October 23, 2020
Quarterly Market Commentary
Markets continue to sway with the 3 Ps: the pace of the Pandemic, fiscal and monetary Policy responses and the omnipresent impact of Politics.
We avoided an income shock despite demand shock, and we avoided a liquidity shock despite heightened market volatility. Yet, we still sit amid a pandemic that is proving to be virulent. Although policymakers around the world prevented the economic hole from becoming too deep, there is more work to be done as we continue to struggle with increased COVID-19 cases and begin to assess post-pandemic economic scars. Against this backdrop, the three Ps — Pandemic, Policy and Politics — will continue to drive risk appetite in both directions, although we expect more clarity on all fronts as we head into 2021.
Slowing but Growing — for Now
The pace of global economic growth coming out of the second quarter trough has surprised even the most optimistic forecasters. Annualized third quarter growth may be as high as 30% in the U.S., quarter-over-quarter, and both Europe and Asia are expected to surprise on the upside. Importantly, though, those results are already solidly in the rearview mirror as investors and economies look ahead: Will third quarter momentum continue?
In our view, momentum is slowing from an unsustainable pace, but we expect global growth to continue into 2021, potentially reaching 2019 levels at the end of next year. Yet, there are several important caveats associated with that outlook, including, most notably, the premise that we will have an approved and globally available COVID-19 vaccine in mid-2021. Further, we anticipate continued fiscal stimulus in Europe and, eventually, a new, potentially substantial pandemic relief package in the U.S. The risk, of course, is that we are too optimistic on these fronts.
We view the probability of a viable, available vaccine by mid-2021 as high, and Pfizer has announced the anticipation of regulatory approval for their vaccine in November. On the fiscal front, however, we see near-term strains on the political will in both Europe and the U.S.
In the meantime, households have adapted to the COVID-19 environment, with social distancing being one such adaptation — and that comes at an economic cost. The resilience of the U.S. consumer has been a function of the massive Coronavirus Aid, Relief and Economic Security (CARES) package. With many benefits having expired, an economic backslide remains a risk, particularly as we enter fall and winter months and contend with already-increased COVID-19 cases.
This backdrop reinforces the need for more stimulus, but the U.S. election has complicated negotiations in D.C. and reduced the probability of a pre-election deal. That said, we expect a package to be approved under the next administration — regardless of whether the administration is led by President Trump or Democrat candidate Joe Biden. In any event, it is critical that fiscal stimulus not wane as the coronavirus continues to wax.
Our outlook for growth is constructive-but-cautious, with negative near-term pandemic-related headwinds offset by probable fiscal stimulus into 2021 and the advent of a mid-2021 vaccine. While we expect inflation to remain benign due to structural headwinds and deep pandemic-related demand destruction, it is possible that we could see near-term upward pressure, should stimulus surprise on the upside. For investors, the environment for risk-taking remains positive, as we expect Fed policy to serve as a tailwind to risk asset markets and fiscal policy to support the real economy.
Source: Northern Trust and Bloomberg. Balance sheet size as of 12/31/2007, 12/31/2019 and 6/30/2020.
The Leaders Keep Leading, but Rotation Watchers Are on Alert
U.S. stocks, and technology and technology-adjacent sectors, continue to lead global risk asset markets as companies with structural advantages and resilient business models post solid results despite the COVID-19-induced economic slowdown. Investors have preferred the relative defensive nature of these companies over the more cyclical sectors as the contours of global recovery continue to evolve.
On the other hand, non-U.S. markets, particularly developed market ex-U.S. benchmarks, are much more exposed to cyclical sectors and thus more sensitive to the global growth outlook. While investors have piled into U.S. growth stocks, many eagerly await an opportunity to reposition for growth, which would benefit not only U.S. value stocks but also non-U.S. markets. We have seen a few “head fakes” this year, with nascent rotations taking hold only to reverse as COVID-19 cases increase and recovery is called into question.
In the meantime, U.S. stock valuations, particularly those of U.S. growth stocks, are currently significantly above historical averages. While valuations can remain elevated with very low interest rates, high valuations will likely put a ceiling on near-term price appreciation. We anticipate relatively low U.S. equity returns over the near term, with higher, but still-muted non-U.S. equity returns, as valuation compression somewhat offsets a V-shaped earnings recovery.
Equity prices are forward-looking and have certainly gotten it right this year, anticipating and reflecting an expected V-shaped earnings recovery in 2021. At the same time, valuations are elevated across global equity markets, particularly in the U.S. Therefore, we advise investors to moderate their expectations over the near term but remain invested in their global portfolios. At the same time, the three Ps — Pandemic, Policy and Politics — will continue to drive market volatility, so investors should prepare for a potentially bumpy ride into 2021.
Anticipating a V-Shaped Earnings Recovery
Source: Northern Trust, Bloomberg, MSCI. Globally confirmed daily new COVID-19 cases shown in 1,000's. S&P 500 used as a proxy for U.S. equities. Data through 10/20/2020.
Central Bankers Are All-in, Again
Central bankers around the world have remained active, and we expect rates will stay “low-for- long, for even longer.” On this front, the most interesting development during the past quarter was the change in the U.S. Fed’s framework. It moved to a flexible average inflation target that promises to make up for past misses and also changed the language around how it looks at its full employment objective; it will now focus on shortfalls to full employment. For investors, this affirms that the policy rate will likely stay at zero for the next few years. And our view is that it will remain anchored at zero for the foreseeable future, perhaps as long as five years, as the U.S. economy continues to recover but inflation remains constrained.
At the same time, the Fed also stands ready to use another powerful tool to ensure fully functioning markets: quantitative easing. For investors, this backstop has encouraged flows back into credit. Recall, credit — both investment grade and high yield — faced tremendous pressure in the first quarter as fears of a deep recession and difficult liquidity conditions combined to seize many markets. With Fed intervention ensured, investors have had the confidence to increase credit risk, which has driven spreads — the additional yield one can earn by investing in investment grade or high yield bonds — down significantly, close to pre-pandemic levels.
We have remained positive on bonds across the credit spectrum, believing that Fed support combined with an improving economy presents a constructive backdrop. Importantly, we have also remained constructive on municipal bonds; however, we reiterate that credit research is key, as many state and local issuers face financial stress, given deep revenue declines. Those issuers who entered this pandemic period with strong financials and “rainy day funds” will fare best, as we do not expect full economic recovery until late 2021 or 2022.
The two main risks associated with fixed income are duration risk and credit risk. Our view on interest rates suggests very low rates well into the future, with a yield curve that may steepen at the margin but without a meaningful move higher by longer-term rates. On the credit side, many issuers have taken advantage of the low rate environment to refinance bonds, extend maturities and create financial flexibility. While credit spreads may have narrowed sufficiently, and we don’t expect them to tighten much further, we also think that tight spreads can persist in a world where investors continue to search for yield.
A Constructive Environment for Credit Risk
Source: Northern Trust, Bloomberg, Barclays. Monthly data through September 30, 2020. Averages over period charted.
A Word on the Election
As we approach the November 3 U.S. presidential election, many investors are concerned about portfolio positioning, or repositioning, for a potential outcome. The good news for investors is that history shows that markets rise under either party, both under sweeps as well as divided governments. We also note the following:
- Markets adjust, quite quickly and efficiently, to changing tax regimes and regulatory landscapes.
- What seems an intuitive market outcome often flies in the face of eventual market movements.
- While not dismissing some of the major policy initiatives under each presidential candidate, we remind ourselves that significant changes must also go through the legislative process.
That said, we do think it is important for long-term investors to expect increased market volatility but to stay the course as this election season evolves.