As the final quarter of the year commences, an appraisal of 2020 leaves one wishing the year to end now. Undoubtedly 2020 rightfully deserves the moniker annus horribilis as plague, social unrest, political dysfunction, environmental cataclysms of both fire and water, and finally economic dislocation appear to be an enduring feature of life.
During the past quarter, the Commerce Department confirmed what was generally known: the COVID lockdown had devastating consequences as it precipitated an economic contraction without precedent in modern times. Second quarter GDP contracted at a mind-numbing 31.7% annual rate and comes on top of the 5% fall during the first quarter.1 Unemployment remains painfully high at 8.4%, while weekly initial unemployment claims continue to number more than 800,000 a week.2 As business activity disappears in some sectors, corporate distress appears to be causing a surge in bankruptcies across Main and Wall Streets. Trailing 12-month defaults in the high-yield bond market are running at 5.7%, which is a 10-year high. Unfortunately, defaults will likely rise into the low teens before recovering.
A Study in Contrasts
Despite the dystopic societal backdrop, investors appear to have quickly found their footing as U.S. markets continued to rebound during the quarter. The tech-heavy NASDAQ composite index enjoyed a dizzying run of roughly 20% through early September, but bled the gains during the month, ending the quarter up 11.2%. The large- and mid-cap Russell 1000 index and the small-cap Russell 2000 index both enjoyed smaller but robust runs, jumping roughly 16% and 11% respectively through early September, before settling to gains of 9.5% and 4.9% at quarter’s end. For the year through September 30th, the Russell 1000 index was up 6.4% and the Russell 2000 index was down 8.7%.3
Investor optimism rebounded with greater vigor in the U.S. than the rest of the world, especially in Europe where the economy contracted even more severely during the COVID shutdowns. That, plus a new spike in cases that is fanning fears of a second wave of the pandemic on the Continent, helps explain why the MSCI EAFE index of developed international stocks fell more than 7% through the first three quarters of the year, while U.S. shares were up.
In the U.S., the monetary chieftains of the Federal Reserve are credited with the disconnect between Main and Wall Streets. The central bank’s traditional mandate of stable inflation and full employment have mutated into assuring capital markets remain liquid, investors stay confident, and Congress and the President can spend money with alacrity. The central bank’s balance sheet, which has climbed to Olympian heights, now stands at more than $7 trillion, up roughly 80% from this time last year. As the pile of money on the central bank’s balance sheet increased, the price of money has collapsed. The 0.69% yield on the 10-year Treasury Note, which began the year at 1.9%, requires a jeweler’s loupe to examine.
Inflation-adjusted real yields are negative across the entire U.S. Treasury curve when using a trailing 12-month moving average of monthly inflation. This is a devastating environment for pensioners and pension sponsors alike as the purchasing power of capital invested in the “safest” fixed-income security guarantees a loss of purchasing power. Capital’s loss of purchasing power is effectively the loss of capital, albeit by gentler means than a stock going to zero. It is the effort to avoid this state of dissipation that forces money in motion as it seeks a return to maintain its value.
Sorting Out the Winners and Losers
As interest rates fall, the price of other assets rise. Indeed, certain types of investment are special beneficiaries in a low nominal/negative real interest rate environment — growth and hyper-growth stocks. Conceptually, the relationship is straight-forward. In a low-growth environment, reflected by low interest rates, companies that produce profit growth are desirable and therefore capture the affections (and capital) of investors.
In a zero/negative interest rate environment, the relationship between time and money inverts. When interest rates are positive, a dollar in hand today has greater value than a dollar tomorrow because of the income that dollar can generate between today and tomorrow. This is a central tenet of corporate finance known as the time value of money.
The promise of fast-growing future earnings attracts capital, thereby pushing valuations higher. Indeed, this state of play has helped elevate darling growth stocks to stratospheric valuations this year. One company that struggles to manufacture its product and recently turned in its first year of profits now sports a market value that recently exceeded the collective market capitalization of its competition. The company’s price/earnings ratio stood at 953. Based on current profits, it would take almost a millennium for the investor to earn the price paid for the stock. In other words, it would take from the Norman Conquest until to today for the company to earn its current stock price.
A New World Order
When interest rates are determined in the marketplace they clarify; when they are centrally administered by well-intentioned central bankers, they muddy. Whether an economy is expanding or in recession, money seeks a return. That search is made much more difficult when recession and a muddled price of money hamper the search for responsible return.
Recessions always reorder the commercial and public policy landscape. The record-breaking recession now underway will surely create a future that could break significantly from the past. This is clearly seen in the retail sector, where titans of yesteryear are being ushered through bankruptcy reorganization. The list includes storied names such as Brooks Brothers, Neiman Marcus, J. Crew, J.C. Penney, and Sur La Table.4
The commercial real estate sector, along with the hospitality and travel industries, are also getting battered by changing consumer patterns brought about by the pandemic. Airlines are shrinking their capacity as passenger revenue crashes. The numbers behind this shift are sobering: transactions for business travel are down 88% from last year. Revenue on international flights is down roughly 90%. Third quarter revenue for domestic carriers will likely fall roughly 85%.5 Airlines are struggling for survival as they reimagine a very different future. It is hard to see how the jobs they are shedding will ever return.
Turbocharging Growth Investing
As noted in previous letters, crises tend to accelerate existing trends toward new businesses and business models. The pandemic has turbocharged the pivot away from brick-and-mortar retail to online shopping. Amazon and those larger format retailers with robust online operations are the beneficiaries of the lockdowns. Infrastructure players that facilitate video conferencing and remote work are also winners in the world of social distancing. New companies, such as Zoom and Slack, have captured the imagination of investors.
These are new companies that have not yet had their business models tested by time and durable competition. To put a finer point on it: the challenge of valuing these “darlings” is really an exercise in futility. For starters, we do not know if the margins of these companies are defensible. And in many cases, we have no idea what their profit margin structures will be. It truly is a “buy high and hope” strategy or faith investing in a different form.
Today’s great technology is tomorrow’s laggard, especially when the barriers to entry are low, capital is cheap, and the potential payoff for the next “hot dot” tech company is enormous. Investors will have to differentiate and discriminate between those companies that have durable business models and those that have compelling products that are not the basis for an independent business but a product in a larger portfolio of solutions. In a sense this is the age-old challenge with which investors grapple.
Judging from the performance of growth versus value stocks both globally and locally, the battle is being convincingly won by the growth camp. The performance gap between these companies is historic. Perhaps one the most frustrating trades of the last decade has been a bet on the resurgence of value stocks. It seemed to be a reasonable bet as more money chased an increasingly narrow set of growth companies, while a larger set of solid companies saw their share prices languish as yesterday’s discarded merchandise.
It seems as if the value gang lost the plot as interest rate normalization failed, providing cover for growth companies to continue marching higher. Our approach has been to try and have a foot in both camps and not make a factor bet like growth versus value. Our equity exposure aspires to a core posture where both growth and value are represented.
We have also endeavored to achieve this balance in our international holdings with core funds that serve as the foundation of our global stock exposure. Indeed, classifying companies according to factor style has become more like an ecclesiastical debate: Google is represented in both the Russell 1000 Growth and Value indexes. Apple, which is generally considered to be a benchmark growth stock, is assigned a Core designation by Morningstar. When considering individual stocks, we are attracted to features of the business first, such as earning a return on investment that is durably above the cost of the capital behind the investment. We favor buying these companies at prices that reflect conservative estimates of projected cash flows. In short, we try to look at the exercise of security selection as a businessperson buying a company rather than as an investor buying a “name” for his or her portfolio.
On the fixed-income front, perhaps the most compelling area for both income and capital appreciation sits within the mortgage sector. This market appears to be marking time until investors discover the risk return in this sector looks favorable given falling mortgage rates and rising home prices.
Approaching the final months of 2020, the potential for autumnal market ructions is high, as the rising probability of a contestation of the results from the November election combined with a second wave of COVID infections batter investor confidence enough to precipitate another fall in the market. It is a reminder that proper portfolio construction is key to financial success.
1 Bloomberg (U.S. Department of Commerce data). Data as of August 27, 2020
2 Bloomberg. Data as of September 4, 2020
3 Bloomberg. Data as of September 30, 2020
4 Retail Dive, The running list of 2020 retail bankruptcies, September 14, 2020
5 Bloomberg Intelligence, August Lower Fares Pressure 3Q Revenue Further, September 17, 2020
The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.