A record-long economic expansion for the U.S. ended abruptly in March, but its demise was not brought about by the usual culprits of a downturn. A healthy labor market and steady, albeit modest, gross domestic product (GDP) growth to close 2019 could not portend the state of the economy today, even as news of a novel coronavirus emerged from China early in 2020. Five months on, the World Health Organization has reported more than 4.5 million confirmed cases globally, with nearly one-third in the U.S. alone.
Containing the virus brings economic contraction.
Similar to other regions around the world, most U.S. states issued stay-home or shelter-in-place orders, limiting work and travel to essential needs as much as possible. Public gathering places — sports arenas, theaters, dine-in restaurants, shopping malls, schools, places of worship, etc. — shuttered, and employers, when possible, instituted remote work arrangements. Many manufacturers suspended operations or shifted to producing medical or personal protective equipment.
The U.S. economy responded to the clampdown in activity with a swift and significant contraction. With first-quarter U.S. GDP falling 4.8%, this shows the severity of the economic disaster as the economy was shut down for just two weeks in the quarter. Jobless claims are at unprecedented levels, as are stimulus dollars aimed at supporting impacted businesses and individuals. As new cases of COVID-19 begin to taper off in some areas, however, attention is turning to reopening the economy. Although the federal government instituted guidelines for resuming activity, governors can exercise discretion when setting policy for their states.
The economic downturn brought about by COVID-19 is unlike any recession in recent memory, and the nature of the nation’s recovery is anticipated to follow suit. Given state-by-state variations in reopening parameters and social distancing measures, as well as the potential for new COVID-19 hotspots to flare up or a second wave to materialize, any economic recovery is expected to happen in fits and starts. Until an effective treatment option or vaccine is available, the virus is likely to be with us for some time, exerting its influence on the pace and extent of an economic recovery.
We will likely see a shift in market leadership.
As the economy opens up again, market trends are expected to shift in two distinct ways. First, market leadership is anticipated to adjust as certain sectors demonstrate an ability to capitalize on the changing environment and assume leadership in an expected recovery.
Over the past 10 years, domestic large-cap growth stocks, buoyed by the technology and consumer sectors, turned in strong performance relative to other major asset classes. The outlook for the consumer sector is cloudy because spending is likely to be curtailed amid employment and income uncertainty, as well as heightened concerns around continued virus transmission. However, optimism remains for technology, given the sector’s propensity toward innovation, the importance of access to information and technology’s ease of mobility. Further, the sector should be propelled by increasing work-from-home innovation as well as social media and internet use.
Key value sectors are also poised to build leadership in a recovery. Financials, the largest value sector, should benefit from higher lending and a steeper yield curve, which makes bank lending theoretically more profitable. The second-largest sector, healthcare, also is expected to make gains due, in part, to the growing need for virus remedies. Additionally, the postponement of elective and nonurgent treatments has created significant pent-up demand; in the first-quarter GDP report, healthcare spending declined approximately 18% as compared to the previous quarter. As states ease restrictions and allow medical and dental practices to reopen, spending on healthcare services should revive. Spending is also expected to lift in the industrials sector, particularly in infrastructure as well as supply chain shifting and repairs, which is leading to optimism.
Along with the growing relative attractiveness of the value sector, small-cap stocks are showing potential. These assets have benefited from unprecedented monetary and fiscal stimulus, and in the past, small caps have been one of the best-performing asset classes in post-recession market rallies. Non-U.S. asset classes — including developing and emerging markets — are other areas that could perform well. Although impacted by COVID-19 early on, certain markets have been able to get a handle on the situation, and they appear to be leading the U.S. in returning to economic normalcy.
Active management can navigate uncertainties.
With the reopening of the economy, the second shift in trends is anticipated in market breadth and its implication for active vs. passive management. As of April 30, the top five outperforming stocks in the S&P 500 represented about 20% of the market cap, had an average price-to-earnings ratio of 36 and represented just 8% of revenues. In comparison, the remaining stocks in the index averaged a price-to-earnings ratio of 18, contributing to their relative attractiveness and potentially expanding market breadth in a recovery.
Concurrently, as the nation emerges from lockdowns instituted in response to COVID-19, uncertainty is expected to persist and be reflected in economic reports. Between mixed economic data and wider market breadth, optimal investment decisions may require quick and in-depth research and analysis, an approach that requires active managers. Given this dynamic, the dominance of passive indices is likely to ebb somewhat as active managers can demonstrate their value in navigating an unprecedented situation with few, if any, models for a guide.
The cyclical nature of the economy inspires hope.
Though the world is coping with a challenging situation, governments are working to provide fiscal and monetary stimulus to keep economies afloat. The U.S. has experienced recessions in the past — some longer than others — but the nation has always emerged and embarked on a new expansion phase. Until researchers can get a stronger grip on COVID-19, the economy may operate below capacity, and unemployment may remain elevated. Nonetheless, a recovery should slowly materialize, and life should eventually return to some semblance of normal.