And the winner is....
It’s been a fascinating US election so far, as we all thought it would be. Fears of a presidential meltdown at the prospect of losing appear to be materialising before our eyes. A record number of voters have turned out and, given that so many people are at home around the world, I would suggest that an unprecedented number have tuned into news networks to see what the next twist will be. But just like the UK parliament survived the “Gunpowder Plot” 400-years ago, American democracy will survive lawsuits and demands for recounts. Markets are taking the view that no government, means no harmful policies – and the abundance of liquidity means higher prices for bonds and equities. On that basis, maybe markets will fall back when a President is eventually announced. No doubt the drama will continue to fill our lockdown lives.
In the United Kingdom, as I write this, it’s the first day of the second lockdown. It’s also the anniversary of the Gunpowder Plot of 1605 – the failed attempt to blow up parliament and assassinate the monarch in 1605. The conspirators were a group of English Catholics and their ire was focussed on the protestant King James, the first head of the union of the crowns of England and Scotland. The plotters were discovered in chambers beneath the parliament building and, for the last 415 years, 5 November has been a day of fireworks displays, bonfire parties and the consumption of teeth-destroying toffee apples. It’s also my birthday and an opportunity, given current events, to reflect on political conflict and the way events, whether they happen or are narrowly avoided, can change history. This year, there has certainly been events of major historical importance and they continue to shape our world and future. Thankfully, so far, no gunpowder has been involved.
Over the line
The final result of the 2020 US Presidential Election was not known at the time of writing. It might not be known for some days, or weeks even, given the contest to get the 270 electoral college seats needed to secure the White House is a close one and that some the results are going to be contested. However, what appears to be the most likely outcome now, is – a Joe Biden led-Administration, a continued Democrat majority in the House of Representatives and a wafer-thin majority for the Republican Party in the Senate – all of which has got the mark of approval from markets. For now at least. The narrative seems to be that both a major fiscal stimulus (that might have been negative for bonds) and a big corporate tax hike (which may have been negative for equities) are less likely. Throw in continued strong monetary support and everything goes higher. Compared to the close of business on Monday, the S&P500 is up 5.3% and 10-year Treasury yields are down 15 basis points (a price rise of 1.4%).
The narrative could change again quite quickly, depending on political developments. But from a markets point of view we are stuck in a groundhog-day scenario. Treasury yields have backed off once again from moving decisively higher, the yield curve has re-flattened and growth stocks are outperforming value. It’s quite a defensive stance in a way. Bonds benefit from uncertainty about the short-term economic outlook – and we know that the fourth quarter is looking more challenging given the acceleration of coronavirus infection rates across many economies since September. Bonds are also benefitting from the belief that the Federal Reserve will need to match the European Central Bank and the Bank of England in terms of new monetary stimulus. The overall environment favours equities in the absence of evidence of an aggressive slowdown in activity. Yet there is short-term uncertainty over earnings and employment and the prospects for those parts of the economy that continue to suffer from the virus. So those sectors that have demonstrated strong and stable earnings growth continue to benefit - technology, health and parts of consumer services. Even today, looking at consensus earnings estimates for 2021, these are the sectors with the strongest numbers. Historically, an equity portfolio tilted to these sectors would have outperformed the overall market for much of the time. For now, I can’t see how that changes. Financials are challenged by low rates, cyclicals by the virus and the lack of pricing power likely to be a feature of the next couple of years. Additionally, consumer discretionary has been hit by the absence of a vaccine and spending.
In Europe, the political and economic outlook is dominated by coronavirus. Infection rates have risen everywhere, and most countries have re-introduced a form of lockdown. The measures are not quite as stringent as they were in the spring so the impact on European economies should not be as bad. However, growth will be slower relative to what was expected when infection rates were falling during the summer. Hence the promise from the ECB of more quantitative easing to be announced in December. It’s a fairly moribund growth outlook for Europe until the virus is conquered and there is no chance of inflation picking up. As such, so bond yields will remain low and prospective returns will be minimal.
Waiting for the vaccine, still
The narrative of how things change is also a bit groundhog-day like. To get economies motoring on all cylinders again we need to be able to successfully re-open hospitality, leisure and travel. That day seems some way off given the virus numbers we are seeing right now. The prospect of a vaccine has been an anchor for a constructive view on the medium-term outlook for some time and this will remain the case through the winter. There is nothing definitive yet but the news around trials, the capacity for pharmaceutical companies to manufacture drugs and the logistical support that governments will provide in distribution all sound quite positive. The lockdowns presently in place might bring about a peak in infections in the coming weeks and the beginning of the deployment of vaccines in the next few months could see a rapid decline in the prevalence of the disease by Q1 or Q2 next year. This would be when the cyclical and value trade would work, and maybe when bond yields could move higher.
The curve has shifted since the world was hit by the virus. We are able to have a higher level of economic activity at the same time as arguably much higher rates of infection than was the case in March and April. That is due to more targeted policies and a better understanding of the virus. Low yields are an issue for the investment case for bonds. Returns will be low and, if there is any rise in yields, there is little carry to protect from negative returns. That is why high yield is attractive in my view. Historically, higher risk-free rates have tended to be associated with lower credit spreads in, normally, a positive economic environment. The decline in spreads never fully offsets the hit to total return from higher underlying yields. But the higher yields are to begin with, and the lower duration is, the better suited returns are to remain positive. Given current yields, index duration and credit spreads, investment grade indices are not particularly well placed to deliver positive returns should 2021 see any rise in risk-free yields in a more positive economic environment. So far this year, the return from the US high yield index has been just a whisker above 0%. That compares to a 6% total annualised return over the last ten years. There is upside potential in high yield, especially with the Fed probably pivoting ‘dovishly' again in the short term.
We may or may not be at the end of the Trump era. Investors have generally done well over the last four years and so has the economy. Yet the end of that era – if it is indeed the end – has been marked by a period of social and economic devastation as a result of the pandemic. Financial markets have managed to continue to drive wealth gains this year because of the power of central banks, governments ability to offset private sector income destruction, the resilience of both the corporate and household sectors and their ability to adapt to changed circumstances. The importance of the election will fade in the coming months and the ongoing support of policy, pharmaceutical progress towards a vaccine and other remedies, and the flexibility of certain economies to get back on a growth path will be the drivers of market performance. That story will take some shaking.
I began by referencing the lockdown starting again in the United Kingdom. It will hit the economy just weeks before the UK loses its current trading relationship with the European Union. Given how long the Brexit story has been running and how difficult it is to second guess what the eventual legal and economic settlement will be, it is no wonder that the UK markets have become something of a sideshow for global investors. On most counts the UK equity market is cheap having seriously underperformed. The Bank of England has announced another £150bn of quantitative easing over the next year. The government has extended its employment support scheme until the end of Q1 next year. The policy measures are substantial, but the combined anxieties of Brexit and COVID-19 are impacting on consumer confidence and economic activity. The optics of political discourse in the UK are also not encouraging. The UK is cheap and could be a great buy at some point, but it would not be the first bet I think of in a post-pandemic cyclical recovery.