Quarterly Investment Commentary Q3 2020

Third Quarter Market Recap

Despite choppiness in September, equity investors saw solid gains during the third quarter. The S&P 500 Index rose 8.9% in the quarter and recovered all its losses for the year. Underneath the surface, mega-cap growth names continue to lead the U.S. market. Without the 42.5% year-to-date price return of the six so-called FANMAG stocks (Facebook, Amazon, Netflix, Microsoft, Apple, and Google), the S&P 500 would be down for the year.

The outperformance of these top names means they now dominate the index. Market concentration is not unusual, but with the top 10 stocks in the S&P 500 making up 28% of the index, it’s extreme today. The important investment takeaway is to not be lured into chasing the returns of what has worked well in the recent past.

Nevertheless, this U.S. mega-cap growth effect is driving the outperformance of U.S. stocks versus foreign stocks this year. Developed international stocks gained 6.0% this quarter, almost three percentage points behind U.S. stocks, though, emerging-market stocks outperformed U.S. stocks with a return of 10.2%.

Bond markets were calm throughout the summer, thanks in large part to the Federal Reserve’s accommodative monetary policy. Treasury yields were unchanged, and core investment-grade bonds gained 0.6% in the third quarter. Fed officials say they are targeting “average inflation” of 2% and have signaled that they do not expect to raise rates at least through the end of 2023.

The U.S. election approaches in November. The market doesn’t like uncertainty, so the weeks leading up to the election and afterward may be volatile. But history shows any election-year declines are usually short-lived and the political party in power is not a significant driver of investment returns. Political views have no place in our investment process, and we don’t attempt to predict the short-term market reaction to elections (or any short-term event).

Looking ahead, there are reasons to be warily optimistic about the investment prospects for global equities and corporate bonds, and there are reasons for caution.

Reasons for Optimism

An economic recovery is underway. Economic data and forecasts are improving. All else equal, rebounding economic growth here and abroad should support equity and corporate bond markets.

On the virus front, the speed of progress in vaccine development is promising. An effective and widely distributed vaccine could allow economic activity to return to its full pre-pandemic potential.

This year’s supportive monetary policy and huge fiscal stimulus, both here and abroad, were key drivers of the speedy recovery in markets and the global economy. Albeit, Central bank actions and government spending don’t guarantee the absence of volatility, another bear market, or recession.

Reasons for Caution

It remains to be seen how strong the actual economic recovery is and how much of it is already discounted in current prices.

While vaccine development steams ahead, the potential remains for a large resurgence of COVID-19 in the fall and winter months. This raises the risk of renewed shutdowns and another economic downturn.

Monetary policy is supportive, but more fiscal support from Congress is likely needed to further protect citizens, help businesses survive, and shore up state finances. If it doesn’t happen, it will be a hit to economic growth, which could impact markets.

Finally, there is always the potential for a negative geopolitical shock. The U.S.-China conflict and Brexit come to mind, but a new development could emerge that no one is considering (like the pandemic did earlier this year).

Portfolio Positioning

Our portfolios are balanced across multiple dimensions: domestic versus international stock exposure, growth versus value strategies, interest rate risk versus credit risk, traditional versus alternative investments. We are very comfortable with how our portfolios are constructed, with the current positioning emblematic of the watchword’s “balance” and “resilience”.

On the equity side of our portfolios, we were underweight to U.S. stocks and stocks in general going into the pandemic due to unattractive valuations. In March after an initial large decline, we added an approximate 5% allocation to U.S. equity exposure at more attractive prices. Since that time, U.S. stocks have appreciated strongly, outperforming most other investments.

Our slight overweight to emerging-market stocks offsets some of our underweight to U.S. stocks. We also hold a full strategic weight to developed international stocks. We don’t want to reduce our global diversification right now as stock valuations are cheaper in non-U.S. stock markets. In a sustained global economic recovery with Fed-repressed U.S. interest rates, the odds are that foreign currencies will appreciate against the U.S. dollar. This would further enhance the returns of international assets for U.S. dollar–based investors.

On the fixed-income side, core bonds are an important shock absorber in a negative economic or geopolitical shock. However, even a modest increase in interest rates could lead to negative short-term returns.

Closing Thoughts

History shows markets are consistently unpredictable. Adding to the uncertainty are the unprecedented circumstances, challenges, and structural changes the global economy is currently facing.

Having a high degree of conviction in any single outcome strikes us as imprudent. Instead of trying to continuously predict the future, we are focused on building resilient portfolios across multiple plausible scenarios, accounting for a range of shorter-term risks but keeping our primary focus on the medium- to longer-term fundamentals that ultimately drive investment returns.

Investing this way requires discipline, patience, and a willingness to stray from the herd at times. It can feel uncomfortable to stay the course, put capital at risk when markets are plunging, or refrain from chasing overvalued markets higher when they are soaring. But in the end, this is the best approach we’ve found to achieve the long-term investment goals that you all cherish and hold dear.