A Cautious Outlook

Stock prices have roared back strongly through the second quarter, as investors grew increasingly optimistic over prospects for economic reopening and the unprecedented monetary policy support that provided a strong tailwind for equities. At this point, however, stocks are looking somewhat richly valued and we think investors may be looking past some key risks. We think long-term prospects for stocks remain compelling, but markets may be in for prolonged volatility, a possible setback and ongoing churning over the next few months.

The coronavirus pandemic and accompanying economic shutdowns have undoubtedly caused a deep recession. Per the IMF, U.S. GDP will fall 8% and global GDP 5% in 2020. U.S. industrial production is 16% below its high, and the unemployment rate stands at 13.3% or 16.4% (depending on how furloughed workers are counted). The situation would clearly be worse were it not for extraordinary fiscal and monetary stimulus. The U.S. has increased federal spending by $2.9 trillion since the pandemic began, and we expect another $1 to $1.5 trillion package before the end of the summer. Governments around the world have also been pumping money into their economies. At the same time, the Federal Reserve and other central banks have slashed policy rates to zero or below and allowed real rates to collapse. Forward guidance suggests rates will remain zero-bound through at least the end of 2022. Monetary policy, however, has already become about as accommodative as it can. Central banks are continuing to ease, but that easing is no longer accelerating.

The biggest shock of the last few months is how quickly stocks came roaring back. The S&P 500 Index is less than 10% below its February all-time high. And at this point, we see several reasons for caution. The first is valuation: The 12-month forward P/E ratio for the S&P 500 has climbed from a low of 13.4X on March 23 to 21.4X now, as investors began pricing in prospects for economic recovery. Such an acceleration is probably setting investors up for possible disappointments over economic and earnings results.

We are also concerned about political risks, which will likely heat up over the coming months. There is a growing possibility of a Democratic sweep in November, which could result in tax increases and a tougher regulatory environment. We are also concerned about the deteriorating U.S./China relationship and trade disputes with Europe. These risks were easy to overlook when investors were focused on easing monetary policy, but we expect they will come back into focus. Additionally, the future path of the coronavirus itself remains a wildcard. Infection levels are rising in many countries and in the U.S. Sunbelt. And this wave is likely to continue as economies continue to re-open. Investors are likely to continue to be rattled by news of new spikes and a slowdown or reversal of reopening policies. At this point, we think stocks as a whole appear fully valued. Over the

next few months, we expect stocks to be trendless and volatile. A correction is possible, but we don’t expect it would morph into a renewed bear market since the underlying economy remains sound. We expect stocks to continue trading at a level between 2,750 and 3,150 for the S&P 500 for the time being. Additional clarity on the political front, news of effective treatment for the virus and a more coherent and consistent public health policy would all help stocks to break out of this range to the upside, which could happen later this year or in 2021.

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