Losing Momentum: A market wrap of Q3

Warren Buffet famously said 'only when the tide goes out do you discover who's been swimming naked'. So it is with the fading impact of the CARES act, whilst the terrible economic data of Q2 and the amazing rebound of Q3 are now in the past, giving way to a clearer landscape that reveals a slowing in economic momentum.

Macro Overview

The third quarter of 2020 saw impressive gains for the global economy, but more differentiated outcomes for risk assets after their more universal bounce back in Q2. The US and emerging markets had strong gains for equities, whereas Europe struggled and Japan was somewhere in between. Positive support for risk assets came from continued ultra-low rates, fiscal and monetary support and treatment advances/vaccine optimism re COVID-19, which all led to increased flows and market momentum. However in September the mood changed with a second wave of COVID-19 in Europe, the inevitable slowing of economic momentum globally alluded to above and US election risks coming more into focus.

Economic data can often be noisy and generate more heat than light when looking at short term numbers such as Q2 (awful) and Q3 (amazing). The table below considers the longer-term outlook for real GDP growth. The same analysis has been included as with the last quarterly note in terms of looking at the cumulative growth over the 2020-21 two year period; and the same over the 2020-22 three year period. This is instructive in seeing at a glance how quickly the previous baseline is recovered, or not. Developed Markets overall see real GDP at the end of 2021 still 1.8% down on the end of 2019, so more than 2 years of lost growth. Emerging markets on the other hand fare much better, significantly helped by China which is expected to only lose a few months equivalent from its previous track. Of the EU5 only Germany sees GDP back above the previous high water mark in 2022, whilst the rest are looking at over 3 years of lost growth. The US is more resilient than Europe, but is still forecast at over 2 years of lost growth.

These forecasts give pause for thought when considering equity indices reaching new highs so early into a recovery. Yes, the stock market is not the economy, but S&P 500 earnings forecasts, for example, show a similar pattern with earnings per share forecasts for 2021 very similar to 2019.

Sentiment Indicators - improvements slow and readings more mixed

In terms of a more real time tracking of the current sentiment, Purchasing Manager Indices (PMIs) are shown below for manufacturing and services. These are surveys of business sentiment where a reading above 50 would indicate an economy in expansionary territory and vice versa.

For manufacturing PMIs the picture looks generally positive, with good readings and/or upward sloping trends, albeit a slower pace than earlier in the quarter. The recovery in manufacturing though may not be a good guide to the broader recovery, as the larger services sectors will be more impacted by new restrictions. Production has also been catching up with consumption, with inventories relatively lean. For services PMIs, the situation is more mixed, with the US levelling off whilst the Eurozone saw a decline in September.

Compared to Q2 with its strong increases from rock bottom levels, the situation is necessarily more nuanced now and this is inevitable moderation and slowing in momentum that has been voiced as a concern in this note in recent months. Global industrial production has now most likely peaked in September as has growth momentum more generally.

From a consumption perspective, the chart below from Capital Economics shows some key indicators and where things are now compared to pre COVID-19, in the US.

Labour Market Gains Decelerate

The US labour market remains the other key concern where markets don’t appear to have paid sufficient attention to the size of the incomplete recovery. From the 22m decrease in non-farm payrolls in March and April, 10.6m had returned prior to the September employment report. This latest report just released at time of writing shows only 660k workers were added in September, below estimates and down from a revised 1.5m in August. With only half this lost work force having returned and the heavy deceleration in the pace of gains, the employment picture will surely become more top of mind as part of the slowing economic momentum. Considering wider measures, 26.5m Americans are now claiming unemployment insurance compared to 2m at the start of the year.

One other point that often doesn’t receive enough attention is the increase in permanent job losses, often masked by the rapid gains from those on temporary layoff. The chart below from Credit Suisse is prior to today’s report, which confirmed that permanent job losers had now increased to 3.8m, up by 2.5m since February.

In Europe, the jobless rate is likely to rise from 7.5% to 10% by the middle of next year, as many short term schemes are due to end soon.

Fiscal and Monetary Support

In terms of the support provided to markets from fiscal and monetary stimulus, there was less activity in Q3 after all the huge measures announced in Q1 & Q2. On the fiscal side, the quarter ended with disagreement over the latest proposed stimulus program. The House Democrats have now passed a $2.2trn proposal, but Republicans are not in agreement. The difference between the 2 sides is not insurmountable, but this close to an election it would not be surprising if the greater concern amongst politicians is who will be perceived best or worst under different outcomes. The acrimony over Amy Coney Barrett’s nomination to the Supreme Court has also not been helpful in this respect and led many to conclude that a further package being agreed prior to the election may be unlikely.

From the Fed’s side, new policy came in the form of Flexible Average Inflation Targeting (FAIT), which in essence is seen as a dovish shift, as it removes the imperative to start raising rates when the economy sees ‘full’ employment unless accompanied by ‘unwarranted increases in inflation’. Instead the Fed will allow inflation to run above the 2% target after periods of undershooting, which effectively adds an easing bias. Separately, the Fed has been vocal on several occasions in recent weeks about the need for further stimulus alongside its own efforts. It has also achieved what raw data releases on their own seem unable to do, in getting the market to take note that the economy has a long way back to go, through Chair Powell’s Congressional testimony and other comments.

The ECB followed suit towards the end of September with Christine Lagarde, a former self-proclaimed owl (when asked if a dove or hawk) morphing into a dove, as she announced that she too wanted the ECB to move towards a form of average inflation targeting. She said that whilst in prior years concerns were ‘too high’ inflation, concerns now were different.

The Bank of Japan was quieter and recently confirmed no change in policy. Under Suga Yoshihide, the new Prime Minister, core policy is expected to remain largely unchanged, although he has been more vocal about reform of the regional banking sector against a backdrop of deteriorating profitability, which may lead to more mergers.

On inflation, whilst the initial impact of the pandemic was deflationary, prices have now begun to rebound and forecasts show a gradual drift back up. The forecasts from the Fed and ECB are shown below and these don’t differ too much from private consensus estimates. Whilst the euro zone has more work to do on the road to a 2% target, this has always been the case in recent times and the figure for 2019 was 1.0%

The US Election - An exercise in Combinatorics

Combinatorics is not a word I thought I would use again after leaving university 25 years ago and I apologise to any mathematicians for its crude insertion if incorrect, but after reading many notes on all the possible permutations and combinations, not to mention legal wrangles and constitutional quandaries, it struck me as a good opportunity to give it a go!

On clear election outcomes, most market participants don’t appear too concerned about either a Biden or Trump presidency and the greatest concern by far is over a contested election. Whilst Biden may have policies that would typically not be favoured by markets such as tax and regulatory increases, on the other hand fiscal spending is likely to be higher (which at present would be a positive) and tensions with China are likely to be lower. So whilst calm may be restored by February whatever the outcome, in the interim expectations are high for heightened volatility in coming weeks, given the unprecedented number or postal votes due to be cast, the preponderance of those in favour of Democrats, the attempts to already discredit the system and Trump’s repeated refusal to confirm he will respect the outcome of the result. A recent Economist feature that war gamed various scenarios ended with Trump being escorted from the White House by the secret service on inauguration day; whilst a recent piece from Michael Cembalest of JP Morgan includes the following amongst many scenarios:

'Nightmare scenario: dueling inaugurations. Assume in the new Congress that Democrats control the House and the GOP controls the Senate. If Democrats believe that VP Pence is attempting to skew the count through his rulings as chair of the joint session on Jan 6th, they could leave to deny a quorum and refuse to recognize his announcement of the winner. It could also lead to a situation where House Democrats insist that a new President has not yet been picked (meaning the Speaker would take over as Acting President on Jan 20th), while the Senate and the GOP insist that Trump has been picked. In the election of 1876, up until the day or two before Election Day, the two major parties were each planning their own inauguration and reaching out to military Generals to see which "new" President they'd be willing to take orders from'.

Of course none of these scenarios are the base case and we could yet be surprised with a clear result; but equally none are impossible.

Back to the policy and likely implications, the below analysis from Goldman Sachs highlights their expectations of a Biden administration in coming years under a blue wave with unified Democratic control. The fiscal expansion highlighted leads them to expect that the first interest rate rise may come in 2023, versus their current expectation of early 2025.

In terms of bond yields, their expectation is US 10 year yields may rise 15 basis points immediately and around 30-40 basis points overall after a month or so.

The below from Credit Suisse also speaks to the same point and considers changes expected under different scenarios in Congress and the Presidency, for GDP, inflation and interest rates. As can be seen a unified government under either party (which they ascribe 75% probability to one way or the other) is expected to be much more similar directionally than any kind of split Congress.

Credit Suisse actually see a Biden unified government as providing the greatest boost to growth from fiscal stimulus and infrastructure spending, which outweigh the negative impact of tax hikes. Whilst both unified scenarios would be inflationary, they believe a newly appointed Fed chair by Republicans may allow inflation to run hotter, whereas a Fed chair appointed by a unified Democratic administration may have a more conventional policy and act sooner. For the same reason interest rate forecasts differ along the same lines.

If a more inflationary scenario arrives post election, this could lead value stocks to move back on the road to recovery sooner rather than later, given that low rates are one of the key supports of growth stocks. But that is a question for 2021 and any change isn’t likely to be rapid. For now the immediate concern is getting through year end and potentially January, depending on how things play out.

COVID-19 with Regional Lockdowns and winter approaching

The key unknown in all of this of course remains the speed to which a safe vaccine can be found for COVID-19 and the success (or not) that governments will have in the meantime with their differing restrictive measures, particularly as the Northern Hemisphere moves into winter.

The chart above from Johns Hopkins shows what are at present the 10 most affected countries. The US made it back to a reduced rate of infections from mid July although now may have stalled somewhat; whilst Europe is of course the focus in the developed world at present with the rapid increases in the likes of the UK and France. India now appears on a downward track. Whilst governments and their populations seem to be in agreement that full lockdown is no longer acceptable economically, socially or mentally, it remains to be seen how effective the more minor measures are, as patience decreases and compliance frays at the edges.

What (US-China) Trade Deal?

It seems a long time ago that the Phase 1 trade deal between the and US and China agreed at the start of 2020 was top of mind, let alone any thought of Phase 2. The agreement with its 91 pages of text including a schedule setting out $200bn of increases in US exports to China never really had much chance of those levels being achieved; but anyone who chose to highlight this at the time was a bad sport and missing the point of the exercise. The first 6 monthly review in September was first postponed and then made lower key. The Peterson Institute estimate that to the end of August, China has imported less than half of its target to be on track. For the now the focus instead is on technology dominance and security, with high profile cases such as Huawei and Tik Tok.

Skinny (Brexit) Deal?

A large yawn is acceptable at this point. Sadly no macro commentary would be complete without reference to the interminable Brexit saga. At quarter end talks between the leading negotiators, Barnier and Frost, were due to conclude and give way to a meeting between (EC President) Von-Der-Leyen and Johnson. Most likely however they will need to look to the EU Council meeting on October 15th to have the pieces in place for a possible deal and it has been reported that finalisation of a text could slip into the first half of November. Whatever deal is agreed, if any, looks like it will have fairly thin content on trade and so the EU will be able to pass avoiding the national ratification process by focusing on the minimum need for a trading relationship. Meanwhile few Britons care beyond 'get on with it', as whilst politicians may worry about attention spans being lost over COVID-19, that process happened long ago for Brexit.

ASSET CLASS REVIEW

The outcomes for key asset classes are shown below for the whole year to date, and then considered individually beneath for the quarter. For the whole year, global equities have done a round trip back to 0 and the DXY dollar index has lost 2.6%. USD investment grade bonds have again proved their worth as a diversifier with over 7% this year to add to 17% last year, against all expectations. Lastly gold has delivered a healthy return for the year, although has come back some way from August highs.

Fixed Income

Sovereign bond yields saw almost no change in Q3 and didn’t react to the moves driving equity markets. Often these charts with 2 static points of time require further qualification about big moves in between, but in this instance volatility and the trading ranges were very narrow throughout the quarter.

It seems that central banks have anaesthetised these markets and the nominal yields are as much a reflection of where the central banks want them as investor sentiment.

In other parts of US credit, investment grade bonds added 1.3% (Bloomberg Barclays USD Liquid Investment Grade index) as credit spreads (the extra compensation over equivalent government bonds for the extra risk) nudged down a fraction from 1.5% to 1.35%. In High Yield the Bank of America Merrill Lynch High Yield index added 4.7% in the quarter, as spreads came down from around 6.5% to 5.5%.

As mentioned earlier expectations of a Biden administration would be that the US 10 year yield may nudge up by a modest 30-40bps, albeit the initial move could be lower given the change until things settle. In the event of a clear result with a split Congress, the change expected would be less as a smaller fiscal package would be anticipated. Finally a contested election could take yields back to and potentially through previous lows of 50 bps and would also be likely to spill over into other developed bond markets.

Equities

The table below shows the outcomes for key equity markets for the quarter and the year, in each case both in local currency and USD.

Total Return Equity Indices

The US market had clear leadership in developed market indices, helped by its structural composition containing more secular leaders whose advantages have only increased in many cases under COVID-19. Japan also made good gains whilst Continental Europe flatlined and the UK went backwards. Emerging Markets in aggregate did much better that most, matching the US returns overall, with strong performances from China and India, although Brazil was treading water for Q3. The chart below shows these outcomes more clearly over the quarter.

Returning to the US equity market, sector outcomes at index level are shown below (total returns) with consumer discretionary leading the way, followed by industrials, tech, materials and consumer staples all with double digit returns. Energy was the clear laggard and weaker returns came from financials and health care. 

The last decade continues to contradict the prior 100 years in terms of the outperformance of value investing and the rotations to value so far have only been fleeting. It’s also not the typical experience coming out of a trough, where value historically has led. Instead higher quality, growth oriented companies have led from top to bottom and have continued outperforming throughout the year. Given that these companies have better profitability, growth and better leverage metrics its likely that this leadership will persist, especially given the uncertainty around COVID-19 and the upcoming election. The chart below from Capital Economics illustrates the story this year so far.

MSCI USA Growth v Value for 2020

Growth seems to have beaten value as a) COVID has accelerated many pre existing industrial trends (business models that are tech based and don't require interaction or travel; or larger and consolidating dominance) and b) falling interest rates favours growth given longer duration i.e. more dividends further ahead. So whilst ultimately things may change with a vaccine and/or a more inflationary environment if one party has full control, this rotation does not appear imminent.

Commodities

Oil saw fairly muted moves over the quarter, by its own standards and eeked out a gain of 2.4%, with WTI ending at $40.22. Despite inventories showing drawdowns towards quarter end, the price didn’t move much. On the supply side, Libya has announced the resumption of certain exports, but there is uncertainty and in any event this may be offset by greater compliance from Iraq and the UAE. Most pressure though now seems to be coming from weaker demand expectations as COVID-19 second waves take hold. A vaccine down the line would of course offer a big fillip for oil (as for all risk assets).

Gold had an interesting quarter, initially appearing to fulfil its potential and forecasts as it rose through July and into August to a new high of $2,063. Then came an abrupt fall back to $1,911 and further retreat into quarter end, closing at $1,885. Still a gain of 5.9% for the quarter, but not quite what was hoped for. Many column inches have been spent trying to explain the moves in gold, given the safe haven bid no longer appears to be in evidence and there has been positive correlation lately with risk assets. Negative real rates are certainly a key factor and inflation expectations have eased off a little lately. Dollar strength in September will also have been a headwind. With cross asset correlations breaking down in the short term its hard to have a clear picture, but its quite possible that if/when risk aversion reaches more extreme levels that the safe haven bid takes hold again.

Commodities overall in the quarter rose by 9% for the Bloomberg Commodity Index or 7.6% for the S&P Goldman Sachs Commodity Index. The uptick in COVID cases in developed economies trimmed earlier gains from July & August for the asset class as a whole, with most industrial metals and precious metals falling in September, not helped by dollar strength. Agricultural commodities were more of a mixed bag with some helped by purchases from China; and energy generally did well with the exception of oil. Since the end of April, the correlation between commodities in aggregate and equities has been exceptionally high as illustrated below, yet again removing another textbook source of diversification.

Forex

Dollar weakening was a key factor in Q3, that impacted many other asset classes. The net impact shown below though had 2 parts. Most of the move happened in July, a little more in August and then September saw some resumption of strength as risk appetite faded. This was always the possibility, against all the predictions of dollar collapse, that in times of lower risk appetite there is demand for the dollar. That said the move back up was limited, so far at least, and overall there were strong gains from the likes of the euro, sterling and Aussie dollar which all gained close to 4% over the quarter.

One of the main drivers certainly seems to have been the rapid decline in real rates in the US compared to others and inflation expectations in the US moved up faster. The global recovery had also been outpacing the US on many high frequency metrics although things are now again in flux. From the euro side, earlier in the quarter the EU were seen to make good progress with the Recovery Fund, which helped the euro.

Outlook

The key concerns in the shorter term appear to be the following:

1. Continued uncertainty over COVID-19 until there is a safe vaccine with good efficacy that can be widely distributed, whilst in the meantime cooler weather arrives in the northern hemisphere
2. Slowing economic momentum, with the easy gains now in the past, which may reveal the incomplete recovery in sharper contrast as fiscal support for individuals and firms fades whilst at the same time consumer spending may be hit by new restrictions. The impact of the CARES act is fading and a new deal is far from certain.
3. A possible disputed US election with a minefield of permutations about how an eventual winner may be declared. Clarity may not be achieved before January in a worst case, whilst volatility pricing is rising well beyond election day.

Particularly given the last of these, now would not seem to be a time to be adding any risk. Instead it may be better to focus on well known stories/stocks/managers within existing portfolios, as well as assess if existing exposures are acceptable, at a time when many traditional cross asset correlations have broken down. The September pullback was fairly modest compared to the gains of earlier months and with volatility on the rise into year end, more backtracking is quite possible. In the New Year, as we gradually have a better grasp of what winter may bring re COVID-19 and have clarity on the US Presidency, the landscape should become clearer and allow strategy to be reviewed more easily.

One other observation from a more general portfolio management perspective is that given the disconnect between Main Street and Wall Street mentioned in previous notes and the amount of head scratching about the performance of indices v the economy, bottom up selection of strong companies and strong managers seems more important than it ever was, as parts of top down analysis become less useful than in the past.

Sources: All charts and tables are attributed within the text or within the specific chart or table, where relevant. Any data, charts or tables without explicit sources are from Bloomberg or made using data from Bloomberg.

The above commentary is as of Friday 2nd October 2020

The above is for information only and does not constitute advice