Ron Temple
The public health conversation has shifted to focus on when and how public life and economic activity can return to normal around the world. In a note to investors, Ron Temple, Co-Head of Multi-Asset and Head of US Equity, shares his thoughts what to look for on the road to recovery.
Economic update
The US employment report was the most important economic news of the week, propelling the US equity market almost 3% higher on 5 June. Consensus expectations called for the unemployment rate to rise to 19% and nonfarm payrolls to decline by 7.5 million. Instead, the report showed a 2.5 million-person increase in nonfarm payrolls and a decrease in the unemployment rate to 13.3% from 14.7% the prior month.
Forecasters missed this outcome primarily due to the negative story unfolding in the weekly jobless claims data, which showed another 1.9 million people filing claims in the week ended 30 May and a total of 42.7 million such filings in the prior 11 weeks.
The two data series are almost certainly both subject to mismeasurement in light of the unprecedented economic turmoil in the United States. However, there were clues in the weekly report’s continuing claims data that the employment report might not be as bad as feared. Continuing claims for jobless benefits tripled in the four weeks ended 24 April, rising from 7.4 million to 22.4 million. Since that time, the number has fluctuated between 20.8 million and 24.9 million. Backing into the numbers, the relative stabilization of continuing claims indicates that some number of people are finding new jobs or returning to their existing jobs.
The data from the employment report shows a similar story: 7.7 million people went from being unemployed to employed in the month of May, while an additional 5.4 million moved from being “not in the labor force,” defined as having worked or actively sought work in the prior four weeks, to employed. Partially offsetting this progress were 4.9 million people whose status went from employed to unemployed and 4.4 million who moved from employed to not in the labor force. The net of the two is a very positive number.
Overall, while the news certainly surprised us, it is unquestionably positive. We will watch the weekly claims data and June employment report very carefully to see if the positive story continues. We continue to believe data will be erratic for the next six-to-12 months as the economy begins to normalize. The various US states are opening in a largely uncoordinated way, and we believe some will pause or even reverse their reopenings as the number of cases begins to rise locally.
Households and companies are likely to husband their resources until they feel confident the recovery has taken root and is sustainable. That said, we could also see surges in demand for goods and services as people are finally able to return to restaurants, bars, and travel destinations. Our hope is that the reopening will progress smoothly and wisely, giving healthcare experts time to develop a safe, effective vaccine.
Policy response update
The European Central Bank (ECB) announced a €600 billion expansion of the Pandemic Emergency Purchase Programme (PEPP) to a total of €1.35 trillion. The ECB also announced that it would continue reinvesting proceeds from principal and interest payments through at least the end of 2022. The consensus expectation had been for an increase of €500 billion.
The upside surprise was encouraging coming on the back of the European Commission’s proposal of a European Recovery Fund the prior week. We are cautiously optimistic that the European Union might be reaching a turning point where it begins to act more decisively to break the economic stagnation that has afflicted the region since the global financial crisis.
On 5 June, US President Donald Trump signed the Paycheck Protection Program Flexibility Act into law. The bipartisan legislation relaxed the rules for forgivable loans issued to small businesses in the United States. Under the original rules, small businesses were required to spend at least 75% of the funds on payroll over a period of no longer than eight weeks. The requirements did not align with the cost structure of many small businesses, however.
Under the new rules, at least 60% of the funding must be used for payroll, and the company has up to 24 weeks or until 31 December to spend the funds, whichever is earlier. It also allows companies more time to rehire employees, extending the deadline from 30 June 2020 to 31 December. These changes should broaden the appeal of the funding to more small businesses. As of 4 June, 4.4 million borrowers have been approved for PPP loans totaling $510 billion, according to the Small Business Administration.
Investment implications
Markets spiked in response to the 5 June employment report, with the S&P 500 Index closing 5.7% below the record high close of 19 February and the median stock down just 8.9% since that point. Investors were encouraged by the prospect of the US economy reopening faster than previously expected, reviving cash flows into corporate coffers. The job data certainly offers a good reason for such enthusiasm.
We continue to remain more cautious, almost entirely due to our concerns over the pandemic and developments in terms of therapies and vaccines. Throughout the crisis, we have thought that the right call is to remain fully invested with a bias toward quality. We believe that is still the optimal choice, but recognize that lower quality, more cyclical stocks might take the lead temporarily if investor enthusiasm is sustained. We understand that there are always times in a recovery cycle when this is the case, but remain steadfast in our view that firstly, it is very difficult to call the beginning and end of low-quality rallies and secondly, that over a multi-year time horizon, high-quality stocks have sustainably outperformed lower-quality peers.
All told, we are unquestionably happy about the positive economic news, as it means less damage to household, corporate, and government finances. We hope the trend continues. In the interim, we would not chase the rally, but would instead remember that monetary policy is fading in scale relative to the supply of new government debt being issued.
As this net balance of supply and demand adjusts, the real economy will be the key driver of markets, rather than the flood of liquidity that propelled the initial leg of this rebound. The bottom line is that the fundamentals of each company and security are likely to become even more important as we move forward from this point. Security selection will be an increasingly important driver of total return, in our view.