Look inside the index—there’s a sharp split between winners and losers. Locating value and identifying durable trends are key.

  • The gap between the real economy and the stock market is wide, but you can bridge it by considering the anatomy of the market. There’s a sharp split between winners and losers.
  • Monetary and fiscal policies are supporting cash flows for businesses and households.
  • Stark differences across countries underscore the importance of policy.
  • There are consequences to massive U.S. stimulus, but we think higher taxes are much more likely than spiraling inflation.
  • Focus on our key themes of navigating volatility, locating value and identifying durable trends for the coming years.

The grim facts have become familiar. The U.S. unemployment rate is at its highest level since the Great Depression. The COVID-19 death toll tragically continues to climb, and a vaccine or treatment may not be ready until 2021. Half of all small businesses reported they would not be able to operate for more than three months under current conditions.  

Now consider a different set of facts. The S&P 500 is only 15% below its all-time high, reached on February 19, 2020, and it trades with a forward price-to-earnings multiple that is the highest since the dot-com bubble in 2000. Technology and healthcare stocks are close to flat on the year, and the FANG+ Index of global tech giants has added $1 trillion to its market cap since its March 23 lows.

On the surface, it doesn’t make sense. Global growth is set to have its sharpest decline in 100 years, but equity markets seem to be ignoring the damage. It may take years for the U.S. economy to get back to where it was at the end of 2019, but the market is only another 10% rally from regaining its December 31 level. What gives?

Global business activity in April was the weakest on record

Source: J.P. Morgan, Markit. April 2020.
The chart displays the J.P. Morgan Global All-Industry Purchasing Managers’ Index from 1998 through 2020. It indicates that global activity in April 2020 was the lowest across this time period.

Equity markets have bounced back despite the dire economic data

Source: Bloomberg, MSCI, S&P.  May 11, 2020.
The chart shows the total return index of equity markets, MSCI ACWI and the S&P 500 from January 1, 2020, through May 7, 2020, indicating that the equity markets have signaled bouncing back starting at the end of March through May, since the total return of equity markets have increased 25% from their lowest point.

To be blunt, the performance of the overall index is misleading. It masks weakness at the individual stock level. The S&P 500 may be only 15% from its all-time high, but the median stock is still down 25% from its respective 52-week high. The technology sector is up ~1.5%, but the energy sector is down 38%. The software industry is up almost 15%, but airlines are down 63%. Investors have split what they think are “winners” (mainly technology and healthcare) from the “losers” (including financials, travel and energy). Concentration at the top is also indicative of broader weakness as investors flock to the safety of the largest companies with the clearest growth prospects. The top-five stocks in the S&P 500 haven’t made up this large a share of the overall index in over 40 years. The index may suggest that stock investors are optimistic, but a look under the surface tells a very different story.

The chart below illustrates the divide. As a rule of thumb, the business models most affected by the new normal of a COVID-19 world (cruises, airlines, oil and gas) have experienced the steepest share declines. The business models least affected have had more resilient stock prices. 

The markets has split the winners from the losers

Source: Bloomberg. May 19, 2020.
The chart shows the range of stock market performances this year so far by displaying the distance from 52-week high, indicating that some stocks were hit harder than others during this time period.

Investors may be splitting winners from losers, but it may not matter if there are catastrophic outcomes in the real economy. It is bizarre that companies that sell RVs are rallying when the unemployment rate in the United States seems set to flirt with 20%. Likewise, even the most dominant companies would feel the impact of half of small businesses failing to survive three months.

Policymakers have at least temporarily bridged the gap for the real economy. First, the CARES Act provides robust support for workers who have been laid off. Recent estimates suggest that three out of every four workers who have been laid off actually earn more now than they did when they were employed. The real test will come over the summer when the increased benefits are set to expire. Second, unprecedented actions by the Federal Reserve (Fed) signal that the central bank will do whatever it takes to ensure that businesses and consumers can access credit. Among the signs that Fed policies have delivered:

  • March and April both saw record investment grade (IG) corporate issuance; IG bonds have recovered their crisis losses.
  • Commercial paper spreads relative to Treasury bonds are more or less at “normal” levels.
  • Treasury market volatility is at pre-crisis levels.

So far this year, U.S. stocks have outperformed those outside the United States by 9%, even though the United States has the highest gross number of COVID-19 cases. Policy response explains much of that divide. The U.S. federal government is boosting support for the real economy by expanding the budget deficit, while the Fed has committed to keeping sovereign debt costs low. Only a few other regions (e.g., Japan, the United Kingdom and China) have this luxury.

The European Monetary Union’s policy response has been less effective, reflecting an awkward mix of monetary union and fiscal disunion. Countries that cannot issue debt for fear of inflation or currency weakness are also challenged (e.g., many Latin American countries). The chart below shows the range of stock market performances this year. The ability of policy to support the economy through a sudden stop to economic activity, as well as the ability to contain the spread of the virus itself, explains much of the difference between market winners and losers.

LATAM, EM Europe and Euro periphery hardest hit by COVID-19 shock; New Zealand, Denmark, China, Taiwan, United States closest to recent highs

Source: Bloomberg. May 11, 2020.
The graphic shows the average stock distance from 52-week high by sector as of May 6, 2020. It indicates that some sectors have had more severe negative losses than others during this time period.

Many fear that unprecedented central bank “money printing” to buy securities, along with fiscal deficit expansion, will lead to an adverse inflation outcome. But to us, the risk of spiraling inflation is very remote. In our view, central banks are doing all they can to ensure that we do not fall into an equally dangerous paradigm of deflation.

Still, while the risk of inflation may be low, there is a growing risk of higher taxes on corporations and wealthy individuals. The ratio of U.S. federal debt to GDP is set to rise to war-time levels. To lower that ratio, the U.S. economy will need to grow and/or taxes will need to rise to retire debts.

The performance of individual stocks may appear reasonable, but that does not mean the stock market overall offers compelling value. As a result, we are approaching the investment landscape with an abundance of caution. 

We are focused on adding portfolio diversifiers that could protect us in the event that a second wave of new virus cases threatens healthcare systems, or if policy support proves insufficient to protect the real economy. The COVID-19 crisis will likely entrench the strained relationship between the United States and China. As supply chains shift in response, potential new winners and losers will emerge.

Market volatility allows us to find value where we think asset prices reflect economic projections that are unduly pessimistic. For example, we are finding opportunities in high yield debt ex-energy.

We believe digitally exposed and healthcare companies have led the market for a reason. Both digital transformation and healthcare innovation have clear, long-term growth trajectories, and adoption of new solutions is likely to accelerate because of the COVID-19 crisis. We think these stocks will continue to lead through the economic recovery. 

Finally, we advise that investors stick with, or revisit, their goals-based investment plans. It’s important to keep a long-term perspective, especially in the current crisis. Someday, we will solve the problem of COVID-19, and asset prices will reflect that reality.