Following a sharp recovery in the second quarter, U.S. equity markets continued to bounce back in the third quarter, supported by optimism surrounding a COVID vaccine and reopening of the economy. The S&P 500 and the NASDAQ Composite indices set new record highs last quarter as investors continued to focus on beneficiaries of the shelter-at-home economy. Growth stocks again outperformed their value counterparts despite temporary bouts of underperformance that had many believing the rotation into value names was finally upon us. The massive fiscal stimulus from the federal government paved the way for the market rebound but has also created a K-shaped recovery by increasing wealth disparities.
Even with the Congressional Budget Office projecting a record deficit of $3.3 trillion for 2020, negotiations continued with lawmakers on a second round of stimulus that will provide muchneeded aid to troubled sectors as well as state and local municipalities. The U.S. economy continued recovering jobs, and leading economic indicators improved, creating hope for the economy as nearly half a dozen major drug companies are conducting phase trials on a vaccine. While sentiment was positive for much of the quarter, a second wave of COVID infections in Europe and a sharp rise in cases in parts of the U.S. stoked fears that more challenges lay ahead.
Third-Quarter 2020 Performance Highlights
- When adjusted for net exposure and beta, the Thornburg Long/Short Equity Fund performed roughly in-line with the S&P 500 Index.
- In the long book, a concerted effort was made to upgrade the quality of the businesses owned. This led to the sale of several companies that we consider low-quality or leveraged. The sales had a positive benefit to the portfolio during the rally and the temporary sell-off.
- In the short book, we covered positions in speculative growth names that created challenges earlier in the year. The thematic nature of the recovery in equities has made shorting very difficult, which has required us to adapt. Improvements made earlier in the quarter helped performance through both the rally, and the temporary sell-off.
Current Positioning and Outlook
The recovery in the equity markets from the March low has been incredible. Indexes have returned to record levels with unprecedented swiftness. The monetary and fiscal stimulus has provided a springboard for valuations with risk assets benefiting from a zero-interest rate policy that has pushed real yields into negative territory. The liquidity injection from the U.S. Federal Reserve has created what many investors interpret as a price floor and credit backstop for large swaths of the fixed income market. The Fed’s $4 trillion increase in its balance sheet this year includes purchases of not just Treasuries and mortgage-backed securities, but even investment grade corporate and high yield paper. While the impact of rates on bonds is obvious, areas of the equity market have benefited as well.
In a low-rate environment, future earnings become more valuable because the opportunity cost of a future return prospect, or yield, diminishes. In other words, the “time value of money” in an environment of rock-bottom rates means a dollar earned tomorrow is being valued as highly as a dollar earned today. That makes it easier to invest in speculative stocks in hopes of out-sized future earnings when the alternative is investing in bonds at historically low yields. Zero-bound rates push investors out the risk spectrum, benefiting equities of companies in many cases that are free-cash-flow negative.
Market returns during the quarter were driven meaningfully by investor willingness to pay up for future earnings as high-growth names came back in vogue. The popularity of growth stocks was reinforced by flows into “momentum” factor strategies, lifting high-growth stocks even further and sharply expanding their valuation multiples. While relatively few high-growth stocks pay dividends, those that do saw their dividend yields swoon, while the dividend yields of out-of-favor value stocks soared.
The bifurcation has created a somewhat challenging environment for fundamental, valuation-sensitive investors. The goal of running a high-quality, balanced portfolio without bets on factors, such as growth, value or momentum, has become more difficult. The thematic nature of the rally has led momentum and growth factors to significantly outperform, and like a snowball rolling down a hill, their market caps and valuations have surged. As humans we are susceptible to cognitive biases and this seems to be a classic case of recency bias. Greater importance is being placed on the most recent events, which may explain why higher multiple stocks have performed so well and why stocks with a higher dividend yield have performed so poorly.
The market forces investors to adapt, and current market conditions have accelerated many changes that were already in motion. We welcome market volatility, which plays to our strengths. While we remain nimble in our portfolio management, we stay steadfast in our process, which has been foundational to our success. Soaring valuations on growth stocks ultimately lead to thin margins of safety within the portfolio. So, as we closely monitor the evolution of our investment theses on those positions and reassess our conviction levels in them, the truth is, we’re doing the same with all positions across our balanced allocations in both the long and short books. We’re staying disciplined about culling the portfolio of those that don’t meet our milestones for thesis evolution.
Investors’ willingness to pay-up for sales growth, even in the absence of earnings, has skewed the risk/reward trade-off on both sides of the book. We have since covered short positions in speculative, high-growth names while removing low-quality and leveraged businesses from the long book. We have positioned the portfolio to mitigate risk, protecting on the inevitable downside, while participating in any broad-market advance. The late quarter results were very encouraging, as the portfolio performed as we had hoped during both the rally and selloff.
We thank you for your support and investing alongside us in the Thornburg Long/Short Equity Fund.
Performance data shown represents past performance and is no guarantee of future results. Investment return and principal value will fluctuate so shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than quoted. For performance current to the most recent month end, see the mutual funds performance page or call 877-215-1330. The maximum sales charge for the Fund’s A shares is 4.50%.