Stocks climbed higher for the third week in a row, oil jumped, and Treasury yields rose to an 11-week high following a surprising gain in payrolls last month. The U.S. economy added 2.5 million jobs in May, while the unemployment rate declined to 13.3% from April's record level, suggesting that an economic recovery is under way faster than previously thought. Even though economic activity will likely take a while to return to pre-crisis levels, last week's employment data may be laying the foundation for a long-term recovery. Following last week's rally, the S&P 500 has now erased its losses for the year. Some uncertainties that could trigger higher volatility remain, but the recent market advance highlights the importance of staying invested, even through the most difficult times.
Reopening and Recovery: Slowly Clearing the Way
Driving through fog is difficult. It’s hard to see the road and even harder to see the destination. In the same sense the path from recession to recovery can be just as hard to make out. As the economy emerges from the unprecedented lockdown, investors continue to look for signs that the recovery is going in the right direction. In a week when civil protests were widespread in cities across the U.S. and geopolitical tensions between the U.S. and China continued to be elevated, the market kept its focus on economic and corporate drivers of long-term equity performance. That focus was rewarded last week by the release of the May jobs report showing that the unemployment rate defied analyst forecasts and, instead of increasing, declined to 13.3% from 14.7% in April.
The S&P 500 closed the week up 5% and just 6% from the February record high1. Its best week in 8 weeks1. All told, the index has risen 43% from the March lows even as fundamental conditions deteriorated considerably over this time period due to the COVID-19-triggered economic lockdown and shuttering of businesses1. Though the path between the strength of the equity rally and the current weakness in the underlying fundamentals is still clouded in a haze of uncertainty due to the unknown next stages of the pandemic, three positive indicators are beginning to slowly clear the way.
1. The Labor Market
Over the last three months, the U.S. economy shed 19.6 million jobs, the largest three-month decline on record2. May was expected to be another bad month for workers, with much of the retail, hospitality and leisure sectors either still shuttered or operating at reduced capacity from COVID-19 containment efforts. Instead, the nonfarm-payroll employment rose by 2.5 million jobs in May, a stronger and earlier-than-expected start in recouping the jobs lost during the shutdown. Beyond the headline numbers there was more good news2. Labor participation also increased, signaling that people were drawn into the labor market by employment opportunities instead of on the sidelines, and the number of hours worked increased, signaling the second-quarter downturn may be also a little better than expected.
As welcome as the better-than-expected jobs report is, the rise in the unemployment rate is still the highest its been post world war II. Additionally, the report made a couple of notable caveats. First, it stated that a classification error led it to understate the unemployment rate by three percentage points. Had workers been properly classified, this rate would have been 16.3% instead of the 13.3% reported2. Second, May's gains may have received a temporary boost from government relief efforts that could fade without added stimulus over time. More specifically, the Payroll Protection Program requires that firms keep workers for at least eight weeks in order to receive funds. Since over half of the gains came from restaurants that are still either closed in many cities or operating at reduced capacity, it remains to be seen if employers are able to retain their workers after wage subsidies expire.
Takeaway: Green shoots in the recovery from the reopening of the global economy are starting to grow stronger, but there's still a long way to go before they begin to bear fruit for a durable recovery.
2. Central Bank Stimulus
Last week the European Central Bank (ECB) boosted its emergency bond purchases by another $600 billion euro, while Germany, the EU's largest economy, added another 130 billion euro in new spending and economic stimulus3. The one-two punch of federal and monetary stimulus across developed economies has been an important driver of the market rally but also a key support for the downtrodden global economy, in our view.
In addition to fiscal spending relief efforts to highly impacted companies and consumers, major central banks acted aggressively to stimulate an economic recovery. The early stages of the March market turbulence in response to the COVID-19 outbreak was marked by a rare sell-off in both equities and investment-grade bonds that threatened firms' ability to access financing. Major central banks acted quickly to keep low-cost credit flowing to businesses and consumers and to limit sustained damage to the labor market.
These efforts are paying off. U.S. investment-grade bonds are up 5.0% year-to-date, and it is the strongest performing asset class so far this year3. Additionally, though lending conditions continue to be tighter than before the outbreak, they are still more favorable to borrowers than they were in 2011 or during the 2008/2009 recessions. However, like the labor market, the credit-market outlook is still foggy. Companies entered the 2020 downturn already with a high degree of leverage, which could lead to elevated defaults and delinquencies down the road.
Takeaway: Better credit conditions due to aggressive actions by central banks are partially offset by high corporate debt, which we think could slow but not derail the recovery.
3. Corporate Earnings
Corporate earnings are a fundamental driver of stock returns over time. Given the magnitude of the economic uncertainty, there are still blind spots within the COVID-19 impact to corporate earnings. From January to June of 2020, analysts have lowered their forecasts for corporate earnings per share by 28%, according to FactSet, which would be the biggest decline in earnings estimates since FactSet started keeping record in 1996, surpassing the previously recorded decline of -26.4% in the first five months of 2008. So far, the equity markets have looked past the downturn in corporate earnings with the optimism that a reopening economy will cause a rebound in profits later this year and into 2021. Moreover, over the last two weeks, with positive signs of a safe reopening of the domestic and global economy, the market rally has broadened from a handful of large tech companies with strong balance sheets that were largely immune to the COVID-19 lockdown, to other sectors tied most tightly to the economic conditions, such as financials, industrials and real estate.
Takeaway: We think that corporate earnings will benefit from a sustained improvement in economic conditions, like the stronger-than-expected job gains posted for last month. Moreover, continued advances in medical treatment and testing that fosters the economic reopening can also help earnings rebound more quickly and support equity returns in coming months.
Last week revealed early indicators of progress from recession to recovery as the economy reopens. That being said, the recovery is still in the early stages of this journey, with continued hazy conditions in key economic and corporate fundamentals due to the uncertain path of the COVID-19 pandemic. In uncertain times, we recommend investors be guided by a disciplined investment approach with a focus on systematic investing to take advantage of elevated market volatility. Rebalancing to maintain a proper mix between stocks and bonds for individual risk tolerance and diversification across asset classes, sectors and geographies can also help investors stay on the road towards their long-term financial goals, despite all the fog.