A Persistent Conundrum

Imagine being told on January 1, 2020 that the coming year would be plagued by a highly infectious global pandemic leading to global lockdowns, 14% unemployment at the peak, and over 22 million jobs lost. Very few would have guessed that the S&P 500 would end the year in the black, much less above its average long-run return of 10%. Yet as of writing, the S&P 500 total return index stands at +16.27% year-to-date, defying all expectations. This month we explain why we believe this to be the case and propose allocation strategies for the coming year.

The Great Nesting

We begin with a snapshot of personal consumption expenditures (PCE), which is a measure of national consumer spending and essentially tracks how much Americans spent on goods and services. It is decomposed into two major categories of consumer purchases: goods and services.

Fig. 1

Source. Bureau of Economic Analysis

Overall aggregate spending was relatively resilient (-3% year over year) with a (i) significant substitution in expenditures from services (-7%) into goods (+7%) supported by (ii) aggressive fiscal policy support in the form of transfer payments to household ($2.6 trillion). 

The increase in consumer expenditures on goods is consistent with what some have called the “Great Nesting.” Social distancing and lockdown has led to an increase in car sales and sales of recreational goods and vehicles. Anecdotal evidence abounds of shortages in at-home exercise equipment, bicycles, and camping gear. Home furnishings and durable goods have also seen an increase in demand, as stay-at-home orders led households to focus on making their homes more comfortable and enjoyable. Remote work and work-at-home policies also spurred demand for computer related items, as ad-hoc home-offices were hastily assembled across the country.  

Similarly, on the services side, the 7% decline in spending on services is consistent with what one might expect to result from social distancing, widespread travel restrictions, and elevated unemployment rates.

Fig. 2

Source. Bureau of Economic Analysis

Business profits are typically driven by consumer spending, and while aggregate consumer spending was relatively resilient, it still printed a decline year-over-year. It is therefore difficult to reconcile a stock market at +16.7% with PCE down -3%. We make two observations that may help bridge the gap.

The devil’s in the details

Drilling down into the subcategories, COVID-19 related travel restrictions and social distancing guidelines led to sharp declines in recreation, transportation and food (dining) and accommodations of -25%, -32%, and -20%, respectively. 

The composition of the S&P 500 is not a good representation of the overall economy

Fig. 3

Source. Reuters

Figure 3 shows a significant divergence between the makeup of the S&P 500 and the American economy. (As we previously explored, the S&P 500 is a misleading indicator of broader economic health because of the disparity in its constituent returns.) Figure 1 shows that the hardest-hit services categories comprised 14% of total expenditures in Q3 2019, but those same categories make up a significantly smaller share of the S&P 500. Restaurants and small local businesses without an online presence bore the brunt of the COVID-19 pandemic, and such businesses are not represented at all in the index. Once again, the S&P 500 is simply not a good indicator of overall economic health.

Despite these headline returns, the constituent portions of the S&P 500 did not see gains across the board. Indeed those sectors expected to be hardest hit did suffer large losses. How then to explain that the S&P 500 as a whole is experiencing large gains despite 2020’s economic shocks? 

A dive into the S&P 500 sector returns show that the returns broadly align with spending data from the Bureau of Economic Analysis (BEA). Energy took the brunt of losses as lockdown and travel restrictions silenced demand for both business and personal travel. Real estate also suffered losses as unemployment rates shot up and small businesses and brick and mortar shopping centers saw a sharp decline in foot traffic. Consistent with the PCE table in Figure 2, financials were roughly flat.

On a positive note, materials and industrials saw healthy gains from the prior year’s depressed levels as the manufacturing complex picked up to meet substitution demand for goods and away from travel, recreation and dining. The shift towards online shopping and remote work, helped spur gains in information technology and communications services.
Monetary easing continues to drive S&P 500 returns

The second piece of the puzzle may be explained by the aggressive monetary easing implemented in the U.S. and abroad. Since the beginning of the year, M2 money supply in the U.S. has increased +24.7%. The FOMC stepped in to fill a large liquidity gap at the depths of the COVID crisis to plug the liquidity crunch that resulted from the indiscriminate selling that arose from market fears of a deep recession in the spring.

Source. Federal Reserve Bank of St. Louis

So successful, however, was that combination of aggressive monetary and fiscal stimulus that investors quickly shifted cash back into markets. The chart below shows JP Morgan’s estimates of total non-bank holdings of stocks and bonds as a percent of M2 money supply, which have returned to pre-COVID levels.

With M2 money supply up 24.7% and non-bank holdings of stocks and bonds back to pre-pandemic levels, it is no surprise that stocks were able to gain +16% year to date. In fact, as compared to gold, which gained roughly +22.8% year-to-date and commensurate with the increase in M2 money supply (as discussed in a previous newsletter), stocks have underperformed compared to what might be expected from the 24.7% increase in money supple, ceteris paribus.

Looking forward

Because of the unprecedented printing of money in 2020 (24.7% increase in money supply) and the fact that the composition of the S&P 500 is more heavily weighted towards the goods-producing and information technology and communications sectors, all of which are beneficiaries of lockdowns, social distancing, and work-from-home, it is not unreasonable that the index is showing robust double digit gains year to date.

But just as the makeup of the S&P 500 index is such that it did not bear the brunt of the pandemic downturn, it is similarly not likely to benefit greatly to the upside from economic normalization after the easing of social distancing and travel restrictions.

Moreover, given that the durable goods cycle has largely been pulled forward (consumers don’t need a new car or bike every year), next year’s year-on-year comparisons will likely disappoint on a year over year basis. As such, we recommend a closer look at the hardest-hit sectors, such as energy, travel, and recreation (which currently sit at depressed levels) rather than a overweight in the overall index for a view towards mid- to late-2021 normalization.