like homes and stocks. Trillions already spent in government transfers are also helping families weather this economic storm and contribute to the rise in asset prices. Low mortgage rates and overall robust demand for homes has pushed housing prices higher by nearly 5% year over year. Household net worth reached a new high during the 3rd quarter of 2020, sustained by rising stock and home prices.  

 


Monetary and Fiscal Policy

While there are some positive economic trends that we have outlined above, there can be no questioning the role monetary and fiscal policy has had in supporting the economy as the country and the world continue to navigate this economy. The Federal Reserve extended several lending programs through the end of 2020 that were originally set to expire in September. The Fed is also likely to keep rates near zero for months or years to come until inflation exceeds its target of 2 percent. Below you can see the mind-boggling expansion of the Fed balance sheet increasing by $3 trillion this year.  

 


 Meanwhile, there seems to be agreement by the President, Senate and House that there should be some additional fiscal support as the virus cases persist. Federal Reserve Chairman Powell has also encouraged the President and Congress to move forward with additional fiscal spending programs, but they haven’t yet reached an agreement on the scope of an additional spending package and may not do so until after the election. In any case, the prospect of additional fiscal support either later this year or early next year is likely having a positive effect on asset prices – all of this despite booking what will be a record $3 trillion plus budget deficit for fiscal year 2020. We are watching to see signs that the increased liquidity around the world will finally lead to inflation.     

Election Risk

I suspect that for many of us, November 3rd cannot come soon enough. In some ways, it seems the election risk has receded in recent weeks. Perhaps the market sees a more decisive outcome at least referencing recent polling data and prediction markets. Or perhaps the market sees one scenario with lower taxes and the other with greater stimulus. With every Presidential Election comes questions about whether the investment strategy should be adjusted based on the various outcomes. It is generally advisable to keep politics out of your investment portfolio. For example, it would have been a mistake if you had sold investments or adjusted your investment strategy in the wake of a Trump or Obama victory. 

As investment advisors, it is our responsibility to position our client accounts appropriately based on a wide array of conditions affecting investments. There is a “consequential” election every two years, and that is likely too often to consider deviating from your long-term objectives by trying to guess which sectors or companies are positioned best for each candidate. Conventional wisdom would have argued that a Trump win in 2016 would likely have benefited energy and financial stocks, because of potential friendly regulations for those sectors. Tilting your portfolio overly aggressively towards the conventional wisdom in this case, solely because of politics, likely would have left your portfolio underperforming. 

Planning Opportunities for 2020

2020 has been a year like no other in history for many reasons, but it’s also providing some unique financial planning opportunities before the end of the year. The uneven economy this year has created a great disparity in personal economies. Some ideas are going to be appropriate if you’ve had a relatively positive economic experience, while some options would be more fitting if your economic situation has been more of a challenge.

1.  Consider a Roth Conversion – There are no required minimum distributions from IRA accounts this year, so a Roth Conversion might make good financial sense. In fact, if your income is artificially low or you think you will be paying higher tax rates in the future a Roth Conversion may be worth considering.

2.  Refinance your mortgage – Mortgage refinancing is about to get more expensive starting in December. Mortgage rates are at historic lows as many are getting loans well below 3%. We continue to advocate refinancing into shorter term lower cost loans.

3.  Fund your retirement accounts – Another anomaly of 2020 are the super high savings rates. If you have extra cash on hand and have not fully funded your employer sponsored retirement account (401k, 403b, etc.) you still have time to increase your contributions. And of course, everyone with taxable income can contribute to a tax advantaged IRA or Roth IRA.

4.  Consider extra charitable gifts – The CARES act allows a cash charitable contribution deduction of up to 100% of your AGI this year, rather than the standard 60% maximum deduction. Coupling the Roth conversion with charitable contributions is a worthy strategy to consider.  

5.   Take an IRA Distribution – The CARES act also allows up to $100,000 distributions from retirement accounts if with special provisions for paying the tax and returning funds if you have been affected by COVID 19. We don’t ever recommend raiding retirement accounts, but if there is an emergency there are special provisions which make early distributions from retirement accounts less punitive than normal.

These are a few of the issues we are watching into the end of the year. We remain encouraged about the future, especially witnessing how our resilient economy has evolved this year. As always please contact us if you would like to discuss your investments or review your financial plans. 

While 2020 has been a challenging year like no other, it’s thus far been a satisfying year from an investment perspective. We hope you all are staying safe, healthy, and calm as we close out 2020.

Best regards,

Edward J. Wilcox, CFA, CFP