Rising to the Challenge
Dear Clients and Friends,
Americans are encountering a series of challenges this year, as COVID-19 continues to disrupt work and school routines. Meanwhile, social distancing guidelines weigh heavily on travel and leisure industries, while job losses and an economic slowdown fuel emotional and financial havoc. Nonetheless, recent trends suggest that parts of the economy are starting to improve, and markets are taking notice. Manufacturing, services, and technology earnings are recovering, and the Federal Reserve stands ready to support the next leg of economic growth.
Within this context of a gradual recovery, broader stock markets rose 9% in the third quarter as investors pounced on technology solutions that are helping the globe navigate social distancing requirements. With many workers and families spending more time at home, buyers and sellers are doing more business online, driving demand for online ads, ecommerce, smart phones, and cloud computing. In some ways, the tech sector, which makes up nearly a third of the S&P500, is rising to the challenge. As technology companies provide a bridge to a COVID vaccine, stock prices are chasing the upward move in tech earnings.
During the quarter, we found opportunities to take profits in some of our surging tech stocks as we gradually shifted into more defensive sectors such as healthcare. We are comfortable with a meaningful exposure to software, IT services, and tech hardware. However, we also like the durable growth and reasonable valuations we see in drug, device, and health service companies.
COVID and the Three Es
We expect market volatility to increase heading into year-end as new information emerges on the path of the virus and the speed of a vaccine rollout. Additionally, investors will be closely watching the three Es: the economy, the election, and earnings.
So far, we have seen two COVID waves and a third could stem from increased personal activity or hospital bottlenecks as doctors treat flu and COVID cases simultaneously. A third COVID wave could lead to more quarantines and slower economic activity. Still, a growing body of scientific data suggests that new COVID vaccines and treatments may start to reach the broader population in 2021. The timing and execution of a vaccine rollout will likely impact consumer confidence and the broader economy.
In addition to the COVID dynamics, we are also watching other factors that could drive the economy in the fourth quarter. Surveys suggest that manufacturing and services may continue to expand, although unemployment may remain stuck at elevated levels. The Federal Reserve seems willing to let inflation run up a bit, which could help the job market if steady monetary stimulus continues to support the economy. Another shot in the arm for jobs and the economy could come from an additional round of fiscal stimulus, although negotiations are currently tied up in political knots.
Speaking of politics, investors are also focusing on the upcoming Presidential election for clues on potential tax and regulatory changes that may impact markets. During our recent call with political strategist Greg Valliere, we came away with a sense that Democratic control of the White House and Congress could lead to higher corporate tax rates over time. We could see some short-term volatility coming out of the election, but we expect markets to gradually refocus, as they tend to do, on the economy and earnings.
The corporate earnings picture will become clearer beginning mid-October as firms report quarterly results giving investors a chance to see how companies are recovering. We expect year-to-date trends to persist as technology companies exceed investor expectations, while more cyclical industries such as energy, banks, retail, travel, and leisure continue to struggle. If overall corporate profits exceed Wall Street estimates again, our sense is stocks could see a modest leg up.
How are we positioning?
Our analysis of COVID trends and the three Es suggests maintaining a defensive posture. We currently favor a modest cash position to take advantage of any market volatility stemming from unexpected events heading into the New Year. We also prefer more stable sectors such as healthcare, consumer staples, and utilities compared to industries struggling under the weight of the recession (commodities and financials). For technology stocks, we favor a selective approach to owning long-term market share gainers with reasonable valuations.
Turning to bonds, low levels of growth, inflation, and Federal Funds rates are keeping interest rates low for high quality, income-generating bonds. Within these constraints, we continue to own short-term Treasuries as a safe way to partially offset inflation. If we get a modest uptick in either inflation or growth, we may swap into longer-term Treasuries to lock in more attractive yields. At the same time, we are extending corporate bond ladders by purchasing some longer-term high-quality bonds as older bonds mature.
As we approach year-end, we will be watching fiscal and monetary policy makers as well as tech companies as they continue to rise to the challenges of a global pandemic. COVID trends and treatments along with the economy, election, and earnings may fuel some volatility for markets. However, our broader view of an economic recovery suggests cautious long-term optimism as we see opportunities to own attractive stocks, bonds, and other securities. As we enter the final stretch of the year, we remain committed to our core investment principles and ever mindful of your goals and objectives.
With Warm Wishes for Fall,
Michael Bailey, CFA
Director of Research
Michael Mussio, CFA, CFP®