Monthly Letter July 2020

Economy and Earnings

The government reported that the gross domestic product (GDP), the broadest measure of U.S. economic activity, declined at an annual rate of -32.9% in the second quarter, the sharpest quarterly drop in many decades.  However this is backward-looking data, and more forward-looking indicators from June and July suggested that the economy may still make a strong recovery in the second half of this year.

The monthly employment report for June, released in early July, was much stronger than expected, showing a gain of 4.8 million jobs, and the employment report for July will be released in early August.  The ISM manufacturing index rose to 52.6 in June, up from 43.1 in May, while the ISM services index rose to 57.1, far above estimates and up from 45.4 in May.  June retail sales were stronger than expected with a gain of 7.5%, while industrial production rose by 5.4%.  

In addition, the homebuilding sector has been a bright spot in the economy, and has not been hurt by the virus.  Recent data on mortgage applications, new home sales and housing starts have been very strong, driven by low interest rates.  The interest rate on 30-year fixed rate mortgages recently fell below 3.0% to a record low.  Refinancing activity has also been strong. 

Second quarter corporate earnings were reported throughout July, and due to the historic downturn in the economy, expectations were very low.  Many companies did report weak earnings, but roughly 80% of the reports were better than consensus estimates.  As July came to a close, some of the biggest stocks in the market, including Facebook (FB), Apple (AAPL) and Amazon (AMZN), reported results that were much stronger than expected, and the stocks rose sharply.

More Government Stimulus

As the number of virus cases has continued to grow in certain parts of the country, various states imposed rules and regulations on wearing masks and keeping businesses closed.  In general, the persistence of the virus across the country has led to worries about the economic recovery stalling. 

Therefore both Congress and the White House agreed on the need for another fiscal stimulus package to help support the economy.  As July came to an end, negotiations on a Phase 4 stimulus package were still continuing in Washington, and the markets awaited news on the shape of the package.  In general, any signs of progress on the stimulus bill were viewed favorably by the markets.

Hopes for a Vaccine

One of the most encouraging developments for the market in July was progress on vaccines for the virus.  Most of the recent news on this front has been positive. Major pharmaceutical companies involved in vaccine research include Novavax (NVAX), Moderna (MRNA), Pfizer (PFE), BioNTech (BNTX), and AstraZeneca (AZN). 

Most of these firms have received large government contracts for vaccine development and production.  In early July Novavax received $1.6 billion in government financing for a vaccine, with the goal of having 100 million doses available by the end of the year.  In mid-July Moderna announced that its vaccine looked very promising, as all 45 participants in a trial study produced antibodies.  Pfizer and BioNTech also announced positive results from their vaccine study, and AstraZeneca reported good news as well.

Some of the vaccine candidates are now entering Phase 3 trials, and there is hope that several hundred million doses of a vaccine can be produced and distributed by early 2021, or possibly even before the end of this year.

Geopolitical Developments

In recent months tensions have continued to build between the U.S. and China.  The Trump administration has been taking steps to hold China accountable for the virus pandemic.  The President ruled out a Phase 2 trade deal, and the U.S. pulled out of the World Health Organization.

In mid-July the President signed the Hong Kong Autonomy Act, which placed sanctions on Chinese officials because of China’s takeover of Hong Kong, and the administration also ended a longstanding policy which gave special status to Hong Kong.  Taiwan said that China has been invading its airspace, and in response to China’s aggressive behavior in the South China Sea, the U.S. sent aircraft carriers to the region, raising the risk of a military confrontation. 

Tensions rose yet again in late July when the U.S. ordered China to close its consulate in Houston, on the grounds that it was being used for various illicit purposes such as stealing intellectual property.  Secretary of State Pompeo gave a major speech on China at the Nixon library, suggesting that the U.S. and China are in a Cold War.

On a brighter note, President Trump met with Mexican President Lopez Obrador at the White House on July 8^th, to celebrate the implementation of the U.S. Mexico Canada Agreement (USMCA).  This new trade deal should have a number of positive benefits for the U.S. economy, including bringing manufacturing jobs back to the U.S.

Gold Prices Rising

As mentioned above, the price of gold rose by more than 10% in July, reaching almost $2,000 an ounce by the end of the month.  Gold has been climbing higher for several reasons, including the fact that it traditionally serves as a hedge against inflation.  The risks of future inflation have risen because of the extremely easy monetary policies adopted by the Federal Reserve and other central banks.  Also the dollar has been dropping for the past few months, and gold normally moves in the opposite direction of the dollar.

Gold also benefits from today’s extremely low interest rate environment, which reduces the opportunity cost of holding assets that do not pay interest or dividends.  Finally, gold also serves as a safe haven in times of crisis or geopolitical stress, such as the recent increase in tensions with China.  Therefore, although gold and silver have become overbought on a short-term basis, these precious metals are likely to continue moving higher over the longer term, and we believe that investors should own some gold and gold stocks in their portfolios. 

Stock Market Remains in an Uptrend

A review of our market indicators show that they remain generally strong, with no major signs of a peak in stock prices.  Breadth remains healthy, leading stocks continue to make new highs, money flow indicators remain positive, etc.  However after the market’s big gains over the past four months, a pullback or consolidation period would be normal.

On a related note, due to the extraordinary strength in big cap growth stocks this year, the Nasdaq has far outperformed the small cap Russell 2000.  The relationship between big cap and small cap stocks has become very extended, so some reversion to the mean should be expected, which implies that there could be a period of small cap outperformance ahead.

As we mentioned in a blog post in mid-July, our work showed that the homebuilding stocks were one of the most attractive groups in the market, based on a combination of fundamentals and technicals.  Over the past few weeks these stocks have outperformed the market, and we believe they will continue to do so.  In fact our model portfolio that we published in February contained a large overweighting in the homebuilding group, and this model portfolio has outperformed the S&P 500 over the past five months (more detail will be shown in the next blog post).

Conclusion

Stocks rose in July as investors were encouraged by progress on a vaccine and hopes for more government stimulus spending.  We continue to have a constructive view of the market outlook, while keeping an eye on a number of risk factors and unknowns which have the potential to disrupt the bullish picture in the months ahead.  

Valuation levels are high and tensions with China are rising.  The political backdrop should start to have more influence on the market for the next three months, as the Presidential election is starting to heat up.  Also the pace of the economic recovery is largely dependent on bringing the virus under control, but the speed at which this can be done remains a wild card at this time.