Eagle Asset Management | Core Investment Team
Recession unlike any other means murkier outlook
The recession of 2020 developed faster than any on record. The National Bureau of Economic Research (NBER) dates it starting in February and recognizes it a mere four months later, compared to an average gap of seven months. This recession is also one of the most severe, with an expected drop of 40% annualized GDP declines in the second quarter relative to the first, pushing severity indices (which measure the amplitude and duration of the recession) to all-time highs. As this is a pandemic-related recession, it has very different characteristics than a typical recession. We have sparse data from the epidemics of 1918-19 and 1957-58 to help guide our forecasts, and these structural breaks occurred when knowledge of viruses was limited. Another conflating factor is that the current downturn represents the first time the demand for consumer services (half of GDP) has fallen. Investors have little to go on when forecasting a recovery.
Historically, recessions present opportunities for value stocks, as these tend to be penalized in cyclical downturns. This scenario is relevant for both the first and second quarter of 2020. In the middle of March, value stocks became three to four standard deviations cheaper relative to history and explained the negative 10% performance gap between value and growth in the first quarter. Encouraged by stimulus checks and vaccine news, investors jumped into the earnings void in mid-March as value stocks became too cheap and they staged a healthy recovery, closing approximately one-half of the historical gap. The biggest investment question of 2020 is: To what extent does the value/growth dichotomy continue? The answer depends upon several factors: the length of this recession (V-shaped or U-shaped), the degree of economic stimulus, the health of the financial system, and the possibility of a vaccine that forestalls additional shutdowns.
Vaccine development is the primary reason our group believes the recession will be V-shaped. This factor’s importance is a surprise to us, as history has shown it has taken years to develop vaccines – it took five years to develop an Ebola vaccine.
Our healthcare analyst expects decisive stage 2 results in the summer, as well as positive stage 3 results as early as the fall. We view several significant drug companies as having robust vaccine candidates. Many drug companies, along with governments, have started to prebuild the vaccines’ capacity. Crucial stage 3 vaccine results will drive optimism as the production lags are much shorter than in the past. The market seems to already be pricing in some of this good news.
Tactically, the background suggests some exposure to value as an earnings recovery seems likely. Discontinuation of stimulus may slow this recovery, as will difficulties in bond markets due to rent payment suspensions. These factors may cause dislocations, but despite recent runs, some exposure to traditional value areas is prudent: High-quality out-of-the-home stocks such as restaurants, gaming, industrial, REITS, and select consumer discretionary stocks fit the bill. We are less enthused about the value names in energy and banking, as the long-term prospects for these industries is dismal. For banking, it appears the yield curve will be flat for some time, and current prices are less than break-even for even the most efficient energy producers.
One major consequence of this pandemic is that we have quickly transitioned from a disinflationary or even mildly stagflationary regime to a deflationary economic regime. The duration of this regime is an open question, but the combination of central banks’ monetization of debt and long-term interest rate trends will tend to support long bonds and growth equities. The recent outperformance of biotech stocks in a challenging market is explained not only by the market searching for vaccine solutions but by low discount rates that cause biotechs to act as very volatile zero-coupon bonds. Essentially, any break-even or cash burning equity (for example, a “software as a service” company) is a duration play that is very valuable in times of meager rates. This duration phenomenon makes it difficult for investors like us who rely on valuation metrics as a safety measure. Flexibility is key, and investors may need to widen their horizons when it comes to investing metrics.
Perhaps inflation might be triggered by relentless monetary easing. Still, demographics and the accumulation of past debt that depresses spending may keep rates low for a long time. Admittedly, several of us have been wrong for years with reflation forecasts. As before COVID-19, growth stock performance may continue once the post-recession bounce occurs. The virus sped up existing trends, and the major one is that financial gravity will remain low and allow long-duration assets to thrive. Our focus on the current recovery has pushed this fundamental change in the markets to the background.
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