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The Island Investing Blog
From an email sent out to IIM investors…
Good evening, IIM investors.
The economic recovery continues to send mixed signals in early August. Increased COVID-19 cases in many parts of the country have led to increased restrictions by local governments and businesses. Nonetheless, there are clear signs that the economy is getting back on track. The data suggest that the worst is behind us at a national level, and that jobs will slowly return as businesses find their footing.
Recent GDP data for the second quarter showed the economy suffered its worst decline in history. On an annualized basis, the economy shrank by 32.9% – worse than any quarter during the Great Depression nearly a century ago.
However, it’s important to keep a few facts in mind when seeing those headlines.
First, we often annualize economic numbers in order to understand trends. Normalizing the data helps better compare measurements…by imagining what would have happened had these events been stretched out to a whole year.
In this case, the magnitude of that GDP decline is not expected to last a full year – since the worst likely occurred during April and May. The actual quarterly decline was 9.5% – compared to the first quarter, and the same quarter a year ago. While that is still awfully ugly, it really shouldn’t be compared to the Great Depression, either – which lasted a decade and technically spanned two economic cycles.
Second, those GDP numbers are backward-looking – since they are only released quarterly, and with a lag. Many stocks continued to perform well over that same time because those numbers were widely anticipated. In fact, the consensus forecast for a 34.5% decline in GDP was nearly right on point – and we already knew that a new economic cycle began in March, according to the National Bureau of Economic Research.
Finally, those GDP numbers don’t take into account what we’ve learned since the economy first went into free-fall: that businesses can successfully reopen, and the economic numbers can improve. That’s highly dependent on COVID, of course, but if businesses can continue to run and expand their operations – even at partial capacity – then jobs can return and corporate profits can recover.
There were clear signs of this in the jobs data during May and June when even weekly jobless claims were improving. As retail sector jobs return, there are also signs that business and industrial activity has picked up. Various manufacturing and non-manufacturing levels are now rising at pre-crisis rates – a positive sign for the rest of this year and into 2021.
As expected, corporate profits are trending with the economy. It’s estimated that earnings fell between 35% to 40% during the second quarter (they are still being reported) and will likely decline in 2020 overall by a little more than 20%.
However, estimates also suggest that corporate profits will return to pre-crisis levels by the end of 2021.
While a two years of lost profit growth is not what anyone wants to see, let’s keep some perspective there, too. Namely, this is occurring after the worst quarterly economic decline in history – and it may be shorter than the four years of flat profits we saw after the 2008 financial crisis.
Ultimately, it’s important to see through this interim period in order to benefit from the economic recovery. Financial markets are forward-looking…one reason that stocks have performed well over the past few months despite the on-going crisis.
So, please consider this a reminder that it’s still important to maintain discipline and not over-react to backward-looking data in the coming months.
Below are three charts that put recent economic trends in perspective.
1. The economy has experienced its worst decline in history
The Q2 GDP decline was the worst in history. The economy fell 32.9% at an annualized rate or 9.5% on a quarterly basis. Still, unlike in prior recessions and depressions, this is not expected to continue at this pace. There are already many signs that the economy is rebounding, even if the pace is uncertain due to the on-going COVID-19 crisis.
2. However, the recovery is still continuing
Other data show that activity has been returning since the economic bottom. The ISM manufacturing and non-manufacturing indices both show that business activity has returned to a healthier pace. While these numbers will depend on how local governments and businesses deal with COVID-19 outbreaks, the overall trends are positive.
3. Profits are expected to take two years to recover
In the end, what matters to investors is how the economic data affect corporate earnings. So far, earnings have trended with the economy. Profits are expected to recover in the second half of the year and into 2021. This trend is one reason that stocks have recovered in recent months.
The bottom line? While the Q2 GDP report was the worst in history, that was widely expected. There are many signs that the economy has been recovering since then – and will continue to do so, through 2021.
Please let me know if you have any questions.
Thank you and hang in there.
– Caleon August 9, 2020 , Commentary
Sturm und Drang
Our hearts go out to those whose loved ones are being impacted by COVID-19; we empathize with those businesses that are trying to find a path forward during this difficult time.
As if this insidious virus wasn’t enough of a challenge, investors had to deal with early tropical storms, a Godzilla dust cloud, civil unrest and outbreaks of dengue fever in Florida and Ebola in Mongolia – not to mention the typical geopolitical gyrations. By mid-March the S&P was down 34% from its record close; but rebounded in the second quarter to just a negative 3.1% for the whole first half of 2020 as some countries gained control over the spread of the virus and many (including some that didn’t have control) began to reopen businesses and even their borders to select foreigners. The MSCI ACWI ex USA index also bounced back, ending down 11% for the 1st half of 2020.
Our International Folios
Despite all the Sturm and Drang, Frigate our ADR (American Depository Receipt) Folio focus on capital appreciation only fell 7.3% (all returns are estimated and Folio returns are net of fees) versus the S&P 500 ADR index which fell 14.7%. In general, Frigate’s benefitted from a higher cash position early in the year and its exposure to healthcare stocks; in addition, new purchases Adidas and L’Oreal did very well. Financials, in particular those exposed to emerging markets such as Brazilian Banco Bradesco and HSBC holdings (also known as Hong Kong Shanghai Banking Corp), were obvious detractors for the six months as was energy solution provider TechnipFMC.
Treasure Harbor, our ADR Folio focusing on yield, fell approximately 14.5% versus a negative 18.74% for its benchmark (15% SPDR Emerging Markets Dividend ETF, 85% SPDR S&P International Dividend ETF) for the first six months of 2020, as many typically defensive companies conserved cash by cutting their dividend. In addition to the aforementioned HSBC, energy stock Pembina Pipeline and Royal Dutch Shell were drags on performance. On the other hand, Deutsche Telekom and Spanish utility provider Iberdrola were positive contributors, as was spirits producer Diageo, which was purchased this year.
Our international small/mid cap Folio, Yellowtail, was down 10.5% for the first half of this year versus a negative 13% return for the Vanguard FTSE All-World ex-US Small Cap ETF (VSS). Strong detractors were as expected: Swiss travel retailer Dufry, British staffing company Hays and French caterer Elior. Logitech, the Swiss provider of computer and mobile accessories purchased in the first quarter, did very well the first half, as did Japanese packaged-food company Nichirei Corp and French provider of diagnostics BioMerieux.
Other IIM Investments
In addition to our proprietary Folio, we have invested many of our clients’ funds into Exchange Traded Funds that address other areas of the markets. Adding large-cap growth has been especially effective as both our selected domestic and international growth ETFs outperformed their value peers over the first half. Our selected domestic and international small-cap ETFs, however, underperformed their large-cap peers. An unpleasant surprise was the performance of our low-volatility ETF; usually offering protection in down markets, it was down 13.53%. This is likely due to the ETF’s overweight in utilities and real estate which were at risk for provisioning for bad debts and bad loans. On the other hand, the gold ETF we bought for client’s accounts did very well.
At the request of some clients during this period, we invested in some relatively conservative, fixed-income ETFs that were on the spectrum of ultra-short to medium- term durations. These behaved as expected with flat to middle single digit returns.
The strong rebound in the markets while the virus is still spreading in some countries is a bit worrisome. The valuations of the US market, especially, seem high considering our relative lack of progress in containing the virus and the risks this may have for businesses and individuals. Although valuations in other equity markets appear more attractive, international companies’ earnings aren’t fully immune to what is happening in the US. As we caution that past performance is not a guarantee of future results for any of our propriety portfolios or other investments made for our clients, we do suggest investors consider diversification consistent with their risk tolerance, investment outlook and financial goals.
As some of you may know, I have moved to Raleigh, North Carolina. I am still managing the International Folios and working with Cale on the portfolios of our wealth management clients. My phone number will remain the same, as will my email address, so please don’t hesitate to reach out with questions.
We wish for you all a safe summer and thank you for investing with Islamorada Investment Management.
– Lauretta “Retz” Ann Reeves, CFA AWMA
Disclaimer: This post nor any of the material linked to herein in any way constitutes investment advice. Historical performance data above represents performance results as reported by the portfolio identified. Performance results are for illustration purposes only. Historical results are not indicative of future performance. Positive returns are not guaranteed. Individual results will vary depending on market conditions and timing of initial investment. Investing may cause capital loss. The publication of this performance data is in no way a solicitation or offer to sell securities or investment advisory services.