Despite a slight pull back in markets in September, the third quarter turned out to be very positive for equity markets. Although we still see a large divergence in markets with especially the companies that tend to profit from the stay-at-home trend doing exceptionally well and companies that will profit from a reopening of the economy still lagging. In other words, tech and healthcare companies have outperformed basically any other company.
The big difference between the current pandemic recession and a normal financial recession is the level of hope people have. This is the main reason why equity markets are relatively positive despite the economic damage that the virus is causing. Globally there is hope that the virus will recede, that a potential vaccine will help us go back to normal life and from there on everything will be better.
In a normal financial recession, a lot of people lose hope and only see darker times ahead. While now many people see brighter times ahead. This is important because it makes all the difference why people keep spending.
The S&P 500 corrected 6% in September, which is still fairly muted given Washington’s inability to reach a much-needed fiscal compromise. This resilience reflects that European and the Australian economies and China have pleasantly surprised investors despite rolling second waves of infections across the world, fiscal policy paralysis and generalized uncertainty. The recovery has fueled higher earnings expectations. Meanwhile, global central banks are promising to keep accommodative monetary conditions in place indefinitely, which has allowed valuations to rise.
The cyclical outlook for stocks remains attractive. Nonetheless, global equities have entered a period of heightened volatility and downside risk until year-end. Investors are concerned by a lack of fiscal support and rising policy uncertainty created by the approaching US election in November. This nervousness can still spark strong fluctuations in stock prices.
The Impact of the U.S. Election
The U.S. election will drive the news cycle and will add to the market volatility. A rebound in economic data and a strong stock market in the coming weeks will potentially be positive for President Trump’s reelection chances and vice versa.
Whether Biden or Trump wins, either could be positive for equity markets as both candidates will make it a priority to provide additional fiscal stimulus. The real risk for markets is a contested election outcome as it would create uncertainty and delay the additional stimulus.
As of this moment, both public opinion polls and betting markets suggest that Joe Biden will become President, with the Democrats gaining control of the Senate and retaining the House of Representatives.
Such a “blue wave” would have mixed effects on the value of the S&P 500. On the one hand, corporate taxes would likely rise under a Biden administration. On the other hand, trade relations with China would improve. The Democrats would also push for more fiscal stimulus, which the stock market would welcome.
The odds of Republicans and Democrats agreeing on a major new stimulus deal before the November elections look increasingly slim. In a blue wave scenario, the Democrats will enact $2.5-to-$3.5 trillion in pandemic relief shortly after Inauguration Day. Joe Biden‘s platform also calls for around 3% of Gross Domestic Product (GDP) in additional spending on infrastructure, health care, education, climate, housing, and other Democratic priorities.
The bulk of the Coronavirus Aid Relief and Economic Security (CARES) Act’s income support provisions expired at the end of July and Congress has still not reached consensus on a follow-up package. Unsurprisingly, consumer spending responded by growing much more slowly in August. U.S. households saved a lot going into the autumn, so a sudden stop in spending is unlikely. Nevertheless, cracks in the economy are appearing as core retail sales contracted in August for the first time since April. Consumer expectations of future income growth remain weak.
We expect U.S. fiscal policy to turn accommodative again. There is no appetite for fiscal austerity. Both political parties are moving in a more populist direction, which usually signals larger budget deficits.
China’s stimulus-driven recovery will provide a crucial boost to the global business cycle. The Chinese economic engine is revving: An aggressive stimulus campaign followed Beijing’s swift actions to contain the domestic spread of COVID-19. China’s policies are generating economic dividends that will filter through the global industrial and commodity sectors. Rising demand and constrained supply will support oil prices, while Chinese stimulus will buoy industrial metals.
The US dollar is more likely to weaken than strengthen over the next 12 months. The collapse in interest rate differentials, stronger global growth, and a widening US trade deficit are all bearish for the dollar.
As the USD weakens, Gold’s rally will likely resume. This will revive commodity demand generally. For the longer-term we believe investors should consider buying precious metals and other real assets as a hedge against long-term inflation risk.
In this economic environment we expect bond yields to rise slightly from the current very low levels. As we are positive on the economic recovery, we believe that credit spread, although low, it still the place to generate extra yield. We also think that Chinese government bonds offer an interesting yield for their credit risk (S&P rating A+) while the Renminbi has room to appreciate.
Global Asset Allocation
We favor equities over bonds on a 12-month horizon. We do expect to see a rotation at a certain moment from the “Pandemic trade” to the “Reopening trade.” Vaccine optimism should pave the way for cyclicals stocks to outperform defensive ones, international stocks to outperform their US peers, and for value to outperform growth sectors.
Taking advantage of the small market correction in September and anticipating a positive environment for equities over the coming 12 months, we are making the following changes to the portfolios in October.
On the Equity Front
We are returning the portfolios to full investment by adding 2 global equity Exchange Traded Funds (ETFs), targeting Momentum and Value stocks. By adding the best performing (Momentum) and cheapest stocks (Value) at the same time, we are maintaining our overall exposure to winning technology and healthcare stocks amidst the pandemic while adding an allocation to companies likely to benefit from a gradual return to normal in the real economy, such as financials and consumer cyclicals. These companies have underperformed so far in 2020 but we anticipate a continued rotation toward recovery stocks amid further stimulus and policy clarity post the US election.
In addition, we are taking partial profit on our China New Economy allocation (up ~35% year-to-date) and making a small allocation to global Real Estate Investment Trust (REITs), which continue to pay out a high dividend amid lower borrowing costs and are likely to benefit as economies open up in 2021 and beyond.
Lastly, we maintain our position in Quality names to ensure the portfolio has a defensive tilt should additional Covid waves temporarily disrupt the ongoing recovery.
Fixed Income Portfolio
After strong price appreciation and decrease in yields from late 2019 through most of 2020, we no longer see upside in continued government bond exposure. Yields across much of the government bond universe in USD, EUR and JPY are close to 0% and therefore below inflation. As such, we are reducing our US and developed market government bond positions and allocating to diversified sources of yield, such as US and Asia ex Japan Credit. A yield-pick up of 2%+ is worth the marginal increase in credit risk in our view.
In addition, we are adding an allocation to China government bonds, which yield ~3% vs ~0.7% in the US and 0% or less in Europe and Japan. This exposure ticks a lot of boxes in a world hungry for yield and eager for stimulus and provides a nice diversification to the heavy US dollar tilt in most fixed income portfolios.
Lastly, to leave ammunition for future market opportunities and generate yield from cash, we are adding an ultra-short fixed income ETF, currently yielding 0.6% yield, materially higher than cash or T-bills.