Investors saw it coming – as they often do. The reopening is underway. Restaurants are beginning to serve sit-down meals, beaches are open, hair is being cut, and nails polished. Workers are being called back to factories and offices, although many who can work remotely will continue to do so. The precipitous drop in GDP in March, April, and May will now begin to reverse. Investors bid up stocks in anticipation of this reversal because they knew the shutdown was temporary. The S&P 500 is now down only 8.5% since the start of the year, while the Nasdaq is up 4%. But all is not well. The average stock in the S&P 500 is down 17% year to date and the average Nasdaq stock is down 19%.
If you were looking for a V-shaped recovery, you will not get one, but we are almost surely going to see some strong growth in the third quarter. How this plays out over the longer term is much less clear, because this recovery not only has exceedingly high unemployment to unwind, but must do so under the cloud of COVID. And those two challenges will not only shape the path of economic recovery, but will also elevate risks in certain investments relative to others. Just as investors bid up cyclical stocks in anticipation of reopening, they may just as quickly retreat to safety if that recovery appears likely to stall or even reverse.
The time it will take to get all the way back to pre-COVID economic activity depends on two very delicate, and still unknowable, factors. One is COVID itself: further spread of the virus versus progress in its treatment or a vaccine. The other is much more difficult to pin down: we’ll call it Expectations. Do businesses expect consumers to buy new cars and new clothes? Do consumers expect to get their jobs back? Do they expect to be safe if they venture out to shop or dine? Restrictions are lifting, but expectations will largely determine whether firms embrace recovery fully or proceed more tentatively. If CEOs expect customers to show up and spend, they will bring back workers, fire up the assembly lines, and get product out the door and into stores. Restaurants will hire back chefs, sous chefs, and waitstaff, and place orders for food from ranchers and farmers. Inventories, which were near record lows before the crisis, will be rebuilt quickly, and employment will recover rapidly. That attitude will put households on firmer footing as jobs return and will increase discretionary income, allowing spending to surge higher. But only if firms and households are all expecting that scenario to play out. If, alternatively, firms expect consumers to remain cautious in reemerging from lockdown or to be frugal in spending, they won’t bring back so many employees and won’t set the assembly lines to running at anywhere near full capacity. Inventories will remain low, employment recovery will remain muted, and household budgets will remain stressed.
Jay Powell, Chair of the Federal Reserve, seems to be acutely aware of the importance of expectations in shaping this recovery. His recent public remarks seemed designed to instill confidence. He seems sure of a second-half recovery, even as he notes that a full rebound will likely not materialize until 2022. The market surged higher on those remarks (and on news of vaccine progress). Powell is not just talking: the Fed has effectively removed the risk of a liquidity crisis to preserve the functioning of markets. This creates the basis for the recovery that Powell is promoting. The economy now needs demand to return, and, by touting the general health of the pre-COVID U.S. economy, Powell is reminding us of the potential which lays dormant. If we—firms and households alike—believe we can pick up where we left off, then we can, so to speak.
But if those expectations are tinged with doubt, then it is more likely that firms will proceed cautiously. Building too much inventory would put at risk scarce cash reserves, and shareholders are watching cash very carefully. This would delay rehiring and slow the recovery in personal income. And the first factor—the virus—will play a critical role in shaping those doubts. If infections and hospitalizations reverse course and start to climb after this holiday weekend of beaches and barbeques, firms and households will pull back further. Powell can try to shape expectations, but the hard facts of the virus may very well trump his confidence game.
When faced with two very different possible futures, how can investors prepare? On the one hand, the next several months are likely to see more volatility than usual as expectations shift on the back of new information about COVID. This may suggest a shift to safer positions, perhaps locking in steady dividend income. On the other hand, investors can take the long view and take advantage of the many dislocations that remain in share prices. With the average S&P 500 company down 17% year to date, bargains still abound, but be aware that the largest companies have surged higher. As Randall Coleman noted in last week’s commentary, the prevailing impact of COVID across global economies has been to accelerate changes already underway. This points to secular growth opportunities, even if the recovery turns out to be a slow one. The choice for any investor becomes a personal one: how much volatility is acceptable and how much time do you have for investments to work? We may be living in an unusually uncertain time, but investment principles remain unchanged.