After the “Great Lockdown,” the “Great Disconnect?”

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Adrian Cronje
July 9, 2020
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For many of us, the last quarter felt like it lasted a lifetime. Every day seemed like a week and every week seemed like a month. Capital markets moved with unprecedented speed and fury. Over the course of 90 days, the markets experienced what would normally unfold during a full market cycle which typically takes closer to seven years to run its course.

Summer started with the world slowly emerging from the “Great Lockdown” imposed by governments worldwide to contain the spread of COVID-19. Remarkable progress has been made in understanding how to treat those afflicted and finding effective therapies to help recovery, all while working toward a vaccination which is not likely to be widely available until early next year. Until then, the world has come to the realization that this public health emergency is here to stay for a while and that life and business will continue under a new normal.

In our last quarterly update, we discussed how stock markets had entered a bear market, falling by more than 30%, and how corporate bond market spreads exploded during the last few weeks in March in anticipation of a severe recession ensuing from the “Great Lockdown.” Finally, in early June, the National Bureau of Economic Research officially confirmed a recession began as early as February of this year. The Federal Reserve Bank of Atlanta’s GDPNow indicator, a real-time measure of economic growth, is signaling that second quarter GDP could in fact contract by as much as 35% on a seasonally adjusted annualized rate.

Yet, as the third quarter began, stock markets had recouped nearly all of their losses for the year and were within sight of the previous high-water marks while credit spreads had narrowed significantly, as economic data showed a better-than-expected recovery from very depressed levels. Notably, for the second consecutive month, the monthly jobs report came in ahead of expectations for June, while the manufacturing Purchasing Managers’ Index, often viewed as a leading indicator of the economy, returned to expansion territory. 2020 so far has offered yet another reminder that capital markets lead the economy, not the other way around—a key underpinning of our investment process which captures the forward-looking messages markets send as inputs to our models.

This has been the third-highest three month performance for the stock market since 1954. The only two better outcomes were off the generational market bottoms of 1982 and 2009. Yet, the lasting damage inflicted on the economy as a result of the “Great Lockdown” cannot be underestimated. The unemployment rate remains at 11%, and there is evidence that permanent job losses from the pain inflicted on many small businesses is rising. As the alarming rate of new infections of COVID-19 continues to climb without a decisive medical breakthrough, the economic recovery cannot continue to accelerate and will likely plateau at much lower levels than last year. Yet, capital markets still appear to be willing to look beyond what is likely to be a difficult second half of the year, featuring a “stop-start” recovery. What many are referring to as a “Great Disconnect” appears to have emerged between the tough economic reality we are facing and the more sanguine outlook capital markets have priced in. Perhaps nothing paints a more ominous picture than the current valuation of the S&P 500 index, whose trailing twelve-month price-to-earnings ratio sits at 25.6x versus a long-term average 16x.[1] So what gives?

Reconciling the Great Disconnect

Bulls argue such valuation measures always spike near economic lows and that the stock market actually looked even more expensive at the beginning of the bull markets which started in 2003 and 2009. They will point out that more than 90% of stock prices come from profits earned beyond a year into the future—in other words, that stock market investors should worry less about the immediate future and more about future earnings a year hence. They will also cite the extraordinary “do whatever it takes” approach from monetary and fiscal authorities which is intended to provide relief to the economy and to plug the income gap until a vaccine becomes widely available. The federal government seems ready to do more if needed, even though further fiscal stimulus will not be as easy to hash out in a bipartisan way in the lead up to the November election. In the meantime, bulls also argue the banking system entered the crisis well-capitalized as a result of regulations enacted after the Global Financial Crisis, and businesses are accelerating the adoption of the digitization of payments and other game-changing technologies, such as web-based communication, automation, and artificial intelligence technologies to cope with the pandemic, which will allow for productivity gains and profits. Lastly, bulls point to sentiment levels, often a contrarian indicator, which are negative with cash levels in money market mutual funds at high levels and flows into bond funds sharply exceeding flows into stock funds.

Indeed, the speed with which the Federal Reserve and Treasury acted is staggering. The Federal Reserve indicated it is unlikely to raise short-term rates until at least the end of 2022 while expanding its balance sheet to over $7 trillion, up from $4 trillion at the start of the year, in an effort to backstop the corporate and municipal bond markets. The U.S. government is already one of the top-five largest holders in more than ten bond exchange traded funds[2], and some are estimating it is on course to owning half the tradable Barclays Aggregate Fixed Income universe by the end of the year.[3] After Congress passed the Coronavirus Aid, Relief, and Economic Security (CARES) Act, the federal budget deficit, forecasted to be a mere $800 billion in January, is now estimated to be $3.8 trillion for the current fiscal year, driving up the U.S. debt to GDP ratio by an extra 15%.

On the other hand, bears will argue CEOs withdrew guidance to such an extent due to the highly uncertain outlook three months ago that the second quarter earnings season may bring worse-than-anticipated downward revisions to expected profits, dividends, and share buybacks. They argue that though the Fed’s impact on the bond market is significant, there is still a chance today’s deflationary forces and flight to safe assets could lead to negative interest rates, which has undermined the European and Japanese financial systems and economies over the past few years. In the long term, all the stimulus and debt piled up during 2020 may also lead to inflation and a debasement of the U.S. dollar’s status as the world’s only reserve currency—especially if a slower-than-expected economic recovery leads to a debt/GDP trajectory which looks to become unsustainable more quickly. This is especially worrying in light of successive cohorts of baby boomer generations beginning to retire in earnest, stressing the entitlement programs of Social Security, Medicare, and Medicaid to a greater extent over the next three years.

Finally, bears will point to policy uncertainty emanating from the upcoming election cycle in November. Concerns over its handling of the health pandemic and social unrest has led to the current administration falling out of favor precipitously according to many polls, particularly in swing states and among key constituencies required to win re-election. A hundred years of data suggest recessions and high unemployment preceding a re-election are notorious for ending presidencies. There is a long way to go until November, but capital markets will soon be handicapping whether an election sweep will lead to a Democratic president and Senate, under which a partial repeal of the 2017 corporate tax cuts to fund an infrastructure bill may be on the legislative agenda. In the short-term, this would weigh on corporate earnings expectations. In the interim, as the highly contentious domestic political cycle unfolds, U.S. geopolitical relationships with China and Russia continue to deteriorate.


There are reasons to be anxious about the apparent “Great Disconnect” which has emerged between capital markets and the economy. We believe the next six months are likely to bring greater volatility amid the current bullish vs. bearish outlook struggle. We remain attuned to the messages that capital markets send about the future and will aim to stay grounded, as always, in our disciplined process which pieces them together to inform the decisions we make when positioning investment strategy. This has always been the best way for us to remain unemotional during challenging times, even if it feels uncomfortable to be so. Proactive rebalancing and selectivity will continue to be key as the winners and losers in a post-pandemic world emerge. These have been the hallmarks of our process for more than two decades and are key to why we think the investment performance we have generated over the past few years will be repeatable in the future.

We are proud of the advice we have provided our clients as we shepherded them through a very difficult and traumatic first half of the year in pursuit of their long-term financial goals.[4] We are not resting on our laurels, however. The investment business will teach you nothing if not humility. We recall the bouts of frustration and impatience with all risk-managed and globally diversified approaches during a long, grinding bull market in the lead-up to the dawn of this decade. Thank you for the trust and confidence you place in our team.

Finally, the 2020s are shaping up to being one of the most pivotal decades in history. There are so many important strategic questions about what a post-pandemic world will look like beyond financial goals and investment strategy. We have kicked off a series of webinars over the next six months called the “Road to Recovery” in which we have put panels of subject matter experts and business leaders together to discuss what enduring changes the coronavirus health pandemic will cause. After covering “Private Markets” with leading private market investors in part one of our series, we will next explore the “Global Supply Chain” as businesses around the world move from a “just in time” to a “just in case” philosophy. Later this summer, we will explore the strategic economic impacts from both a big and small business perspective.

[1] Data sourced from Strategas Research Partners.
[2] An exchange traded fund (ETF) is a vehicle by which investors can obtain index exposure to underlying securities with continuous liquidity.
[3] Per Blackrock.
[4] Please see the blogs “It’s Test Time for DIY Investors” and “Buy Thought Partnership, Not Investment Products.”


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