It’s hard to recall a more confusing quarter for investors. While economic data plumbed depression-level depths for most of the past three months, equity markets rallied heavily. This odd juxtaposition led many to opine that markets had disconnected entirely from the economy.

We disagree.

Recall that in our Q1 2020 market commentary we expressed our belief that the market would ignore economic data in Q2. With the data no longer our guiding light, we laid out four milestone markers that we thought needed to be reached on the way to a recovery following COVID-19.

Our first marker was aggressive monetary and fiscal policy to fill the economic valley created by efforts to bend the virus curve (our second marker) via broad social distancing to relieve pressure on hospital systems. We believe the quick, aggressive delivery of relief (no. 1) allowed the market to reach a bottom on March 23, while our initial success in bending the virus curve (no. 2) allowed equity markets to push higher, even against a backdrop of rapidly deteriorating economic data.

Historically, the beginning of the end for past downturns occurs when we start “fixing” the underlying problem that drove the economy into a recession. The reason the economic data was so bad wasn’t because of underlying U.S. economic fundamentals; rather, it was COVID-19 and the initial “treatment” to socially distance or close large parts of the U.S. economy to bend the case curve. Put differently, we intentionally caused a collapse in economic data to begin fixing what went wrong — the virus.

MARKETS ARE DISCOUNTING MECHANISMS, NOT MIRRORS

With the virus subsiding in many parts of the U.S., May and June saw efforts to reopen the U.S. economy (marker no. 3) accelerate, and large parts of the U.S. economy came back online. Coincident with reopenings, economic data jolted from a COVID-19-induced slumber and improved at a historic pace. While we still have much work to do (on both the health and economic front), the data has rebounded much more quickly and sharply than expected.

While we expect pushing and pulling as virus updates dominate the daily news narrative in the near term, we believe the U.S. economy will continue its walk out of the economic valley.

We can even measure the extent to which data exceeded expectations. The Citigroup Economic Surprise Index (CESI) measures the divergence between U.S. economic data and economists’ expectations. Going back to 2003, the index hit an all-time low on April 30 (numbers came in worse than expected) but then spent the next two months climbing to a record high by quarter end. Think of it this way: The market plunge in February and March reflected the anticipation of awful economic data that arrived in April, while the strong Q2 rally reflected the market moving higher in anticipation of better data that was set to occur with the reopening of the economy in May and June. Essentially, the market’s swift rebound has been commensurate with the degree of economic outperformance, as measured by the CESI.

Up until the closing weeks of the quarter, markets reflected an economy reopening without significant spikes in COVID-19 cases. Now, we appear to be at an inflection point, as cases in some parts of the country are rapidly accelerating. This raises the question of what’s next for markets in Q3 2020. Here’s how we’re thinking about the months ahead.