Economic Monitor:  Uncertainty is Certain

BY: Mark Drachenberg

Have you ever felt like you were being pulled in different directions? That's how many feel today: Do we go out or stay in? Do we spend or not? Will stocks rise or fall? Will the economy continue to recover or collapse? Very good questions, all.

Looming over everything, of course, is the virus, but there are also various ramifications regarding election outcomes to add to the mix. Perhaps the only thing that is certain is, at this point, uncertainty, and that means, at least in investment terms, more volatility on the horizon. When competing data points cause competing outlooks, can those outlooks become self-fulfilling prophecies?

September was a down month. With everything going on this year, one would guess that that would not be such a strange statement, but it was the first down month for the markets since March. While the markets did pull back a bit, the S&P 500 and the NASDAQ both remain positive for the year, due to their tech exposure. The problem with those indices – especially the S&P 500 – is that a handful of stocks have an outsized influence on overall performance, while the remaining holdings have not added much value. Fixed income was essentially flat on the month and is still up nicely on the year. Future returns will likely be subdued, as there is little room for interest rates to fall further. 

The economy came roaring back to life in the third quarter – although we do not have GDP data yet – and appears to be growing, but perhaps at a more moderate pace than originally expected. Unemployment has fallen to 7.9%, but the cause is likely due to more pulling out of the labor force than a strong increase in employment. Consumer spending declined in August, as the extra unemployment benefits ended, causing a drop in personal income for the month. The household savings rate, which skyrocketed earlier this year with the stimulus payments, dropped, but remains at historically high levels, as Americans have preferred to keep their powder dry in case the economy shutters again. On the other hand, consumer confidence rose in September to its highest level since March, and the purchasing manager’s index stayed above 50 (expansionary) for the fourth straight month. While manufacturing has rebounded nicely, it remains below the levels recorded in February. Finally, auto sales have increased from their lows beyond where many expected them to be. So, there are signs of life, but the personal income numbers and the unemployment data are hinting at a slower recovery.

From an investor’s standpoint, these economic data points pull in different directions. On one hand, the pick-up in activity should imply a growing economy in which earnings should likewise be growing, leading to higher stock prices and enhanced returns. On the other hand, the declines in personal income and high savings rates imply that the steady growth of the past several months may be slowing. If that is the case, corporate earnings growth will likely slow, and stock prices will lose their momentum.

Valuation expansion has driven the markets since March, as investors look not only to the economic rebound, but also to future growth. This has been compared to the environment in the late 1990s, when stock valuations (primarily tech – sound familiar?) rose dramatically to unsustainable levels. For some stocks, that comparison may be relevant, but there is a substantial difference in that the large (tech) companies this year have earnings, whereas in the late '90s, many (most?) did not. Additionally, most of these mega-companies are positioned for strong growth down the road. Investors must weigh whether they feel the high valuations are sustainable or not. The answer to that will depend, to a large degree, on the virus and the roll-out of vaccines/treatments for it.

Another major issue on the minds of investors is the upcoming election. While there are many potential results, there are three that are most likely:

  • President Trump is re-elected and the Senate stays Republican. Things likely would not change much and trade would be a major issue going forward. This could be marginally beneficial to the markets, although valuations are such that future returns would likely be somewhat muted.
  • Joe Biden wins , but the Senate stays Republican. Again, the affect on the markets would likely be somewhat muted, as there would not be many new policy changes to disrupt things.
  • The Democrats sweep the Presidency and the Senate, and subsequently usher in more substantial changes. Greater regulation, higher taxes, and a potential economic shutdown would be offset by more fiscal stimulus. Market reaction would depend upon what policy changes dominate.

From an investor's perspective, there may be a tug of war, as some policies may be viewed as beneficial and others less so. In any event, the virus, and the course it takes over the next several months, will really determine how the markets perform. Should there be a vaccine, a reliable treatment option, and/or a natural decline in the severity of the virus, the economy would likely surge for at least a quarter or two. This could usher in some inflation, but given where we are coming from, that may not be such a bad thing. If, however, we are forced into another shutdown, the effect on the economy could be devastating.

What is an investor to do, given the backdrop of increased valuations, the ongoing threat of the virus, the uncertainty surrounding the election, and the rock-bottom interest rates that could bounce up if inflation were to come back sooner than expected? For one, not panic, and not make substantial changes to their portfolio based on current or breaking news. Much of the volatility in the markets is related to short-term issues. As an investor, you should take a longer-term approach, and that would argue to stay invested. It may, however, mean adjusting your asset allocation.

Valuations in growth stocks (those mega-caps, primarily, but the sector as a whole) have grown and future returns may be somewhat muted over the next several years, as compared to those sectors that have seen their valuations grow somewhat less robustly. High-quality, value-oriented stocks may offer somewhat greater potential and the possibility of greater income from dividends. Staying diversified, laddering out positions, and possibly taking a small stake in inflation-protected bonds may be warranted. In addition, it may be worth considering fixed income proxies such as utility stocks or other dividend paying, high quality stocks if one is willing to take on a bit more risk. 

As we head deeper into fall, we will continue to analyze the economy, the election, and the effects of the virus on the markets; however, our approach has not changed, and we continue to seek opportunities that provide a balance between protecting the downside, while looking for opportunities to grow. We are here and available to discuss your portfolio or any other issue you may have. Please call the Wealth Management department any time at 608.826.3570. We look forward to speaking with you.

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