Despite medical, economic and social turmoil, the market rebounded in the 2nd quarter to the surprise of most investors.

The recovery isn’t exactly what it seems; while the largest tech stocks posted gains, many other companies are still down double digits.

Our short-term economic outlook is highly determined by the progression of COVID-19 and the timing and effectiveness of treatments and vaccines.

Investors should be prepared for the market to retest March lows should we experience a widespread second wave that forces another large-scale economic shutdown, though we think a bumpy recovery is the most likely scenario.

The Fed has made it clear they will do whatever it takes to provide stability to our economy and the ensuing recovery.

Equity investors have been on quite a roller-coaster ride this year. After hitting an all-time high on February 19, the S&P 500 Index plunged a gut-wrenching 34% over the next month, marking the quickest bear market in U.S. history. Investors who remained strapped in as we did—keeping our arms and legs inside the car at all times—then experienced an equally surprising and gravity-defying upturn. From the March 23 low, the market soared nearly 40%, notching its best return ever over any 50-day period. Talk about whiplash!

Despite medical, economic, and social turmoil, the S&P 500 is down just 3% year to date and is only 8% below its all-time high on February 19. However, there is a major bifurcation beneath the surface of the market. If you remove the largest 5 companies from the S&P 500 (Apple, Microsoft, Amazon, Google, and Facebook), the S&P 500 is down 9% for the year. Viewed from another angle: The S&P 500 technology sector is up 12% on the year, while energy, financials, and industrials are down 35%, 24%, and 14% respectively. So, for many investors, things are not nearly as rosy as they may appear looking at the market overall.

In fixed-income markets, core bonds gained almost 3% for the quarter as Treasury yields dropped slightly (falling bond yields imply rising bond prices) and investment-grade corporate bond spreads narrowed, rallying along with the equity markets. Core national municipal bonds were up 2.6%. Riskier credit-sensitive sectors within the fixed-income universe posted very strong gains, making up some ground from their first quarter losses.

It’s been a wild first half, where do we go from here?

We still believe that COVID-19 is the most important short-term variable. As always, we see a range of potential economic and financial market outcomes looking ahead over the next six to 12 months and beyond. What’s unique about the current environment is how dependent the outcomes are on the course of COVID-19. Significant uncertainty remains as to the virus’s progression, even as economies around the globe start to reopen and relax social distancing standards. The timing, availability and effectiveness of treatments and vaccines are also highly uncertain but crucial variables for the economic outlook.

In our view, the key risk to the economy and financial markets is the potential for a widespread second wave of COVID-19 infections, hospitalizations, and deaths that force another large-scale economic shutdown. In that event, stocks could re-test their March lows. We are prepared for that dire scenario with our portfolio holdings in core bonds. But absent a severe second wave, and even assuming there are smaller localized outbreaks, we think an uneven but steadfast economic recovery is the most likely scenario looking out over the next six to 12 months at least. Given the market’s recovery in the second quarter, investors seem to agree.

Monetary and fiscal policy are also key

While we view the progression of COVID-19 as the most important driver of the short-term economic and market outlook, monetary and fiscal policy are second-most in importance. After the Federal Open Market Committee (FOMC) meeting in June, Fed chair Jerome Powell made it very clear the Fed intends to keep monetary policy extremely accommodative for the foreseeable future.

At the June meeting Powell said, “We are strongly committed to use our tools to do whatever we can, and for as long as it takes, to provide some relief and stability, to ensure the recovery will be as strong as possible and to limit lasting damage to the economy. … We are not thinking about raising rates. We are not even thinking about thinking about raising rates.” As the saying on Wall Street goes, “don’t fight the Fed!”

The Fed is leading the way for other global central banks to enact their own extremely loose monetary policies. According to Ned Davis Research, 97% of all central banks are now in an easing cycle (cutting rates), and 87% of central banks have their current target interest rate at a record low level.

Given all this stimulus, is inflation a risk?

We’re seeing a lot of discussion in the financial press about the risk of inflation in the United States given the massive stimulus from the Fed along with the multi-trillion-dollar debt-financed fiscal support programs.

We don’t view inflation as a near-term risk because there is too much slack in the economy due to the hit from COVID-19. It will take a while—likely a few years at least—for the economy to get back to operating at full capacity and full employment. Until then, the slack should restrain consumer price inflation and wage inflation.

It’s also worth remembering that even when the U.S. economy was at full employment in the months before the pandemic, core inflation was still below the Fed’s 2% target. Now, with the economy running below its potential, inflation is a lesser risk.

Other risks…

Besides a resurgence in the pandemic, there are several other macro risks to be aware of. We’ll name the four at the top of our list:

1) The November elections and policy-related uncertainty (for example, a repeal of the Trump corporate tax cuts if the incumbent party loses)

2) An escalation in U.S.-China geopolitical tensions and/or a re-ignition of their trade war

3) Increasing social and political unrest

4) The potential for corporate earnings to disappoint the consensus later this year

The Bottom Line

We hold a cautiously optimistic view that even with an inevitable uptick in COVID-19 cases in coming months, the overall social policy response won’t need to be as draconian, and therefore the economic impact won’t be as bad as during this first wave.

If that scenario plays out against a backdrop of extremely loose fiscal and monetary policy, there is a good chance we’ll get a sustainable, albeit uneven, global economic recovery. It’s unlikely to be a sharp V-shaped recovery, but something more gradual, with some sectors and industries doing much better than others.

But we should also prepare ourselves for a potential double-dip back down to the late-March market lows, most likely caused by disappointing developments on the virus/medical front.

As always, it is so important to be invested in the right portfolio aligned with your risk tolerance and financial goals. This should enable you to keep a healthy long-term perspective and to remain disciplined and “stay the course” through the inevitable downturns when fear in the markets is palpable.