Covid hits WH
The symbolism of President Trump testing positive for coronavirus will not be lost on market participants and economists. With little confidence that infection rates are falling, one reaction might be that economic behaviour becomes more restrictive again. We might need to again refocus on high frequency mobility data to get a clue on where economies go in the run-in to year-end. As important is the uncertainty that it brings to the US election and everything else that flows from that.
Election uncertainty ramps up
The news that President Trump and his wife have tested positive for COVID-19 has added to sense of short-term uncertainty around the US political situation. Coming after last weeks’ reports about the President’s tax affairs, some will take the view that re-election is even more unlikely now. However, it will be important to see what the opinion polls say. The campaign will clearly be impacted as the President won’t be able to appear in person at debates or rallies. However, health providing, he will perhaps use Twitter even more. At this stage the world does not know whether the President is suffering any of the symptoms of COVID-19 but it has opened up lots of potential scenarios, just a month away from the election. Needless to say, market volatility is likely to notch up as the odds of different outcomes fluctuate. Many things – from US-China relations, post-election tax policy, the US’s relationship with global institutions, trade, climate change progress, social cohesion in the US –depend on how a 74-year old man reacts to getting a virus that has claimed over a million lives globally this year. Even with a full recovery, the news has changed the election dynamics, might change the way some intend to vote and how they reflect on the nature of the current Administration and its legacy.
US and China better in both the downturn and the recovery
The initial market response, and I am writing just a couple of hours after the news, was negative with S&P futures down and the VIX index up around 2% on the open. The MSCI World equity index peaked on 2 September and now stands more than 5% lower in price terms. September was a risk-off month with core government bonds outperforming credit and high yield in fixed income and equity markets. In local currency total returns, Japanese and UK equities were the relatively better performers in August, but the US and Chinese markets are still way ahead on a year-to-date basis. The impact of the virus has been significant in both human and economic costs across developed and developing countries, and policy responses have been similar at the macro level – monetary easing and fiscal stimulus. The difference in market responses has been that those equity markets that went down the most in Q1 have been the laggards in the recovery. A scatter chart of performance between Dec. 31st and March 31st on the x-axis and March 31st – September 30th on the y-axis shows a clear bottom left to top right distribution. With hindsight the markets you wanted to own where the US, China and Japan. Not sure that following the details of the virus and the minutiae of high frequency data prints has been that useful in making the right investment decisions.
Mega stock role
The difference in the performance of the US and other markets might just be down to the existence of the mega-cap tech and social media stocks. Their businesses have benefitted from lockdowns and investors have put more value on long-term earnings driven by structural changes to our economies more than they have valued a potential cyclical recovery for shorter duration, more cyclically challenged businesses. After all, there have been plenty of reasons to be bearish on the US – policy uncertainties, the election, lack of coherent pandemic and social distancing policies, a huge loss of employment. But as I have been saying for months, the power of low (real) interest rates, credit backstop policies, fiscal stimulus, the belief that things will recover, that a vaccine will come and that the US is the only real home to those companies that will allow greater mobility in all walks of life in the future, have all combined to funnel money into the most dynamic parts of the American stock market.
My basic investment principles rest on the notions of simplicity and diversification. While the more quantitative among us will argue that correlation is a blunt statistical technique and financial modelling has to be sophisticated to deliver the best strategies, my experience is that what matters is the fundamental DNA of the asset class and the fundamental DNA of the investors. Historically, this has been captured in the relationship between returns and risk and the investors’ willingness to position themselves somewhere on the axis between the two (however formulated). Now there is starting to be a third access, that of sustainability executed by integrating ESG or using dedicated ESG or impact strategies into portfolios. It may be that for an increasing number of investors non-financial considerations are the first level of decision making when choosing where to invest. I still contend that we are not there yet and hopefully never will be. Expected and desired returns and a level of capital stability drive most investment decisions but what is now clear is that once the right balance has been reached, the choices can be nuanced by a responsible investing approach. In addition, the investment community is getting better at embedding ESG factors into the return/risk calculation.
Looking backwards, with higher rates
Whenever I play around with back-testing asset allocations, I can always come up with an allocation that delivers good historical risk-adjusted returns by essentially mixing risky and risk-free assets. Long duration government bonds with high yield and growth equities is generally where I end up. Risk-free government bonds provide capital stability, long duration versions of them provide the risk-factor that behaves in a negatively correlated way to economic growth/corporate cash-flow risk. They tend to have positive returns when equities have negative ones or credit returns weaken.
Looking forwards, with low rates
The question now is whether what worked in the past will work going forward, especially in a world of financial repression when bond yields are very low. A very simple back-tested portfolio of 40% over 10-year US Treasuries, 10% US corporate bonds, 15% US high yield bonds and 35% S&P500 equities would have delivered around 10% total return in 2020. That is actually just above the average return over the 2007-2020 period. If we look at the same allocation in euro with similar risk asset classes, the return this year would have been -1.6%, well below the longer-term average. A UK sterling version would have been even worse. When the risk-free rate gets very low and the earnings growth for the corporate sector is constrained, it’s hard to get decent returns. With one of my colleagues recently saying, “they’ve unplugged the rates markets”, even dyed in the wool bond guys are starting to question whether fixed income can deliver the hedge to risky assets that has made it so useful in the past.
Empirically there doesn’t seem much evidence to support the notion that fixed income is a dead-hedge. Looking at total returns from ‘10-year and over’ government bond indices for the US, Germany and the UK, recent performance is not much difference from the historical pattern. The rolling 12-month volatility of daily returns was boosted by the rally in rates in March and remains elevated above long term averages. Returns over the last six months have fallen but, again, there is no evidence of a structural break in the return history. You would expect returns to fall when the economy is growing (yes it has been growing since April) and equity and credit excess returns are positive. However, it is clear that the closer bond yields are to their realistic lows the power of duration is diminished. It is noticeable that despite equity markets falling sharply in response to the news about the President, bond yields haven’t really moved.
Lower (rates) needs longer (duration)
The yield on the 10-year+ German bond index is -0.30% compared to the ECB’s deposit rate of -0.5%. There is more scope in the US and the UK for lower long-term yields, but it would need a renewed and shock-driven equity market decline to bring those yields lower. In the absence of risk-off you don’t need the insurance, but it might be worth having it anyway given the uncertainties in the outlook. If we are in a happy world with equity returns of 10% per year then presumably the macro outlook will allow bond yields to rise. At the moment if investors want to rely on bonds being a hedge, they have to accept that the bond allocation has to be much longer in duration (rate sensitivity) than was the case in the past. If central banks don’t encourage the idea that rates could still move lower, then the power of the hedge is clearly reduced.
The future recovery to higher rates
One thing is for sure is that low interest rates do create downward pressure on returns across markets largely because they reflect a weak macro-economic environment where earnings growth has to be driven by real fundamental changes in the economy rather than price advantages and operational gearing. Despite all the fears around the ongoing impact of the virus, economic growth is happening and spending in many areas has recovered to pre-COVID-19 levels. Housing markets are booming, and consumer spending has benefitted massively from income support programmes. Some policy makers are talking up the economy – perhaps the Fed might not have to wait six years this time before raising rates again. It’s too soon to say but the core US personal consumption expenditure deflator in August was 1.4% y/y after falling to just 0.5% y/y in April. A similar rise in the Fed’s preferred inflation measure over the next six months would certainly re-plug the interest rate markets.