The accelerating changes in a COVID-19 world

The COVID-19 pandemic seems to have accelerated changes that might have otherwise taken a decade or more.

Examples of rapid industry shifts include: work from anywhere, remote sports and entertainment, greater reliance on restaurant take-out and delivery services, increasing industry consolidations, supply chains returning domestically, bankruptcies of many small—especially retail—businesses, and the move of urban digital-era hubs to lower-cost areas. In contrast, some businesses we thought would change have not. For example, ride sharing hasn’t increased—it has actually slowed dramatically.

There is a disconnect between the stock markets and Main Street. Stock prices remain elevated despite economic data indicating deep economic harm. The fiscal, monetary, and political responses to the crisis globally have led to a world awash with liquidity and short-term fiscal stimulation. Much of that liquidity has gone into the stock markets, explaining a great deal of the markets’ ascent.

The key question looking ahead is whether the stock markets will continue to climb based on monetary and fiscal responses or whether something could make equity markets unwind.

Typically, bear markets happen when there is monetary tightening—I think that is unlikely to happen. This time around, the negative catalyst could be economic disappointments relative to expectations for a sharp, “V-shaped” recovery. I continue to believe that stock market and economic fundamentals will not remain disconnected forever.

There are several factors that are currently affecting the markets outlined below:

Historic unrest around racial injustice and the upcoming US elections

I am very heartened to see how many companies have spoken out about racial injustice and societies’ needs. When social unrest is unaddressed, it can affect the overall economy. Increased diversity and greater fairness are good from an economic and societal perspective. Companies will be impacted more than ever by their engagement in societal issues. Many, if not most public companies, are moving toward a wider stakeholders’ model of stewardship of their firms. In my view, environmental, social and governance (ESG)-focused investing will become increasingly mainstream, and many investors will screen for companies that take these matters seriously.

The US presidential candidates present two of the most different political approaches in recent memory, with policy differences on how to address the recovery from COVID-19; the tax system; the role of government in health care; immigration and the workforce; whether and how to address climate change; and whether to take a unilateral or multilateral approach to foreign policy.

The US Congress outcome is as important as who wins the US presidency, and the market may experience additional volatility as we approach the election. The markets have not yet priced in the potential for large increases in personal capital gains taxes, corporate tax increases, and additional business and environmental regulations if the Democratic party wins the US presidency as well as the majority in the US Congress. There would also likely be increased attention to companies and sectors that will benefit from a Democratic party sweep.

COVID-19 infections continue

Much of the recent stock market volatility can be attributed to changes in the outlook for COVID-19 infections. In my view, equity markets’ resilience in the face of rising disease uncertainty demonstrates that investors may be primarily concerned with reserve bank actions and governments’ fiscal stimuli globally, largely ignoring economic fundamentals and the high degree of uncertainty surrounding the pandemic’s path. News around the infection rate, potential vaccines, and better medications to heal the sick will likely continue to roil the markets.

Growing tension between the United States and China

Relations between the United States and China have deteriorated significantly in recent months into several disputes including the origins of the COVID-19 pandemic, Hong Kong’s independence, trade, Huawei, the South China Sea, and other issues. The bipartisan, “anti-China” rhetoric is likely to increase into the US elections—and global trade is likely to suffer.

One of the biggest economic trends may be the relocation of supply chains to be closer to developed countries because of trade tensions, sovereignty issues, and lower cost differentials. I believe there will be a big move back to the United States, particularly the Midwest region of the United States. The employment cost-differential of manufacturing in China vs. the United States has dropped dramatically as the cost of employment in China has risen. More importantly, automation, robotics, lower energy costs, and higher productivity in the United States make a case for industries to return to the United States.

The US economy is about 70% dependent on the consumer, and we may go back a little bit more to 1960s–1970s levels where industrial spending (CapEx) was a greater part of the economy. This would make the US economy much more balanced.

China will likely still grow its gross domestic product at a sustained, slower rate more focused on consumers’ increasing incomes. I’m still bullish on China—I think it’s going to develop differently, with a much more consumer-driven, high-technology economy.

The concentration of a few winners in the equity markets

Performance disparities have been extreme as investors try and pick a few winners. Just six “FAAANM” stocks—Facebook, Apple, Alphabet, Amazon, Netflix, and Microsoft—have appreciated 263.82% over the past five years versus the rest of the US equity market (S&P 500 Index without the FAAANMs) appreciating only 35.68%.2 The FAANM stocks account for about one-third of the S&P 500 Index’s return over the past five years. (See chart above)

The US markets have generally outperformed overseas markets. However, if you exclude the FAAANM stocks from US indexes, the US equity markets have performed about in line with overseas’ markets, and any difference is from currency moves.

Index returns offer more evidence of divergence—the relative performance of the NASDAQ Index is 12.81% year-todate, compared with the S&P 500 Index which returned–3.08% through June 30, 2020.3 The NASDAQ is about 80% weighted in technology, consumer services, and health care sectors which are the best-performing sectors,4 while the S&P 500 is only weighted about 53% in the same sectors.5

Look for opportunity globally

Just ten years ago, the US constituted about 40% of the market capitalization of the world. Now it’s approaching 60% which I believe on a relative basis, makes the argument to invest outside of the United States. In addition to China, I am positive on some emerging market countries and Europe, which seems to be ahead of the curve on coming out of the pandemic.

Globally, while low interest rates, fiscal stimuli, and easily available financing have helped keep alive some weak companies, debt is not a substitute for lost revenues and profits. I think companies that have the following characteristics will do well over time: clear business strategies, economic moats, workforce diversity, attention to ESG, returns above the cost of capital, strong balance sheets, positive cash flow, and skills leveraging technology.