Be Prepared for a Potentially Wild Third Quarter

After falling precipitously in the first quarter, the S&P 500 Index added 20% during the second, making for the best quarter since 1998 and the best second quarter since 1938. What comes next is anyone’s guess.

Ryan Detrick, senior market strategist for LPL Financial, is among the sources who commonly share economic commentary with PLANADVISER.

Taking stock of the freshly ended second quarter, and looking ahead to the third, Detrick says the markets remain at a critical crossroads. So much in the near-term future will depend on our collective progress (or lack thereof) fighting the coronavirus pandemic. Also key will be the management of global trade tensions between the U.S. and China, and the United Kingdom’s ongoing exodus from the European Union. What we can say at this point, Detrick observes, is that the second quarter was something special from a performance point of view.

“What a quarter the second quarter was, with the S&P 500 Index adding 20%, for the best quarter since 1998 and the best second quarter since 1938,” Detrick says. “Of course, stocks fell 20% in the first quarter, so what we really have is a bad case of whiplash in 2020 thus far.”

As Detrick points out, a 20% quarterly gain is quite rare, so it is hard to extrapolate too much from the second quarter’s remarkable bounce. However, historically, previous large quarterly gains have led to continued strength.

“In fact, a quarter later, stocks have been higher the past eight times after gaining at least 15% during the previous quarter,” Detrick says. “In this sense, future strong returns are quite normal after a big quarter. Although it might not seem likely given the headlines and magnitude of the current bounce, it is important to be aware that extreme strength usually begets more strength.”

Detrick says it is also important to keep in mind that the third quarter has historically been the weakest quarter of the year.

“Breaking the data down more, though, shows that July has been actually the strongest month during the summer,” Detrick adds. “August and September have tended to be troublesome and dragged the third quarter down.”

In related commentary derived from data published by the Bureau of Labor Statistics (BLS), Chris Rands, fixed income portfolio manager at Nikko Asset Management, emphasizes the importance of the employment rate when it comes to driving sustainable economic growth post-coronavirus.

“Of the approximately 20 million people who became unemployed due to COVID-19, around 15.5 million currently believe it is temporary,” Rands observes. “This is not an unreasonable assumption given that 3 million of these temporarily laid-off workers just returned to work.”

As Rands explains, most of the job losses tallied so far were in leisure and hospitality. The other top categories were trade, transportation and utilities. These sectors together in March and April shed about 12 million jobs.

“However, if you look at the rehiring that came through May, most of the employment was in the hardest-hit sectors, with the subcategories of food services and drinking places, and retail trade, showing some strong employment,” Rands says.

Rands uses some back-of-the-envelope math to project that approximately 4 million people out of those approximately 15.5 million currently temporarily unemployed could likely remain unemployed in the next six months to a year. These figures would in turn imply an unemployment rate of around 7% to 8% in that timeframe.

“If half of those employed in accommodation and food services and retail trade returned to employment when the economy opens, that would equate to 6 million jobs,” Rands says. “Given the scale of the decline and government policies in place, this doesn’t seem unreasonable. Having said that, my ‘fixed income gut’ tells me that it feels a little too optimistic. … History shows the U.S. economy can put on about 500,000 jobs monthly following a recession, but it very rarely exceeds a million. That being said, we have never experienced these conditions before, particularly for those who believe it is all temporary.”

Rands’ analysis continues: “To put this into context for rates, the U.S. Federal Reserve didn’t hike rates until 2015—seven years after rates were effectively lowered to 0% following the Great Recession—when the unemployment rate fell to about 5%. If the above estimate is correct and unemployment in 12 months’ time is at 7% to 8%, then we can add another three to five years to the time it could take for the unemployment rate to fall from 8% to 5%. This would leave rates at zero for the next four (at the lower end of the estimate) to seven years (at the higher end), before the Fed was in a position to contemplate higher rates—well beyond the Fed’s recent commentary that rates will be low until at least until 2022.”

Like his peers at LPL and Nikko, Brad McMillan, chief investment officer for Commonwealth Financial Network, says 2020 has been and will continue to be a very challenging year from various perspectives. Still, he sees several reasons for tempered optimism.

“Halfway through 2020, we’ve already had enough news (and then some) to fill up an average year,” McMillan says. “So far, we’ve seen a pandemic explode—then moderate. The stock market crashed—then recovered rapidly. There were protests around the nation—and we don’t know what will come next there. In addition to these major events, politics has steadily become more confrontational, and we know it will likely get worse as we move toward the November elections. Given the headlines, the key to figuring out what is likely to happen over the rest of the year is to focus on the most important trends, which for us means the coronavirus pandemic, the economic response to it, and the financial markets.”

Speaking frankly about the coronavirus situation, McMillan says the real question for the rest of 2020 is not if there will be a second wave, but whether it will be large enough to derail the economic recovery underway.

“So far, it does not look like it will,” he says, adding ample notes of caution. “As of late June, we are seeing significant second waves in several states, and rising case counts in many others. Although it is quite possible we will see lockdowns locally, a national shutdown looks unlikely, which should allow much of the recovery to continue. Although there are risks to that outlook, it remains the most probable case for the rest of the year. Despite the rising case counts, the economic reopening is making solid progress. Job reports so far have indicated the damage has peaked and many have returned to work, leading to a bottoming out and rebound in consumer confidence. Surprisingly strong consumer spending data has validated this, as consumers spend only when employed and confident. And, while business confidence remains low, it, too, has rebounded and shows signs of continued recovery.”