COVID-19 Market Update: The Looming Headwind of Increasing Debt Levels
Equity markets ended the week higher except for the technology-laden Nasdaq after pulling back from all-time highs. Early in the week, the S&P briefly moved into positive territory year-to-date before retreating later in the week. The TSX finished the week gaining 2.2%, the S&P 500 up 1.2%, and MSCI EAFE adding 2.2%, while the Nasdaq was down 1.08% but still in positive territory year-to-date. For the week, we witnessed another rotation out of the technology sector into value and small-cap stocks. Previous rotations early this year were short-lived, with technology regaining the leadership role. While lagging most of the year, small caps have a tendency to lead markets out of recessions, and the recently improved performance could be a precursor of increasing market breadth as economic activity continues to improve.
Markets were driven by positive economic news compiled before the latest coronavirus scare, which has forced some states to reconsider re-opening, and in some cases, like California, reclosing restaurants in specific areas to limit the spread. Retail sales jumped 7.5% in June on pent-up consumer demand after a two-month hiatus, and industrial production surprised on the up-side. The additional $600 bonus benefit above traditional US Government unemployment, which certainly has contributed to consumer spending, is slated to expire later this month. While Congress is debating the next stimulus package, little thought is being given to how increasing debt levels attributed to COVID will eventually be paid. Many expect a “V” or “W” recovery, but that does not consider the headwind expected to occur as local, state, provincial and federal governments all decide to increase taxes in an effort to forestall the predictable debt crisis looming on the horizon. COVID has just accelerated judgment day.
Last week was the unofficial start of what is expected to be a significant drop in corporate earnings. Estimates from FactSet expect profits to drop 44% in the quarter compared to last year. Banks reported a significant decline in profits and increases to reserves in anticipation of loan write-offs, despite gains in trading and underwriting activity. Poor Q2 earnings will come as no shock to investors and is expected. The focus is on next year and trending improvement in weekly economic, COVID data and vaccine news. Re-opening setbacks will stall improving data points in the coming weeks but are expected to be temporary as optimism abounds for a return to normal later in the year and early next.
One trend that is worthy of notice is the increasing property values in suburbia and rural locations. The exodus from highly populated cities is on the rise as millennials, previously condo and apartment dwellers, have finally decided they no longer want to be in congested downtown cores. With the addition of COVID hysteria and social distancing likely to be the new norm, city life is losing its appeal, especially when thinking of raising a family. It is just becoming too dangerous. Car sales are also on the rise as millennials find ride-share and Uber not that practical in suburbia. In the US, certain states like Texas and Florida noticed this shift in demographics over the last several years as businesses flee high-tax states to more business-friendly environments. We also expect to see similar behavior from job seekers who want more flexibility in job locations and are not looking to work downtown when there can be no assurances that health concerns are no longer a threat. Behavioral changes are taking place, and the result will be a major shift in spending habits and patterns, how and where we choose to live, and how business is conducted. This will not be a smooth transition and will take years to play out.
With interest rates at historic lows and expected to be low for some time, equity markets will attract investors for both income and growth. As economic growth is necessary to support equity prices, the inevitable risk appears to be, once again, too much government intervention.
Warren Gerow is an independent investment wealth consultant to Sightline Wealth Management.
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