A Tale of Two Economies

Friday Reflections

A Tale of Two Economies

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us.”

– Charles Dickens’ A Tale of Two Cities (1859)

Vacillation between extremes isn’t a new phenomenon in investing, or human experience generally, but it has been particularly pronounced in the past three months. This week alone brought positive (although ambiguous) news of successful early-stage vaccine trials from Moderna and incremental re-opening in parts of the global economy, both of which fostered investor confidence and higher equity prices early in the week. In contrast, this week also delivered concerns about re-igniting political tensions with China and a new virus hotspot in Brazil, pushing stock prices lower late in the week and reinforcing fears of second wave risks.

Equity markets may have recovered to higher levels since March, but the prospects for continued price recovery remain highly asymmetric. Norms around shopping, office work, travel, global production practices, food production and more will have repercussions in stages that are hard to predict, and we feel the market has currently priced in a lot of positive economic recovery without acknowledging the extent of the likely challenges.

We wrote last week about the expansion of the economy further into the digital landscape, and highlighted adaptation by traditionally brick and mortar companies into this new frontier. This week we saw this trend quantified when recognizable retailers reported Q1 earnings that weren’t as dire as many feared.

Retail giant Walmart was expected to exhibit some resiliency from essential item sales, but investors were pleased as well to see their e-commerce sales growing by 74% in the first quarter. Similarly, Target saw first-quarter digital “comparable sales” up 141% from a year ago and same-day delivery business up 278%. Home improvement names participated as well, with Lowe’ and Home Depot both reporting an 80% rise in digital sales during the first quarter. Facebook also hit an all-time high after announcing its new Facebook Shops initiative aimed at helping small businesses boost their digital presence. With the well-chronicled decline of malls, both small and large retailers are faced with finding new customers online, and reach out through new platforms.

While a portion of consumers are besieged by record unemployment, this week showed that work-from-homers have continued to shop at impressive levels. Similarly, while a portion of businesses are forcibly shuttered, many have shifted their operations

The stock market is comfortable with apparent contradiction, balancing current prices and concerns against the context of future earnings. Sure, things are bad right now and the virus is still spreading, but we’ll fix everything by next year… right? Equity markets are energetically embracing this forward view. Having already reacted with a decline from the highs of February, current stock prices are now weighing the pace of economic re-opening, and gauging the likely earnings levels to be achieved in a “normalized” economy in 2021 and beyond.

We feel that prices are high. The S&P 500′s forward price-to-earnings ratio – a widely used valuation metric on Wall Street – currently sits at 19.8. This measures the current price of S&P stocks versus the expected future earnings; a higher number means stocks are more expensive. For context, its 5-year and 10-year averages are 16.7 and 15.1 The rise in prices on hopeful re-opening narratives and simultaneous declines in future earnings forecasts based on current pandemic challenges and concerns about lasting economic impacts have combined to drive the ratio higher.  Based on this metric, the market looks considerably less opportunistic than we saw two months ago.

Further clouding the future is the return of US-China tensions, as the Phase 1 trade deal fades and markets recalibrate expectations for cooperation as a tailwind for global economic recovery. President Trump continues to publically allocate blame to China for the coronavirus pandemic, and the Senate passed a bill this week that will impede Chinese companies’ ability to be listed on U.S. exchanges. China did their part to escalate tensions by introducing a new “national-security law” that significantly limits Hong Kong’s autonomy. The markets there dropped dramatically in response, and the situation will likely rekindle social unrest as well.

As problematic as our current bifurcated situation is, there are vigorous national and local conversations about health, education, and economic inequities. Strategies to resume economic health and public health (and control the coronavirus) are drawing thoughtful attention – from policy makers and from corporate leaders. Various industries are considering on-shoring of component sourcing and manufacturing, and global supply-chains and trade relationships may shift significantly.

The coming months in the markets will to continue to be in flux as they make the effort to anticipate future innovation and growth. There may be longer term structural investments needed, and further stimulus efforts in the near-term, but we are optimistic that the pace of corporate response will bring us through this unique economic slowdown. As always, we are keeping client portfolios diversified – balancing the stability of bonds with the growth potential of stocks, being exposed to innovation within the US and internationally, and across companies in a wide range of industries – since the economic recovery will shift the global economy in still unknowable ways.