The increased number of positive COVID-19 cases across Europe has led to some restrictions on social mobility being re-imposed. The second wave is hitting when economies have hardly had time to steady themselves after the first wave. The picture in the US is more mixed but market focus is on the election and the prospects for fiscal stimulus and a vaccine in early 2021. The outperformance of the US is being helped by what looks like a decent Q3 earnings season. But watch the bond market. Long yields have fallen again. The message may be that the global economy needs even more help. Low yields should allow governments to spend even more next year. If that comes “quicker and bigger” in the US, the continued outperformance of dollar assets and the dollar itself could be the story of the new year.
Two different narratives
There appear to be two different narratives driving US and European markets. In the US it is the election. The chances of a Democratic sweep have improved in recent weeks and investors seem, at the moment, comfortable with the large lead that Joe Biden has in the opinion polls. A clear win for Biden reduces the risk of a contested election and the protracted legal arguments that would bring. This would pave the way for a significant fiscal stimulus in the early part of 2021. This week the International Monetary Fund (IMF) suggested that governments should not worry too much about large fiscal deficits and investors don’t seem to be worried either. Concerns about a Biden Administration raising corporate taxes and tightening regulation have been relegated for the time being. After all, few think it would be wise to raise taxes soon after being elected with unemployment at 8% and many businesses across the United States still struggling to fully re-open. I’m sure that Democratic strategists think the same even if the overall policy agenda will mark a significant leftward shift relative to the last four years. Voters might think that a Biden Administration will make taking control of the pandemic a greater priority too as it is evident that infection rates are rising in many of the states that have not been overly strict in enforcing social distancing and the wearing of face-coverings. This is having an economic impact as states like Wisconsin have seen a surge in infections and last week also saw a large increase in initial claims for unemployment benefit. The “clear election win / cyclical reflationary outlook” has driven markets recently and is likely to remain the dominant thesis ahead of, and possibly beyond, November 3.
Europe looking gloomier again
In Europe, on the other hand, the focus is again on restricting social mobility in the wake of a second wave of infections which, in terms of case numbers, is worse than the initial wave in March. It isn’t the same, but there are concerns about rising hospitalisations and death rates across the region even if the case numbers themselves are boosted by the fact that much more testing is being done. Furthermore, the restrictions being imposed on the hospitality sector and social mobility are much milder than those imposed in the spring. As such, the direct impact on economic activity will be less. GDP will not fall as much in response to bars closing as it did to a third of the economy closing down in March. However, there are real economic concerns. New restrictions are being imposed when economies are operating at lower levels than they were at the end of 2019. The sectors in focus for new restrictions are the ones already decimated by previous policies and changes in consumer behaviour. It is likely that we will see even more businesses close, unemployment rises further, and household income and spending take another hit. Credit deterioration is likely in the corporate and household sector and that is a headache for a banking system already having to deal with an unhelpful interest rate environment.
To some extent the two narratives have been reflected in recent market moves. After suffering negative returns in September, US equity markets have bounced back this month, outpacing European equity returns by some margin. The strong performance at the beginning of this month in the US has been driven by the emerging consensus of a Democratic sweep, fiscal stimulus in 2021, the deployment of a vaccine early next year and the belief that the Federal Reserve will keep interest rates unchanged even if there is higher inflation. Add to that early indications of a better than expected Q3 earnings season and the prospect of very low returns over the medium term for high quality fixed income assets and it is difficult to argue with equities remaining the asset class of choice. At the time of writing, according to Bloomberg, earnings releases so far this season reflect a 23% improvement relative to forecasts. This has been driven by financials so far which recorded strong capital markets trading revenues and lower credit provisions relative to Q2. On the technology side, the unveiling of Apple’s new generation of iPhones in advance of a broader roll-out of 5G networks underscores the likely dominance of the technology sector in the evolution of the global economy in the years ahead. Over the last decade, taking the main US S&P equity sectors, information technology has had the best risk-adjusted returns. I doubt that changes as more and more economic life becomes changed by the deployment of digitalisation, robotics and things like distributed ledger technology (DLT).
More fiscal needed
If that sounds bullish it is because I am thinking more about the medium term. In the short-term I would watch what the bond markets are doing. Long maturity government bond yields have fallen in the last month or so. This reflects the risk-off moves we saw in September, where again, holding long duration bond assets would have provided some hedge against negative equity returns (certainty in Europe where long duration German bunds and UK gilts had returns that more than offset the losses incurred by benchmark equity indices). However, it may also reflect a sanity check on where we are in terms of the economic recovery. Lower bond yields don’t suggest that the expectations of a long period of unchanged policy interest rates should be changed. It may also tell us that markets are comfortable with the notion that more fiscal stimulus needed. The IMF suggestion that governments need not be too concerned about higher deficits and rising debt levels seems to be one shared by the bond market. The yield on 30-year German bunds is minus 20 basis points. In the UK, the yield on 30-year gilts is just a tad above 70 basis points. With global growth continuing to be restrained by the pandemic – and who knows if there might be 3rd and 4th waves to come – the need for additional stimulus is going to increase. Central banks will do their bit by providing the fiscal room by keeping rates down, keeping real rates down and intervening in the market to alleviate any funding stresses that may arise. Is it Modern Monetary Theory or helicopter money? Maybe not quite as the purveyors of economic unorthodoxy would have it, but essentially, we are printing money to support government funded aggregate demand. Anyone want to try the alternative? The other thing to think about is whether the additional stimulus comes bigger and quicker in the US than in Europe. History tells us that it probably will and the divergence in market performance and narrative between the US and Europe could persist for some months. The contrarian view is to look for Euro/Dollar to move much lower again.
Searching for defence
While long bonds in Europe did hedge the equity declines in September, it was not so clear in the US. Treasuries remain stuck in a narrow range and have been there for months now. There is some value at the long end of the Treasury curve but if the cyclical reflation view is correct, there is not much scope for yields to come down unless there is a cyclical set-back. I was following a debate about the relevance of a balanced portfolio approach these days and one of the points made was that when this strategy was popular in the 1980s and 1990s, bond yields were much higher. Today the challenge is to find assets that provide some diversification without creating a significant drag on returns. As an investor, I want to be exposed to long-term secular growth assets where returns are going to be driven by even more technology and structural shifts related to the carbon transition. In public markets it is harder to reduce the volatility and smooth out performance in the inevitable ups and downs of long-duration equity assets. Private markets may offer the alternative with many fixed income, like cash-flows, but with limited liquidity and mark-to-market valuation points. Maybe we need to think about combining high return equity assets with a combination of defensive buckets that are made up of more than just government bonds. Having a defensive bucket of long duration bonds, short-duration credit and some defensive equities like utilities and consumer staples, could combine well with a growth bucket to provide something with a better risk-adjusted return profile than either a traditional 60:40 balanced fund or a pure market cap-weighted equity exposure. More thinking and work needs to be done on this especially as many investors have given up on bonds.
As I try and conclude what I must admit is a fairly uninspired note this week, my screens are lighting up with negative Brexit headlines. It seems that the British government is sending a signal that, as far as it is concerned, negotiations on a free trade deal with the European Union are going nowhere and the UK should prepare itself for a different outcome. This may be a negotiating tactic and we should consider the potential for a deal getting done at the last minute, but the tea-leaves are looking a bit more like they are pointing to something negative. That’s not great news for the UK economy. After a drop in global GDP and a relatively bigger one than for most of our trading partners, it doesn’t seem very sensible to then make exporting to those partners more difficult. I was admittedly a “Remainer” but it’s hard to argue against the view that UK firms might get hit on both the cost and revenue side by the way things are going. Perhaps sterling will bail them out. Successfully dealing with a pandemic and negotiating the biggest trade agreement in modern history would be a tall order for any government and is proving to be extremely difficult for the current UK administration. While UK equities are cheap in relative terms there is nothing about the UK situation at the moment that would encourage international money managers to increase their weighting to the UK. I would not rule out sterling in the low $1.20s again should the US election outlook pan out as suggested above.