Specific and Limited Bearishness
Politics in the US and the UK are contributing to market moves. Uncertainty over US election outcomes is growing, and the stock market seems to be going through a pattern that has been seen in previous election years. Sterling is taking a bath in a “specific and limited way” (ahem). Markets have become somewhat desensitised to the coronavirus but more sensitive to politics and outcomes that could be damaging for business. So, equities might struggle a little near term. Meanwhile, bonds are safe and boring. Just as they should be.
In three out of the last six US Presidential election years, the S&P500 has delivered negative returns between the end of August and election day. Observationally, the years when returns were negative were years that resulted in a change in president. Even in the other three Presidential election years, returns were low during the run-in to the vote. It looks like this year is not going to be any different to this (admittedly restricted) set of outcomes. The market is down by 4.5% since the end of August. Uncertainty around elections is a given and this year the market is entering a period of uncertainty at stretched valuations with fundamentals that have been battered by the coronavirus pandemic. On balance, opinion polls are suggesting that Joe Biden is in a strong position to win on November 3rd. However, given what happened in 2016 in both the US election and the Brexit referendum, confidence in opinion polls is somewhat suspect. There is just over seven weeks to go before the vote and I would suggest that the atmosphere gets even more toxic between now and then. Serious commentators are also discussing the potential scenario of a disputed result which could lead to no decisive outcome until the early weeks of 2021.
This level of uncertainty can’t be good for risk assets. Given the volatility we have seen in the stock market in the last couple of weeks – as more evidence of some bubble-like characteristics in the exposure to growth stocks has been revealed – it’s hard to see a new, strong rally ahead of the election. The issue for investors is attaching probabilities to many different scenarios. There is the Presidential race itself with a potential clear win for either candidate or a disputed outcome, complicated by the scale of mail-in voting and legal challenges to that process in numerous counties across the US. Then there is what happens in the House and Senate and how the result of those elections line up against the race for the White House.
Policy programmes will be important
For markets, a clean-sweep of the Executive and Congress will be the best outcome with the question then coming down to whether markets can deal with the differences in the legislative programmes. In conversations with US analysts over the last week the consensus seems to be that under a Biden Presidency, corporate taxes would be increased, and spending would rise. However, the tax increases may be phased in and probably won’t start impacting until 2022. Deficits are likely to rise under most outcomes. The point here is that there probably is more to worry about for corporates under a Biden Administration – from a tax and regulatory point of view – but that this could be balanced by a more constructive US on the international stage. A Trump-sweep would bring more of the same. The worst outcome is a bitter fight over the result and a split Congress. It will be hard to get much legislation enacted ahead of mid-term elections in 2022. The sense is that the current political leadership in the US would need to work hard to achieve any kind of bi-partisan consensus.
Markets up, uncertainty up, take profits?
Political uncertainty is linked to uncertainty over the economy and to the prospects for growth. Until there is a clearer path ahead there is a risk of more equity volatility into and beyond the election. Total return expectations into year-end should be tempered as a result and investors might be tempted to take profits on risky assets in a year that has delivered way better returns than anyone would have thought if they knew the global economy would be locked down for the best part of a quarter in response to a disease that has killed just short of a million people.
In this period I find it hard to be bearish on fixed income. Equity volatility should support flows into bonds. The policy environment is very supportive. This week the ECB repeated its intention to keep policy set to prevent further declines in inflation. While that does not mean responding to the recent strength of the Euro directly it probably does mean that all its other tools will be reinforced to keep monetary policy extremely accommodative and prevent rising yields. I wrote a couple of weeks ago about the Fed’s new reaction function, which is incredibly supportive for bonds until (and if) there is any increase in inflation. The Fed will keep rates unchanged until inflation has moved above 2.0% and looks like staying there for as long as it takes for the period that inflation has been under 2%. In the meantime, its toolkit will be utilised to ensure that inflationary expectations don’t fall further. That means more QE if necessary, it means keeping credit backstops in place if necessary.
Credit for the carry
At the same time, don’t get excited about bonds. Returns will be low because yields are low. Within bond markets my preference is for the longer-end of credit markets as there should be some reward for taking duration risk and the both the rates and spread curves are steep. The long-dated (10-15-year sector) BBB-rated US corporate bond sector yields around 2.9%, 100bps above the 5-7-year sector and a lot above cash. Curves are less steep in the UK and Euro credit markets, but the long-end probably offers the better value in this potentially risk-off environment. And to repeat the view of a couple of weeks ago, high yield bonds and emerging market bonds should generate positive returns in the run-in to year end.
Cash piles are supportive
The massive issuance of corporate debt this year has both increased gross leverage but has left companies with lots of cash on their balance sheets. This is a good thing for credit for now. The environment is hardly conducive to near-term M&A, share buy-back or capital investment spending. Cash is there to shore up balance sheets and any further issuance in the remainder of the year is likely to be for the same reason. Looking further ahead, a continued recovery in 2021 should help the corporate sector manage that leverage but it will be key to see what happens to those cash piles. I suspect that companies will remain conservative for some time, especially in the US with potential increases in corporate tax rates.
While the US election is the epi-centre of most global risks at the moment, there is something more local that is raising its ugly head again – Brexit! The breakdown in negotiations between the UK and the EU over the UK’s insistence on changing some of the terms of the Withdrawal Agreement has raised the chances of a trade deal not being reached. This has already hit the pound which is down about 4% against both the dollar and the euro since the beginning of September. I am not sure a full-blown sterling crisis is on the cards but fractures between the UK and its biggest trading partner do tend to sharply weaken the currency. Given the US election and Brexit, holding the Euro, Swiss franc or Japanese yen look more attractive in the short-run. For the economy, it’s not great. Unemployment is up because of the pandemic and now uncertainty about trade is heightened. This will dampen investment and consumption going forward. More fiscal stimulus might be necessary in the UK and the Bank of England will need to reassure that it is prepared to do more. Euro/Sterling is above 0.92 at the moment. Look at the chart of the last few years. It spiked higher on the referendum, then on the 2017 election which Mrs May nearly lost (which was essentially about Brexit), then in the middle-of-last year when no-deal odds shortened and again now. The 2008 high of 0.9793 is in sight!
To finish, some market views
* Government bonds are in clear ranges, so hold some duration to get extra yield and provide a hedge. * In Europe, peripheral spreads could narrow further if the ECB ramps up its policy support. * Views on inflation are more polarised then ever but the realisation of actual inflation is probably a long-term wait. However, markets should price in long-term US inflation at 2% and break-evens are currently not there. Lower real yields could be the result of higher inflation expectations and stable nominal yields, a scenario that would be good for equities beyond the election. * Credit provides carry and relatively stability, the higher beta parts are more attractive. * Equity returns are dominated by 2021 earnings prospects, which are improving. The emergence of a vaccine plays a role here in determining the permanence of economic re-openings, so watch the news on that following the wobble over the Oxford-AstraZeneca trials this week. * With a growth recovery there will be the potential for dividends to be re-instated, adding to the total return attractions of equities relative to bonds.
Lest we forget
Please take a moment to remember the victims of the events of 19 years ago today.