Market Year-to-Date Recap
With over half the year in the record books, 2020 has brought forth extreme and unprecedented events that have transformed economies and our way of life on a global scale. Equity markets began 2020 on a positive note, helped in part by the “Phase One” trade deal with China. U.S. economic data remained encouraging. The unemployment rate in February recaptured the 10-year low of 3.5%, and personal income rose. U.S. manufacturing appeared to be picking up. A low-interest-rate environment benefited the housing market, and building permits hit a13-month high. Better than expected corporate earnings pushed equity markets to all-time highs on February 19, 2020.
Beginning in March, the dramatic global spread of the COVID-19 virus plunged world financial markets into turmoil. The U.S. and global economies experienced the most rapid shutdown of economic activity ever seen, weighing heavily on markets and investor confidence. Oil prices plunged, and the U.S. stock market fell into a bear market, declining approximately 37% from its peak. In order to calm the markets and support liquidity, the Federal Reserve cut short term interest rates to 0% and increased its balance sheet. Policymakers launched unprecedented fiscal support with the passage of $2.2 trillion in emergency economic relief and stimulus. Markets remained volatile due to continued uncertainty but managed to trend higher.
S&P 500 Year to Date
As we moved through the second quarter of 2020, the support infused by the Fed and Congress produced a rebound in economic activity, employment, payrolls, industrial production, capital goods, vehicle sales, and housing and retail sales, all reaching near pre-pandemic levels. Gold prices continue to push all-time highs, exceeding $2,000/ounce, due in part to geopolitical concerns, the falling U.S. dollar, and the low-interest-rate environment. But just as investors began to feel more confident, a resurgence of virus cases occurred. The equity and bond markets continued to balance concerns about the sustainability of the economic rebound. The impact on consumer confidence and spending had a negative effect on credit card spending, air travel, and restaurant reservations, all of which point to a second slowdown in economic activity despite the continuously evolving news on potential vaccines and new treatments.
With all that has taken place so far in 2020, investors also have an upcoming presidential election to add to their plate. When it comes to this year’s election, it is important to keep a big -picture perspective. No matter what your political affiliation maybe, when it comes to market performance, it may surprise investors to know that it does not make much difference which party takes office. Conventional wisdom would follow that Republicans, who are supposedly more business-friendly than the Democrats, would be more beneficial for stock holdings. In looking back the last 100 years, Democrats have been slightly better for stock performance, but the difference is statistically minimal. What really seems to matter is whether control of the White House changes parties. When a new party comes into power, research shows that stock market gains an average of 5 percent. When an incumbent is re-elected or if a party otherwise retains control of the White House, returns were slightly higher, regardless of the party.
S&P 500 Returns in Election Years
Presidential elections draw the most attention. It is control of Congress, however, that tends to make more of an impact on policy changes. Some "experts" say it is likely the Republicans will retain control of the Senate and that the Democrats will retain control of the House. Others put zero to little value in political polling in light of the 2016 election results. Two things are certain: 1) The election is still a couple of months away and much can still happen, and 2) The upcoming congressional election results will warrant an unprecedented level of attention and importance.
While Trump and Biden have a host of policy differences, investors’ primary focus will be on tax policy. The concern over a potential increase in corporate tax rates, directly effecting corporate earnings and valuations, and potentially causing the U.S. equity market to reverse its upward momentum, weighs significantly on investors. Other areas of concern revolve around individual tax rates, capital gains tax rates, estate tax exemption levels, and ongoing trade and other issues with China. Differences on policy issues will impact specific sectors, and currently, the most vulnerable ones are Energy (due to highly differing regulatory stances on energy production), Financials (regulatory and tax differences), and certain companies in Health Care (issues involving the Affordable Care Act and who controls Congress).
There will also, however, be sectors of the economy and market that will likely be positively impacted, such as Utilities. Even if there is a Democrat sweep, with the recent economic events and the rise in unemployment, raising individual tax rates in the near term is not likely to be high on the agenda. One can expect elevated levels of volatility as we move closer to the election. Following elections, stock market returns tend to be slightly lower for the following year, while bonds tend to outperform slightly after elections.
The more recent expansion of the Fed’s balance sheet (currently $6.7 trillion) has heightened investors’ concerns over rising levels of inflation. The central bank has increased the amount of Treasury bonds and other assets it owns in an effort to keep markets and the economy afloat during the pandemic crisis. In the short term, the enormous amount of stimulus is not expected to result in an elevated level of inflation. Even as the unemployment rate comes down, and the economy returns to a more normal dynamic, a nervous consumer and weakness in demand could slow the recovery. The U.S. could see a weaker inflation backdrop, possibly even a period of disinflation.
Federal Reserve’s Balance Sheet
But what about the longer term? In recent comments made by Federal Reserve Chairman Jerome Powell, the committee remains optimistic about the prospect of inflation and stated that “longer-term inflation expectations have remained fairly steady. As output stabilizes, and the recovery moves ahead, inflation should stabilize and gradually move back up over time. Inflation is nevertheless likely to remain below our objective for some time.” The Fed’s position is that the balance sheet, at its current size, does not possess any real threat to inflation and that it is only being expanded as necessary.
Powell’s optimism contradicts many market experts. Critics cite several risks associated with increasing the money supply and the potential to drive inflation higher (though this has yet to be seen). However the majority of the money supply is now being used by the Fed to increase its balance sheet, and in the banking sector to purchase financial assets.
Others feel that inflationary concerns are overplayed due to the tools the Fed has at its disposal to combat inflation (reverse repurchase agreements, interest on reserves, term deposit facility, treasury loans). The Fed will use these four methods, with interest on reserves as the dominant one, to prevent an expansion of the monetary base, keeping them out of the hands of the private sector. Interest on reserves promotes banks to maintain high reserve ratios—also keeping money out of the private sector. The Fed will use these tools to prevent inflation, but in doing so, may not see the need to reduce its balance sheet until after the economy recovers. Rapid reserve growth will not lead to runaway inflation as long as the Fed is willing to raise interest rates as needed to keep credit demand in check.
Monetary policy is not the only catalyst. Over time, there are a number of factors that could determine the inflation environment. The shape of the recovery (L-shaped or V-shaped) and how governments, central banks, consumers, and businesses react could affect inflation. A quick recovery could be accompanied by some inflation, which is generally supportive of risk assets, particularly equity sectors such as real estate investment trusts, infrastructure (including energy infrastructure), and utilities. This is because these asset classes tend to outpace inflation over the long run. Geopolitical events such as trade tensions, which tend to weigh on growth, could also cause inflation to resurface. At the end of the day, it is important to keep in mind that growth is a significant determining factor for inflation and that it takes different tools to address different inflation drivers.
As we continue to move through the second half of 2020, investors will still experience periods of volatility as the multitude of forces at work mentioned above affect market conditions. Right now, the economy is steadily improving. We will see continued monetary and fiscal stimulus. The Federal Reserve has pledged to keep interest rates low, which bodes well for housing, capital spending, and the stock market. Once the data on the virus improves, consumers will feel more confident and consistent spending should return. At the time of this writing, Congress is debating details of an additional relief plan with the continuation of unemployment benefits and additional stimulus checks. While the uncertainty of a presidential election can give rise to higher risk and volatility in certain sectors and asset classes, it is important to remember that consistent returns over time are made over full market cycles, which are longer than presidential terms. Although there will be investment opportunities that arise from volatility in election years, staying fully invested in a well-diversified portfolio and a longer-term strategy will allow investors to weather most political climates. Changes in asset allocation should be made based upon a change in an investor’s goals and objectives, which includes risk tolerance.
1. S&P 500 -Year to Date 2020 Standard & Poors 500 Index, Market Cap Weighted Index.
2. S&P 500 Returns in Election Years- First Trust.
3. Federal Reserve’s Balance Sheet – Federal Reserve Economic Data
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chesapeake Wealth Management), or any non-investment related content, made reference to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Chesapeake Wealth Management. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his or her individual situation, he or she is encouraged to consult with the professional advisor of his or her choosing. Chesapeake Wealth Management is neither a law firm nor a Certified Public Accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Chesapeake Financial Group, Inc.’s current written disclosure statement discussing our advisory services and fees is available upon request.