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Encouraging vaccine news has raised hopes for a quicker pace of economic recovery. Although some COVID-19-related restrictions have been reinstated around the globe, they may have less of an overall economic impact than the spring lockdowns. Bond yields have started to rise on expectations for a stronger economy in 2021.
U.S. stocks and economy: Vaccine news boosts optimism
With Election Day over—although vote counting continues in some states, and legal challenges have been filed—investor focus has shifted back to the COVID-19 virus. Fortunately, the latest news is very positive. Drug maker Pfizer recently announced that an early analysis has suggested its coronavirus vaccine, currently in human trials, is 90% effective.
This has raised hope for a quicker pace of economic recovery. If it happens, the faster growth would be building on a strong third quarter. Gross domestic product (GDP) gained 33.1% on an annualized quarter-over-quarter basis, the largest increase in post-war history, during Q3. Of course, the record gain was mainly because economic activity ground to a halt in the second quarter due to the coronavirus pandemic and related social-distancing restrictions. Even with the third-quarter surge, GDP has only reclaimed two-thirds of its pre-pandemic losses.
The October jobs report confirmed that payrolls are still increasing on a monthly basis—up 638,000 in the latest report—but the pace of growth has slowed. Similar to GDP, the level of payrolls still looks weak, as only a little more than half of the pre-pandemic losses have been recovered thus far. As you can see in the following chart, while temporary layoffs have been falling, permanent losses had been rising until recently. October’s reversal is a welcome sign, but not yet the start of a definitive trend.
Temporary layoffs have plunged from highs and permanent job losses have dipped slightly
Source: Charles Schwab, Bloomberg, as of 10/31/2020.
One of the worrisome components of the report was the increase in the duration of unemployment. The number of individuals without a job for at least 27 weeks jumped by 1.15 million to 3.56 million; and they now make up a third of the total number of those unemployed. Should that continue to climb or persist at high levels, many workers may find it increasingly difficult to find jobs in the future; and they are more likely to drop out of the labor force altogether (based on history).
Meanwhile, third-quarter earnings have improved markedly. You can see in the chart below that estimates back in July pointed to a -25% year-over-year decline. However, they’ve improved consistently and profits are now expected to shrink by only -7.8% (this combines already reported 3Q results with expectations for earnings yet to be released).
Q3 earnings expectations have improved since April and July
Source: Charles Schwab, I/B/E/S data from Refinitiv, as of 11/12/2020. April estimates not available for 2Q21. April and July estimates not available for 3Q21.
Undoubtedly, we remain in an earnings recession, and while the improvement this quarter is notable, many companies are still not providing detailed forward guidance to Wall Street’s analysts. Given the virus’ impact on companies’ operating decisions, its trajectory will continue to determine clarity (or lack thereof) moving forward.
Global stocks and economy: Lockdown-lite
Optimism for a COVID-19 vaccine was seen in the markets this week, as the pandemic remains the main driver for the global market and economy. This year’s economic plunge and rebound was generally synchronous around the world, with the low point in April as COVID-19 infections spread worldwide. Since midsummer, nearly every major economy has seen its momentum stall after climbing 60%-90% of the way back to pre-COVID-19 levels. Given that global stock markets also moved synchronously in response to the virus, investors are watching for divergences in economic trajectories as governments around the world start to impose differing levels of restrictions in response to rising infections.
High-frequency economic indicators
Source: Charles Schwab, Bloomberg data as of 11/6/2020.
For example, high-frequency economic indicators in France have pulled back sharply following the start of new restrictions for the month of November. Although the term “lockdown” is being used, compared with the restrictions imposed last spring, it’s really “lockdown-lite.” France has still imposed a curfew and closed non-essential retailers, but kept schools, churches, manufacturing businesses, and construction sites open.
In the spring, all of these were closed during the first lockdown. While the reinstated restrictions are weighing on the high-frequency economic data, they may have less of an overall economic impact than the spring lockdowns, which ignited a recession. The stock market seems to agree. Even before the preliminary results of a successful vaccine hit the news and added to gains, French stocks posted a strong 8% gain during the first week of November, as measured by the MSCI France Index.
November’s “lockdown-lite” in France
Source: French government press release 10/29/2020.
Other European countries are implementing or considering a similar lockdown-lite approach to contain the COVID-19 infections in the continent ahead of a widely available vaccine. In Asia, COVID-19 has remained well-contained given swift and targeted restrictions in response to outbreaks. The number of new daily COVID-19 cases in France and South Korea—two countries with roughly similar-sized populations—is striking.
France and Korea new COVID cases
Source: Charles Schwab, Bloomberg data as of 11/6/2020.
Clearly, there are divergences among countries in infections and the restrictions imposed in response to them, with the most severe in Europe. Yet the market impact has been the opposite of what investors might have expected, with Europe’s stocks outperforming those in Asia since the new restrictions in Europe were imposed. Perhaps that is because the current restrictions are mainly targeted at services—travel, restaurants, entertainment—rather than manufacturing. The pandemic has led to a boon in manufacturing as consumers have shifted spending toward goods from experiences. Because it makes up only 17% of the global economy, manufacturing is not enough to fully offset the weakness in GDP. There is a greater impact for stocks, as manufacturing businesses make up about 50% of global market capitalization.
Manufacturing: Economy versus stock market
Source: Charles Schwab, World Bank and Bloomberg data as of 11/2/2020.
Global Stock Market = MSCI World Index
As a result of the difference in manufacturing exposure, profits and stocks may fare much better than the overall global economy and labor market as the lockdown-lite restrictions continue while vaccine approval lingers.
Fixed income: Bond yields rising
Bond yields have started to rise on expectations for a stronger economy in 2021. Initially, yields moved up on expectations for more fiscal aid after the elections. News of a potentially effective vaccine then sent the 10-year Treasury yield to near 1%, a level not seen since March. With the combination of fiscal relief and a vaccine, the economy could emerge from the COVID-19 crisis sooner rather than later. Even though the United States is currently in the middle of another outbreak, and a vaccine likely won’t be widely available until late 2021, the market is looking forward to a stronger economy.
10-year Treasury yield surged to the highest level since mid-March
Source: Bloomberg. 10-year Treasury yield (USGG10YR Index). Daily data as of 11/9/2020.
Without a clear timeline for how long it will take to manufacture and distribute a vaccine, the upside move in yields is likely to be limited. Before the news of a potentially effective vaccine, we saw 1% as the upper end of the range for the time being. However, if the news continues to be positive, then we would move that up about 1.6% to 1.75% over the next few years. The timing is uncertain, but it appears that the path of least resistance for bond yields is higher.
With inflation still below its 2% target and the unemployment rate still very high, the Federal Reserve likely will continue its very easy monetary policy stance. In the recent revision to its policy, the Fed explicitly said that it would wait for inflation to materialize and may let it exceed its 2% target before beginning to hike interest rates. Moreover, the Fed will want to make sure that the coronavirus crisis has ended before letting up on its support for the economy. That could take until the end of 2021.
However, the timeline for a rate hike could be pulled forward from the current estimate of 2023 if the economy and inflation revive more quickly. The Fed could also begin to ease up on its bond buying program and/or let some of its extraordinary lending programs expire. These are all still possibilities for the future, and unlikely to happen in the near term. As a result, short-term interest rates are likely to remain anchored near zero while long-term rates move higher, steepening the yield curve. A steeper yield curve is usually a sign of optimism about the economy and rising inflation expectations.
The yield curve has steepened
Note: The rates are comprised of Market Matrix U.S. Generic spread rates (USYC2Y10). This spread is a calculated Bloomberg yield spread that replicates selling the current 2 year U.S. Treasury Note and buying the current 10 year U.S. Treasury Note, then factoring the differences by 100. Source: Bloomberg. Daily data as of 11/9/2020.
What investors can consider now
No matter what the market is doing, we always suggest being prepared for future unexpected events. Geopolitical surprises are not uncommon between Election Day and the inauguration in January, as foreign adversaries have sometimes chosen to act in conflict with U.S. interests during a time of transition in Washington. However, market performance during this period historically is more likely to be influenced by the overall economic environment, which means any bearish moves may be short-lived if the global economy remains in recovery. Holding a well-diversified portfolio may buffer short-term market moves—that means making sure you have an appropriate mix of investments, including international as well as U.S. stocks, fixed income securities, and a healthy equity sector mix.
A word about fixed income securities: Given current low yields, some investors have been wondering whether bonds can continue to provide diversification in a portfolio. Many fear that if markets become volatile and stocks decline again, bond yields (which move inversely to bond prices) don’t have much room to fall—and therefore, won’t provide the balance to a portfolio that they have in the past. In fact, we believe bonds still play an important role as a diversifier from stocks. More importantly, we still expect low-risk or risk-free bonds, like Treasuries, to provide diversification from stocks during times of market downturns, even though a 60% stocks/40% bond portfolio may not be the best choice for every investor.
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