Supported by a continued global economic recovery, the market tacked on more gains in the third quarter. The S&P 500 index returned 8.5% (8.9% with dividends) to bring its year-to-date total return to 5.6%. This follows a significant (>50%) move higher from March lows. As a matter of fact, the index hit a new all-time high of 3,580 on September 2^nd before correcting by 6.1% to close at 3,363 at quarter end.

From a sector standpoint, the best quarterly gains came from Consumer Discretionary, Materials, and Industrial companies while Energy, Real Estate, and Financial stocks underperformed the most. Technology has been 2020’s strongest sector so far with Energy being the weakest.

Resilient Corporate America

Q2 earnings reports were largely solid as a number of companies successfully adapted to, or even benefitted from, the pandemic, highlighting the resilience of corporate America in the face of unprecedented headwinds. Many longer-term, pre-COVID trends, such as the shift to e-commerce from bricks and mortar retail shopping, have accelerated. Further, it is apparent that many investors and strategists were wrong in anticipating that the depression-like characteristics of late Q1/early Q2 would continue for a long period of time. Instead, the economy has rebounded strongly as governments ease restrictions and support the recovery, and as businesses re-open and re-hire employees. More progress is likely, with examples like NYC restaurants only very recently opening back up and “hot” industries like housing possibly pulling up other industries like autos and home furnishings.

Earnings Power

Earnings, the most important long-term driver of the stock market, have bottomed. Earnings estimates for the S&P 500 index for 2021 have recently moved upwards, from $161 (Standard and Poor’s) on June 30^th to $164 on September 30^th. This latter figure (seen in the chart above) would represent a 5% increase vs. 2019 levels and justify new market highs. Further, the current 2022 Bloomberg estimate of $194 (24% higher than 2019), though potentially a bit high in light of potential tax increases, etc., supports a continued stock market recovery, especially considering today’s low level of interest rates and inflation.

Pandemic and Election Still Top of Mind

Though the loss of life related to COVID-19 is tragic, and President Trump and the First Lady have recently contracted the virus, there is evidence that the worst of the pandemic is behind us. We know more about the virus now, including how to treat it and test for it, and which parts of the community are more susceptible. There is an unprecedented amount of money and brain power being devoted to vaccine development around the world. Several companies are in Phase III testing trials now, and we believe that an effective therapeutic and/or vaccine is likely to emerge at some point. However, the risk of another flare-up is real and will likely drive continued market volatility. Parts of Europe and the US are seeing a resurgence of infection, leading to some new restrictions. Though a return to complete lockdowns seems unlikely, any new restrictions could slow down the current, generally faster-than-expected economic recovery.

Most polls still predict a Joe Biden victory in the US Presidential election, though an improving economy and COVID-19 outlook could boost President Trump’s reelection chances. It is important for investors to focus on potential policy impacts, not political rhetoric, and also to be cognizant of the fact that markets have performed well when governed by either party as well as during periods of increasing taxes. Major short-term, pre-election changes to a portfolio, especially to one that is acting well, do not generally make sense as long as clients have the right mix of assets to meet their long term financial goals.

In the event of a “blue wave” of Democrat control, higher taxes are likely for both companies and individuals, along with increased regulation for industries such as energy, health care, and financials. However, federal spending would likely rise even more, adding a large multi-year fiscal bump in the form of stimulus/unemployment payments and significant infrastructure spending. If the Republicans retain the Senate or White House, we would expect limited new federal policies, fiscal or otherwise. The recent passing of Supreme Court Justice Ruth Bader Ginsburg and President Trump’s focus on filling her seat have added fuel to the partisan fire and potentially lowered the likelihood of further near-term stimulus. We expect a close and possibly contested election, but also know that the importance of elections tends to be overstated when thinking about long term market impacts.

Domestic Equity Outlook

We believe that the market will remain volatile and range-bound into Q4 due to the election uncertainty, potential delay of further fiscal stimulus, and COVID-19 headlines. Post-election, the market could hit new highs as visibility into a 2021-22 earnings recovery improves, especially if current estimates of growth prove to be reasonable. With lots of liquidity in the system (perhaps more than the economy needs) and sustained very low interest rates, the backdrop for stocks appears to be positive, especially as compared to other asset classes.

At the portfolio level, unless the current positive trajectory of the economy and earnings changes, we would likely view any short-term pullbacks as buying opportunities. Portfolio actions this year have been consistent with our process that seeks business improvement/catalyst driven situations. As the economy has reaccelerated, cyclical names with improving operations have become more attractive. We have added some balance to portfolios by purchasing some cyclicals while retaining some of the mega-cap growth names that have powered the market gains recently but still likely have upside. We could consider making portfolio adjustments based on the election outcome, but it is worth repeating that no major short-term changes are advisable and that we will stick to our proven long term investment/risk management process no matter what the outcome.

Fixed Income Outlook

Corporate bond prices continued to rally during Q3 following the weakness experienced earlier in the year, while government bonds continued to inch higher. The Bloomberg Barclays Aggregate Index, a mix of government and corporate bonds (mostly government), rose 0.6% during the quarter, bringing the year-to-date return to 6.8%. Interest rates remained relatively flat with 10-year Treasuries yielding 0.69% at quarter-end, still well below the 1.92% seen at the end of 2019. Shorter-term Treasury yields remain exceptionally low, with yields at <0.15% for maturities of 2 years or less. Such rates are especially sobering given that inflation is running at 1-2%, depending upon which inflation gauge one follows.

In the near-term, a material increase in interest rates remains unlikely given the Federal Reserve’s commentary that it will keep short-term rates near zero through at least 2023. The timeline for raising rates could be extended even further given that the Fed is predicating any future rate hikes on 1) the economy achieving full employment and 2) core inflation exceeding 2% “for some time.”  Full employment would require the unemployment rate to fall drastically from the current 7.9% to the 3.5% – 4.0% level. Similarly, the core Personal Consumption Expenditures price index (core PCE), the preferred inflation gauge used by the Fed, would need to move from the 1.59% level seen today to over 2% and remain at that level for many months.

Corporate America is taking advantage of generationally low interest rates by issuing all-time record amounts of debt, much of which is going to refinance older, higher rate debt. In fact, over the past several months, many issuing companies have offered to repurchase some of the bonds that we own. In almost every case, we have turned them down, since we would rather capture some yield versus sitting in cash earning close to zero yield.

We have generally remained on the sidelines when it comes to purchasing new corporate bonds. Our plan is to wait for a better entry point when yields are higher – perhaps during the volatility that may accompany the election in November. The vast majority of investment-grade bonds with a maturity of 3 years or less yield less than 0.50%. These yields are no doubt being impacted by the Fed’s multi-billion dollar campaign to purchase both individual corporate bonds and fixed income ETFs. A primary goal for portfolios is to provide stability by minimizing both interest rate and credit risk. With that in mind, we continue to position portfolios with a mix of short-term investment corporate bonds and Treasuries along with longer-term floating rate securities (and in some cases, preferred stocks).

Global Markets Outlook

Global equity markets continued their recovery during the third quarter, with emerging markets leading the way up 9.7%, US large cap stocks represented by the S&P 500 rising 8.9%, international developed markets increasing 4.9%, and US small cap stocks recovering 4.9%. The dollar weakened by 3.5% in the quarter, providing a tailwind for US investors in international markets. Through September 30^th, US large cap stocks are the only positive equity market, up 5.6%, followed by emerging markets down 1.0%, international developed markets down 6.7%, and US small cap stocks down 8.7% year-to-date.

In the midst of angst and uncertainty surrounding the upcoming election, the adage that stocks are a “voting machine” in the short term but a “weighing machine” over the long term appears especially relevant. What this means is that while sentiment and perception create short-term volatility, it is ultimately the fundamentals of sustained earnings growth, interest rates, and inflation that combine to drive equity returns.

Global central banks are maintaining an aggressive monetary policy stance, keeping interest rates low to maximize growth and recovery, while inflation remains quiescent for now. From the perspective of asset valuation and income generation, equities appear more attractive than bonds, and certainly more attractive than cash which yields zero. In fact, most high-quality, dividend paying stocks offer higher yields than their underlying corporate debt.

Portfolio Resilience

We believe building resilient portfolios requires balancing investor goals of maximizing long term returns while mitigating risk with broad diversification. Dominant US mega-cap companies that have thrived throughout this pandemic remain a key ingredient for portfolios. However, leadership rotates, and including different asset classes in portfolios could benefit some clients. Adding non-US markets and small cap equities provides exposure to more cyclical and value stocks that could benefit from a broader recovery. For example, international equity allocations reduce dependence on the US, provide exposure to an earlier recovery, and enhance dividend yields. Small company stocks provide exposure to a sharper recovery from the pandemic. Including Real Estate Investment Trusts provides growing rents from premium properties.

Animal Spirits vs. Investor Fear

Drastic Fed actions of prolonged monetary easing combined with historic levels of fiscal stimulus has successfully cauterized the economic fallout from the pandemic. As the flood of liquidity and lower interest rates boost asset prices and increase valuations, many investors ask if the increased speculation in the markets is a result of easy money policies. In other words, has the pendulum shifted from maximum pessimism in March 2020 to irrational exuberance today?  An element of speculative activity is clearly apparent with retail options trading up 300% from last year, the proliferation of SPACS (special purpose acquisition companies), and record IPOs. The proverbial “animal spirits” unleashed by easy monetary policy have infected speculation into pockets of the markets.

However, total investment fund flows show the exact opposite. In the 2 ¾ years since December 2017, $2.3 trillion has poured into in ETFs and mutual funds, but this net figure includes $2.5 trillion going into bond and money market funds, and $200 billion coming out of equity funds. This shift away from equities and into bonds and cash is indicative of pervasive investor fear, not rampant speculation. While an increase in speculative activity is a natural result of easy monetary policy, we believe the actions of investors, who’ve been building cash on the sidelines, is a more meaningful barometer of investor sentiment.

REIT Commentary

In the third quarter, the MSCI US REIT Index (Bloomberg: RMZ) produced a total return of +1.6%. Year-to-date, the RMZ has produced a total return of -17.1%. After a swift rebound from the low on March 23^rd, the RMZ closed September at the same level as it did in May, despite a decline in uncertainty and the resumption of hiring. We believe REITs remain undervalued versus fixed income and traditional equities at current prices.

The relative discount at which REITs are trading to traditional equities reflects concerns about the timing of the resumption of job growth and secular changes due to COVID-19 that could potentially have long term effects on several property types. While these are legitimate concerns, history has proven that the best times to invest have been during periods of great uncertainty and discounted valuations. We believe that the expected decline in new construction coupled with both record low interest rates and a resumption in job growth will favor commercial real estate and ignite a new real estate cycle.

It is nearly impossible to pick the bottom of the market in real time, but we do know that prices begin their recovery before fundamentals find the bottom. Because real estate construction can vary from six months (industrial) to two or three years (urban office), real estate tends to lag the economy by one to two years. However, as mentioned above, public REIT prices tend to move well ahead of fundamentals. For example, the bottom for REIT prices in the previous cycle was March 6, 2009, but the bottom for REIT occupancy was Q1 2010. The investor who waited until the bottom of REIT fundamentals would have generated an annualized total return of only +5.8% for the duration of the cycle ending March 23, 2020 which compares to a +13.7% annualized return for an investment made at the RMZ trough. Therefore, investors should not wait until fundamentals bottom to begin investing in REITs.

Despite the positive job growth and lack of construction, same store net operating income (or SSNOI) did not turn positive until Q3 2010. Extrapolating the same timeline from the previous crash and recovery, we believe the bottom of real estate fundamentals will be in late 2021, setting the stage for a period of above average SSNOI growth from mid-2022 until the cycle matures, which has historically been five to ten years. In the previous cycle, the initial imbalance of supply and demand led to 33 straight quarters of above average REIT SSNOI growth. From Q2 2011 to Q2 2019, REIT SSNOI growth averaged +3.8%, well above the long term average of +2.8%.

As shown in the figure below, the occupancy gains occur in Phases I and II, also called the Recovery and Expansion stages (highlighted in yellow and green). The same lag effect that creates the supply and demand imbalance in the Recovery and Expansion stages serves to exacerbate the occupancy declines in Phases III and IV, also called the Hypersupply and Recession phases (highlighted in orange and pink). However, in these cases, supply exceeds demand, creating a period of declining rents and occupancy. The resulting “crash” is what signals the end of the previous cycle and the beginning of a new cycle. We feel confident that we found the bottom of REIT prices in March for the new cycle, and thus will enter the Recession phase in the next quarter or two. Using history as a guide, occupancy should bottom in late 2021 or early 2022, sparking the beginning of the Recovery phase.

Bradley J. Eixmann, CFA, beixmann@chiltoncapital.com, (713) 243-3215

Brandon J. Frank, bfrank@chiltoncapital.com, (713) 243-3271

R. Randall Grace, Jr., CFA, CFP®, rgrace@chiltoncapital.com, (713) 243-3223

Matthew R. Werner, CFA, mwerner@chiltoncapital.com, (713) 243-3234