In June, the National Bureau of Economic Research declared the US fell into a recession in February, ending its record 128-month long economic expansion. This could also be the shortest recession in the US history, however, as the country started to reopen in late April and economic activities have accelerated in May and June. While the pundits are still fully engaged in the debate of the possible shape of the economic recession / recovery, be it a V, Swoosh, W, the SP500 index has voiced its opinion by returning 20.54% in the 2nd quarter, and 39.3% from its March 23 low.
While many have been stunned by the quick and sharp rebound of the US equity market, we believe there are good reasons behind the rally. First, the US Federal Reserve has done the necessary heavy lifting. The US Fed alone had expanded its balance sheet by nearly $3 trillion in the past three months, to support consumers, businesses, financial markets, and state and local governments. The federal fund rate was cut to nearly 0%, and the Fed offered assurance by providing forward guidance that rates will remain low until it is confident “the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”
Secondly, the U.S. Federal government has injected massive fiscal stimulus to the economy after passing multiple relief packages, totaling nearly $2.8 trillion. The fiscal stimulus includes direct cash payment to the majority of the US households, expansion of unemployment benefits, and loans and grants to small businesses, hospitals, and state and local governments.
Thirdly, reopening of the US economy had happened faster than most expected. Georgia, Texas partially opened up in late April, and most states have reopened by early June. This reopening pace exceeded the previous consensus expectations which called for July to be the transition period.
Fourth, the reopening has gone well so far. Retail sales, a measure of purchases at stores, at restaurants and online, increased a seasonally adjusted 17.7% in May from April, according to the Commerce Department, though still down 6.1% year over year. The May U.S. jobless rate fell to 13.3%, down from 14.7% in April, as employers added 2.5 million jobs, early signs the labor market is mending. Right after the close of calendar Q2, we received more good news on the employment front as the US economy added 4.8 million jobs in June, which reduced the unemployment rate to 11.1%.
Lastly, there has been encouraging news on the vaccine front. Researchers worldwide are working around the clock to find a vaccine against Covid -19 and there are more than 150 candidates announced so far. The US government has chosen three vaccine candidates to fund for Phase 3 trials under Operation Warp Speed, a public–private partnership to speed up Covid-19 vaccine: Moderna’s mRNA-1273 in July, The University of Oxford and AstraZeneca’s AZD1222 in August, and Pfizer and BioNTech’s BNT162 in September. Operation Warp Speed aims to deliver 300 million doses of vaccine by January 2021. Some companies and analysts are predicting a vaccine could be approved for emergency use as soon as this fall or even before the election.
The way to recovery won’t be a smooth ride, given the characteristics of a pandemic, and we anticipated a surge in Covid-19 cases once the economy reopens. That of course has indeed been the case, and the US equity market has been spooked somewhat by resurgent new cases in the past 2-3 weeks. That said, we don’t believe the country has the appetite to shut down the whole economy again. Six months deep into this pandemic, the data is rather clear respiratory-droplet contact is the major mode of Covid-19 transmission. Since, the major medium for transmission is close-up, person-to-person interactions for extended periods, social distancing and masks are the magic bullet to prevent transmission, an effective but much less blunt way than massive lockdown. In the past week or two, multiple states have paused their economy from reopening further and Texas and California have ordered bars to be reclosed. We believe those are more sensible and more sustainable approaches as we deal with clusters of infections and learn to live with the virus in the foreseeable future. Targeted and nuanced lockdown of infection clusters, and continuous social distancing and mask wearing, in our view, are the right way to carry us to 2021 when a vaccine likely becomes available.
The latest consensus economist estimates call for a 5-6% decline of US GDP in 2020, growth of 4-5% in 2021, and growth of 3-4% in 2022. Wallstreet analysts now forecast the SP500 EPS to be ~$125 in 2020, vs. $165 in 2019, which will rise to $150 in 2021 and $170 in 2022. While neither economists nor Wall Street analysts expect the US economy or corporate earnings to return to 2019 level until sometime in 2022, it is fair to question the current level of the SP500, which is almost flat to the 2019 year end.
So where are we now in terms of valuation? The historic crash and rebound of the S&P500 index in the last 4-5 months have had a notable impact on its companies’ valuation attractiveness, similar to the 2008/2009 experience, though executed in a much speedier manner. While a median company in the S&P500 was attractively priced at the end of March, this is no longer the case three months later. Valuation appeal could improve, however, if discount rates decline or cash flows improve relative to current expectations or both. Looking back at the great recession, valuation for the S&P500 hit a low point in late 2009, and improved in 2010 and 2011.
Incorporating the latest 10 Yr US Treasury yield of 0.64% into our market derived discount rate calculation, the Equity Risk Premium (ERP) per our estimates, is currently at ~6.75% for nonfinancial US firms in nominal terms, significantly higher than the historical 5-year median of 4.48% and 10-year median of 4.96%.
All things considered, we believe current market valuation is rich, and is vulnerable to negative surprises. However, unlike leading to the Tech Bubble of 2000, when the market was overvalued and equity risk premiums were low at 3- 4%, today’s equity risk premium is very high providing some long-term protection. Further if analysts begin to revise future earnings upward in the months ahead, intrinsic values will likely rise.
In the 2nd quarter, the Valuation 50 significantly outperformed the S&P500 until June 8, as investors began focusing on the US reopening its economy and reassessing non-mega companies’ fortunes after the pandemic. In the past 3 weeks, the Valuation 50 has given away much of that outperformance as investors again sought comfort in mega companies amid news of resurging cases of Covid19. We remain confident with the leading positions our companies enjoy in their respective industries, and the updates managements have provided only strengthened our conviction that our companies will be able to take market share in the recovery and continued to dominate over competitors.
Looking forward, we have the certainty the Fed will keep interest rates low and will keep supporting the overall economy and markets. There is also a high possibility that another big fiscal stimulus could be forthcoming, maybe in August. It is uncertain, however, how bad the infection rate for Covid-19 will become in the 2nd half of 2020, which limits the speed and scope of an economic recovery. Our base case scenario is the US won’t reinstate a broad based shut down, and businesses and citizens will learn to live with the virus. A bigger uncertainty which will have a longer-term impact, is the US election in
November. Joe Biden’s upcoming nomination has alleviated investors’ fear of dramatic changes to fiscal policies, should the democratic party take back the white house. That said, it is no secret a Biden administration will result in higher taxes and the candidate has promised to raise taxes by $4 trillion in the next 10 years. Some of Biden’s key tax proposals include: 1) Increase corporate income tax rate to 28% from the current 21%, 2) Impose a 15% minimum tax on corporations with book profits of $100 million or higher, 3) Tax long-term capital gains and qualified dividends at the ordinary income tax rate of 39.6% on income above $1 million. Not to mention, a Biden administration will likely be more heavy-handed on regulating businesses than the Trump Administration, with particularly negative ramifications for industries such as oil and finance.
Each election brings new winners and losers as policy priorities get reflected in regulations and tax policies. Further, the political angst across the country feels much more acute this time around than during past elections. Hopefully regardless of who wins, the next President will use rhetoric and action to reach out and heal. Entering the 3rd quarter, we don’t believe the current equity markets are reflecting a democratic sweep, and we suspect it hasn’t seriously priced in a Biden win despite very negative polling for Trump according to the latest. However, the political season is truly just getting started and we will have much more clarity by the end of Q3.