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Macro & Market Perspectives Quarterly Outlook & Overview

4th Quarter 2020

3rd Quarter Recap & Key Takeaways

By: John Norris

Key Takeaways

  • Fed Chairman Jerome Powell telegraphed the next 2-3 years of US monetary policy: as accommodative as possible for as long as possible. Analysts now believe the Fed will keep the overnight lending target at 0-0.25% until 2023.
  • It was another good quarter for stocks, despite the sell-off in September. There is still a lot of money sloshing about the financial system that ultimately has to go somewhere.
  • Corporate America posted better than expected profits during 3Q. While expectations were diminished, a win is a win…especially in a year like 2020.
  • At first blush, the expiration of much of the CARES Act on July 31st did not negatively impact the economy and the markets as much as originally feared.
  • The political discussion increased as the quarter progressed. The two political parties currently offer two very different views about the nation’s economic future.
  • Bond yields are so low, it is hard to make a strong long-term argument for the asset class. But for the Federal Reserve, and other global central banks, backstopping the secondary markets, you would have to wonder where interest rates would really be.
  • The US economy and markets enter the 4th Quarter in ‘improved health,’ but still not completely healed.

3rd Quarter Commentary

At the start of the 3rd Quarter, Oakworth’s Investment Committee made several predictions for the quarter. Here are a few of them:

  • After a better than expected 2nd Quarter, investors will be anxious to see how the economy responds when various relief packages start to expire towards the end of the summer.
  • The 2nd Quarter earnings season should be interesting given the lack of forward guidance corporate America has been giving. As long as it isn’t a ‘worst case scenario’ and forward guidance isn’t a disaster, investors could move past it more quickly than you would imagine.
  • As the quarter progresses, investors will increasingly turn their attention to the November elections. If the Republicans can hold the Senate, the economy is ensured another 2 years of gridlock, no matter what happens with the Presidency.
  • The recipe for growth is in place: low energy prices, low interest rates, and expansionary monetary and fiscal policies. However, another mandated lockdown of the economy will render that irrelevant. Our elected officials have to be extremely careful
  • Two things are certain about 3Q: (a) stock market returns won’t be as strong as 2Q’s historic ones, and;(b) we will have a better sense of the economy’s true health by the end of the quarter than we have at the start.

These were mostly directionally correct. Things continued to get better during the quarter. Even so, here at the start of the 4th Quarter, it is still difficult to completely ascertain the economy’s true strength.

What isn’t uncertain is the US economy is in better shape than it was at the end of the 1st Quarter and start of the 2nd. Virtually all major economic releases reflect a meaningful increase in activity since the near stoppage at the beginning of the year. While there have been some changes to consumer behavior, the biggest impediment to growth is continued government-mandated interference in the free functioning of state & local economies. These include travel restrictions and quarantines, store and restaurant capacity limits, stringent public gathering guidelines which inhibit industries like amusement parks and museums, and a host of other local ordinances too numerous to list here.

To say we are operating on less than all cylinders would be an understatement. However, this doesn’t seem to be the fault of the private enterprise system. Government lockdowns caused the economic collapse, and continued government restrictions inhibit its rebound. Even so, objectively, some of the results have been pretty impressive given the shackles remaining on the business community.

Consider the following graph from Bloomberg. It shows the number of US payroll jobs. As you can see, these plummeted earlier in the year as governments shut their economies. However, as a partial remedy, the CARES Act helped to reverse the trend. Before anyone argues the government saved the economy, please remember the relief packages were necessary because government(s) closed it. Regardless, we have seen notable job growth over the last several months.

US Nonfarm Payrolls

Source: Bloomberg

As a result of this job growth, the official Unemployment Rate has fallen dramatically since the Spring, from 14.7% in April to 7.9% at the end of the quarter. Perhaps even more impressive than the decline has been the fact it hasn’t been due to a sharp drop in the number of Americans looking for work, up until now. To that end, the Labor Force Participation Rate, the percent of working-aged, non-institutionalized people actively participating in the workforce, has increased substantially since the end of April, the nadir in the labor markets, even if it did pull back a little in September.

While there is still plenty of room for improvement, the recent decline in the official number of unemployment has been significant. While most everyone by now has heard the term ‘V-shaped recovery,’ the chart here would have to be called a ‘lambda-shaped improvement!’

US Unemployment Rate

Source: Bloomberg

Of course, I would be remiss if I didn’t mention the Federal Reserve.

inarguably more than any other public institution, it has done more to ensure the adequate flow of money through the financial system. The thought process is pretty simple even if the comments Fed officials make can be obscure: good things tend to happen in the economy when the credit markets are liquid and the money supply is growing. While we are supposed to say things like “past performance is not indicative of future results,” the Fed knows its history. The last thing this group of Fed Governors and Presidents want to do is tighten the money supply and run the risk of throttling the economy. So much so, Fed Chairman Jerome Powell has basically told the markets they/he intend to keep interest rates as low as they can for as long as they can, possibly out through 2023. Further, it isn’t going to shrink its balance sheet anytime soon. The foot is on the gas and will remain there, even if inflation picks up a little.

Consider the following charts which shows just how much excess liquidity/reserves the Fed has recently pumped into the financial system. It has been astounding, and history will likely record it as either heroic or foolhardy.

Size of Federal Reserve Balance Sheet

Source: Bloomberg

All this money sloshing about and even the partial reopening of state & local economies has consumers and business owners feeling much better than they were. Sentiment has improved dramatically. So much so, you have to wonder what would happen in the economy if the government removed all pandemic-related restrictions. Of course, the number of COVID-19 cases would escalate, and that clearly wouldn’t be a good thing. However, at what point is the cure for virus worse than the disease itself? If the next two charts suggest nothing else, it seems America is ready to get back to work.

Conference Board Consumer Confidence

Source: Bloomberg

That is the consumer. US business owners are also feeling a little spring in their step. Consider this: the last reading for the NFIB Small Business Optimism Index climbed back over the 100 level in September to 100.2. That is 4.3 points higher than the trailing 10-year average! Just take a look at the graph. Interestingly, it doesn’t seem as though small business owners are focusing too much on what is becoming an increasingly contentious political environment.

NFIB Small Business Optimism

Source: Bloomberg

So, if consumers and business owners are feeling better about things; if the Federal Reserve is doing whatever it can to keep the proverbial economic wheels greased, and if the economy is responding well to the lifting of economic restrictions, how are investors feeling? Was it a good or bad quarter? It couldn’t have been as good as the 2nd Quarter, which was literally historic, and it wasn’t. However, US investors made money during 3Q! When the dust settles, the smoke clears, and the cows come home, that is ultimately the name of the game. Valuations? Earnings? Rationale? These all matter, but investors’ confidence that things will get better is a powerful force.

S&P 500 Price Level 3Q 2020

Source: Bloomberg

In the end, the 3rd Quarter of 2020 was pretty much as advertised. The markets were positive, but not as positive as they were the previous quarter. We know the economy is stronger than it was, and that Americans are ready to get back to some semblance of normal. However, we don’t know when the politicians will completely relax the reins.

In so many ways, it reminds one of the first two lines of the refrain in the classic Beatles tune “Getting Better.” While it didn’t chart, as many of the songs everyone knows on Sgt. Pepper’s Lonely Hearts Club Band didn’t, you know the lyrics:

“I've got to admit it's getting better (Better); A little better all the time (It can't get no worse)”

At least that is how we ended 3Q 2020. Better, a little better all the time. After all, it couldn’t have gotten much worse. Right? Well, we shall see what happens with the upcoming elections.

Third Quarter Equity Review

By: David McGrath

The roller coaster ride that is 2020 continued in the equity markets during the 3rd Quarter. July and August produced more incredible returns, but September was the first negative month since March. Combined, we finished with solid positive results across the equity markets for the 3rd quarter.

The top performing sectors for the 3rd quarter included Consumer Discretion (+16%), Materials (+13.4%) and Industrials (+13.1%). The Consumer Discretion sector’s performance was led by Amazon, Home Depot, Lowe’s, and Nike. All 28 stocks in the Materials sector of the S&P 500 showed a positive return. Finally, in Industrials, someone had to deliver all those online purchases that consumers made. UPS (up 50.8%) and FedEx (up 79.9%) were the boats that lifted the tide for the rest of the sector.

The sectors with the worst performance for the quarter were Energy (-20.2%), Real Estate (+1.4%) and Financials (+4.45). Financials have suffered from: 1) extremely low interest rates; 2) the reality they are likely to stay low for the foreseeable future, and; 3) the need to increase loan loss reserves. For its part, the Real Estate sector is dealing with a fast-changing retail landscape that is likely going to need a lot less brick & mortar in the future. Also, more people will work remotely moving forward, and that will dampen the demand for office space. Even so, the results for these two sectors were still positive.

The Energy sector was the real outlier, showing a loss of more than 20%! Of the 27 energy stocks included in the S&P 500, only 2 had a positive return for the quarter. Interestingly, the energy sector return normally follows the price of oil, but that was not the case in the 3rd quarter. As the chart below shows, crude oil was actually up during the quarter due to a somewhat weaker US currency; however, as noted, the sector had a difficult time with investors. It seems Energy has been out of favor for so long only a miracle can save it at this point. Of course, stranger things have happened, and will.

Source: FactSet

As we enter the last quarter of 2020, the S&P 500 has a small positive return, the Dow Jones Industrial Average is slightly in the red, while the NASDAQ is showing a gain of more than 25%. In the meantime, small and mid-sized companies along with international stocks show a significant loss on the year.

One of the most unusual aspects of the rally in stocks to this point in 2020 is how the vast majority of the returns have been produced by quite literally a handful of stocks. I divided up the S&P 500 by weight to determine exactly how concentrated the year to date 2020 returns are. Here are the stunning results:

The largest five stocks in the S&P 500 accounted for 22.66% of the weight of the index (Apple 6.79%, Microsoft 5.74%, Amazon 4.74%, Google 3.13% and Facebook 2.26%). The average return of 40.24% for those five stocks provided 8.53% of return to the S&P 500. Put another way, removing those 5 stocks from the S&P 500 the year to date return would fall from 5.57% down to -2.96%. This also helps explain the incredible performance of the NASDAQ index, with those same five stocks accounting for just over 45% of the weight of that index.

The average return for the first 3 quarters of 2020 falls in direct correlation with market capitalization. I believe that this shows that the true health of the economy is not as strong as the positive return that the S&P 500 indicates. It has been much more difficult for smaller companies to get through the economic shutdown of 2020.

What does this mean for the markets going forward? The performance of both the S&P 500 and the NASDAQ will be led by the performance of the “big 5” stocks. This year we have enjoyed the benefit of a more concentrated market as the largest stocks have shown the best returns, pulling the overall market to a positive return in a very difficult time for the economy. That could turn against the markets, as a broad recovery in the majority of stocks within the S&P 500 could be offset by weakness in just a few names. Currently, the 6.79% weight of Apple in the S&P 500 is equivalent to the weight of the bottom 200 companies of the S&P 500. So as we start into the homestretch to 2020, and the economy hopefully recovers from the COVID shutdown with better testing and a pending vaccine, smaller stocks have an opportunity to outperform the larger names, but that will not be fully reflected in the return of the S&P 500, and especially the NASDAQ. This just shows that stock market strength does not always time perfectly with economic strength.

As we head into the 4th quarter, the election news will likely dominate the headlines and could dictate price performance. Historically, the markets will be volatile in the weeks leading up to the election, and the 2 years of political finality that election results bring allow for solid returns the last two months of the year. The added impact of the pending COVID vaccine and testing availability will make this more difficult to predict. If we get expanded testing capabilities and encouraging vaccine news, we could be looking at third consecutive quarter of strong investment returns, and one heck of a New Year’s Eve party to bid good riddance to 2020.

Third Quarter Bond Commentary

By: John Norris

During the 3rd Quarter, the bond market was analogous to a runner on an oval track who exerts a lot of effort just to get back to where they started. In truth, despite a somewhat wild ride in July and the first part of August, for all intents and purposes, bonds closed the quarter about where they started it. Had you awoken from a 3-month nap at the end of September, you wouldn’t have been able to tell anything significant had happened in fixed income.

And why should it have? The Federal Reserve has bloated its balance in 2020, and essentially promised to backstop the entire bond market if need be. The only thing the Fed hasn’t done is promise to set a ceiling on long-term interest rates, which plenty of people would like them to do. However, you need to be careful for what you wish.

Further, after the September 16th FOMC meeting, Fed Chairman Jerome Powell made the following comments to reporters:

The pandemic has also left a significant imprint on inflation. For some goods, including food, supply constraints have led to notably higher prices, adding to the burden for those struggling with lost income. More broadly, however, weaker demand, especially in sectors that have been most affected by the pandemic, has held down consumer prices, and overall, inflation is running well below our 2 percent longer-run objective. The median inflation projection from FOMC participants rises from 1.2 percent this year to 1.7 percent next year and reaches 2 percent in 2023…
So, we don't reach 2 percent, but we get very close to it in the forecast. We reach 2 percent, I guess the median is 2 percent by the end of 2023. So you know, you know what the guidance says. It says that we expect that the current setting of our rates will be what we expected -- it will be appropriate until such time as we reach 2 percent inflation that we feel that labor market conditions are consistent with our assessment of maximum employment, and that we're on track to achieve inflation moderately above. So that's the test. I don't think there's any conflict between those two, because, you know, the way they're set up, the projections don't show the out years…”

This is about as clear as Fed Chairman’s obfuscatory language can be: “we don’t think there will be much, inflation, and we don’t think we will get pre-pandemic levels of employment back until at least 2023. As a result, we don’t anticipate making any significant changes to monetary policy for the foreseeable future.”

Consider this chart on the yield to maturity of the 30-Year US Treasury Bond, which is (or should be) a reflection of the markets’ expectation for inflation. The lower it is, the lower inflation is expected to be in the future, or so the story goes.

30-Year Treasury Bond Yield to Maturity

Source: Bloomberg

Where the rubber meets the road, bonds were really nothing more than ballast in investment portfolios during the quarter. They didn’t much of anything except for a ‘coupon’ return, and that isn’t much of anything. To that end, the iShares Core US Aggregate Bond ETF (AGG), a good proxy for the broad fixed income market, had a 0.4007% positive total rate of return during 3Q 2020. This was broken down as follows: the price return was (0.1269%) and the income return was +0.5276%. While at times fun during the quarter, the end result was the financial definition of mediocre.

iShares Core US Aggregate Bond ETF (AGG)

Source: Bloomberg

In the end, bonds have a reputation for being boring. Institutional fixed income portfolio managers and traders will try to convince you otherwise, but that is what the average investor thinks. You buy a bond, and you get your nominal principal back at some point in the future, collecting interest payments as you go. BOR-ING. Right?

As much as bonds aren’t really boring, and as much as the fixed income markets are incredibly bloated, they didn’t do much during the 3rd Quarter, at least not from Point A to Point B. They ran around on an oval track, just to get back to where they started.

The best part? Unless something dramatic happens this quarter, and this is possible due to the upcoming elections, bonds will probably perform pretty similarly during the 4th Quarter. When the Fed telegraphs monetary policy, backstops the market, and deflates expectations for inflation, there not much else for the fixed income markets to do.

4th Quarter Strategy

By: Sam Clement

The political landscape is as fractured as it has been in recent memory. The two parties offer wildly divergent visions of the future, namely about the role government will have in our lives and economy. While Oakworth usually maintains politicians get too much credit for the good times and too much blame for the bad, our future investment strategies will be different depending on the result of the upcoming election(s).

Regardless of the political outcome, we believe there are a few consistent themes. These are: continued headwinds for the energy sector (fossil fuels), expansionary monetary and fiscal policies putting pressure on currencies, strong demand and innovation in the technology sector, and a likely infrastructure deal. These agreed upon themes will help drive our investment philosophy moving into 2021.

First off: the energy sector. You would be hard pressed to find anyone outside of Houston who believes crude oil is the future of the industry. Environmentally friendly, renewable energies will be the driving force in the financial markets, and investors will look to find growth and profits in so-called green subsectors. This coupled with a potentially hostile political picture and a societal push for reduced carbon emissions suggest our consumption of fossil fuels will continue to decline. As a result, regardless of the outcome of November’s elections, it is hard to be bullish on the sector, which is largely dominated by large oil-dependent companies

Anybody remember the debt clock? The constantly upward rolling number that people would scream about and fear how we are burdening our kids with incredible amounts of debt? I do, and it’s still a thing. In fact, as I sit here typing it currently is a shade over 27 trillion. On this day in the year 2000 it was slightly over 5.6 trillion. And we thought that was bad? It seems like the one olive branch between the two parties is that we need to spend a lot of money, they just disagree what on. If this trend doesn’t change (and it won’t), then what does that mean? The easy answer is weaker currency. This fact is largely the overriding factor in our investment thesis going forward. The big kahuna. When the dollar weakens, typically we would like those industries that can raise their prices faster than their costs rise. This screams the Materials sector. When charting the materials sector on a chart against the dollar index, we see a pretty strong negative correlation. This along with a likely bipartisan infrastructure deal at some point, makes for a no-brainer in our minds.

Source: FactSet

Currently, the word ‘goldbug’ is almost derogatory. These are investors who believe worthless fiat currencies are leading the global economy to economic Armageddon, developed a ‘bunker mentality,’ and have stocked up on precious metals in response. Well, as Lee Corso might say, not so fast my friend. We all know what gold is: it is a precious metal today just like it was thousands of years ago. But what do you use to purchase it? Well, dollars, or maybe bitcoin but that’s for a future discussion. When the dollar remains weak like we are forecasting, what does that mean for gold? It means it takes more of those same dollars to purchase the same amount of Gold, hence a price increase. Our thought with gold is just like the materials sector, just take a look at the debt clock.

We have often asked clients, if they think they will consume more technology or less in the next decade, and the tally is, you guessed it, 100% more. Now, does that mean we want to go all in on the sector? Not necessarily, but it is a tailwind. The fears with the sector remain more around regulation and the political impact on the big names; however; to put it simply, we think the technology sector will continue to expand over the years to come. Sure, it will have bumps and bruises along the way; however, the innovation, growth, and demand are, and will be, constant themes.

All this being said, the upcoming elections are throwing a real wrench in everyone’s prognostications. Our recent serial about the election, entitled ‘The Election Projection,’ hopefully shed some light on our thought processes, and I hope this piece has as well. One of the highlights from the series is a table which outlines our potential economic sector weightings depending on the political landscape. These are:

So, as you can see, our Investment Committee will have its work cut out for it during the 4th quarter, or could as the case may be. Unfortunately, we have simply had too much discussion about the potential alternatives to include them all in this piece.

Election Series Synopsis

By: Sam Harris

In our latest Thought Leadership series, The Election Projection, the Oakworth Investment Committee explored the possible scenarios on the other side of November’s election. While also focusing on congressional seats up for grabs, the team analyzed four potential outcomes, and how each would impact future macro-economic activity, and, in turn, their impact on the capital markets.

In short form, the crux of the matter relies on Democrats assuming the offensive, sweeping the Congress and assuming control of the Oval Office. Republicans in the Senate must defend 23 seats, whereas the Democrats only 12, clearly granting the advantage to the latter. This scenario, the proverbial “Blue Wave”, would send into motion the most significant changes felt by markets.

Although all four scenarios are perfectly in the realm of real possibilities for outcomes, we felt, as things stand today, the event of a Democrat in the White House and a Republican maintained Senate to be the most likely end result. Joe Biden’s compelling lead in most swing states’ polls, combined with Republicans across the board fighting tooth and nail for their Congressional positions in the two-person-a-state legislature, equates to the strongest likelihood of actually happening.

What does this mean for your portfolio? Frankly, probably not a lot. A majority Republican senate would serve as a roadblock to the more ‘progressive’ of the Democrats initiatives. For example: it would be difficult for them to make significant changes to existing tax law. It would, in all likelihood, stop or at least slow a “Green New Deal”. And, in lieu of recent events, heaven only knows what would happen if a Supreme Court seat opens in the next two years! Pickett’s Charge? The Charge of the Light Brigade? Though we would be inclined to suggest a more defensive positioning, this scenario would surely warrant a more aggressive posture as compared with the “Blue Wave” (the most defensive, from a portfolio outlook, of all scenarios).

In our estimation, the most bullish scenario would be a both Republican White House and Senate. This is, basically, the current status quo. In fact, it would largely emulate that of the past four years: it seems time is a flat circle, and it would be déjà vu all over again. This result, even with a majority Democrat-elected House, would allow for the fastest and largest expanding economy of all the scenarios while also adopting some progressive notions.

Throughout the series we uncovered some truths. Some inevitabilities. Some axiomatic “locks”. In its most clear form, this included an infrastructure deal. A weaker greenback, agreed in unanimity, would be bullish for said infrastructure deal by way of allowing multinational firms to capitalize on, well, exactly that – exploiting a weaker dollar through supply and distribution channels worldwide. Similarly (or perhaps relatedly, as the two must travel hand-in-hand), across all scenarios we envision increased government spending. Recovery from a global pandemic and standstill economy isn’t going to be cheap, much less dare we say free.

In closing, we reiterated the same thing every week, regardless of the scenario: these are just our projections, predictions, and opinions. No one, not even Elon Musk, can look into the future with 20/20 clarity. While this series hopefully provided insightful takes from our Investment Committee to our body of clients, there of course exists the exceptions, the one-offs, and the circumstantial changes. After all, a lot can happen in a month. Just look at September.

A First Look at the 4th Quarter

  • All eyes and ears will be on the election and the Supreme Court nomination process. This will be the most politically contentious 3-month period in recent memory. It will also be the most important. The two parties currently offer two different visions for the future of the US economy.
  • The US economy performed reasonably well during the 3rd Quarter. This should give it enough momentum to finish 2020 on another positive note. However, concerns over COVID-19, continued economic restrictions in some of the largest state economies, and the gap between relief packages will slow the rate of growth.
  • The 3rd Quarter earnings season will likely be pretty decent, potentially making somewhat elevated valuations seem only slightly less so, all the more so since interest rates should remain very low in absolute terms.
  • The political scene will get ugly during the 4th Quarter. Economic activity and corporate profitability should slow from their 3Q pace, but will continue to be positive.
  • The recipe for growth remains in place: low energy prices, low interest rates, and expansionary monetary and fiscal policies. However, another mandated lockdown of the economy will render that irrelevant.
  • On December 31st, the loud sound you will hear will be a massive, collective sigh of relief that the worst year any of us can remember will finally be behind us.

As always, if you have any questions, please call your Oakworth Capital Client Advisor.

Meet the Oakworth Capital Bank Investment Committee

The Oakworth Investment Committee is always available to meet with clients when convenient for them to review investment performance and objectives. We are accessible to answer any and all questions and information is distributed on a regular basis in an effort to educate all of our clients about pending investment decisions, the current state of the markets, and the state of the economy.

The investment committee consists of experienced professionals with integrity and a true passion for their work. At the end of the 3rd Quarter 2020, total assets under advisement were approximately $1.385 billion.

Oakworth Capital Bank Wealth Advisors

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