Economic Resilience (Except in Europe)
Economic data in the US is holding up well, despite higher Covid-19 caseloads and the lack of a subsequent pandemic fiscal package. Yes, savings are coming down from their forced lockdown highs, but spending is proving resilient. The labor market is gradually improving and the housing market is booming. The Chinese economy is doing even better, with a number of markers back above 2019 levels and expectations for a positive GDP print for 2020 overall. Concern for Europe, however, is justified. The sharp rise in cases since the end of summer has led to a drop in PMIs,1 in consumer confidence, in inflation; and the just-announced lockdowns, albeit lighter than in the spring, indicate the fourth quarter will suffer even more than previously anticipated. With a long winter ahead, growth and earnings expectations will probably need to be adjusted downward, including for 2021.
Additional Support Measures?
The fiscal impetus is likely to shift to the US again. A number of European countries have already increased or extended support measures, but they are unlikely to be large enough for the extended period of sub-par activity. The EU Recovery Fund should be approved this year, but it will take time to implement and its size might fall short of needs. In the US, legislators could not agree to fiscal stimulus in advance of elections, but we know it is coming. The size will depend on the results of the election, but we are confident that at least $1.5 trillion can be expected at some point, and upwards of $3 trillion in the event of a “Blue Wave,” or Democratic Party victories in the White House and Senate.
While fiscal spending is really all that matters at this point, we can still count on central banks and their nearly unlimited support. The European Central Bank and the Bank of England are set to increase their quantitative easing (QE)2 programs in the coming months, and the Federal Reserve could follow suit as inflation expectations have not materially risen. Moreover, central bank actions are keeping bond markets, including credit spreads, very well behaved, which should continue in the coming months. I will be keeping an eye on Treasury yields with a Democratic sweep, but I believe they should remain contained.
Overall, I remain constructive on risk assets over the medium term, even if the short term might see further volatility. Sentiment had become more bullish on fiscal stimulus optimism, but has now retreated again, bringing a positive technical support. Cash levels remain elevated. While the Q3 earnings season has been good so far, the outlook for 2021 is what will drive markets, and investors could see a differentiation between the US and Europe given the virus situation. Europe will need more confidence in the economic outlook for the reopening trade to support the more cyclical region. Finally, while the next few weeks could prove complicated, election volatility tends to be short-lived. A focus on the long term is important.
The pre-election volatility has materialized and it could last a bit longer, but I maintain a constructive outlook over the medium term. While next week’s election results can have a big impact on US policymaking for the coming years, underlying supportive factors for equity markets will likely remain in place, regardless of who is president.
Indeed, the fourth phase of US fiscal stimulus is coming, even if markets have to wait until February 2021. Central bank support may no longer be an incremental additional support, but it is maintaining a base. Cash levels remain elevated and positioning has retreated back to more bearish territory after a jump based on fiscal spending optimism. Indeed, a Blue Wave would see significant spending and polls indicate it is still the most likely scenario, though confidence in this result has faded recently.
Concerns surrounding the virus have spiked in Europe with renewed, albeit lighter, lockdowns, but I believe US virus concerns could be overdone and do not expect large-scale lockdowns; growth has proved resilient despite higher cases. As such, I believe that more confidence in the recovery will be needed before Europe benefits from a re-opening trade. Then, it can play catch-up to its US counterparts. In addition, I believe emerging Asia should benefit from strong Chinese growth and a good handling of the health situation.
The disconnect between European and US sovereign yields continued in October, with German bond yields retreating while US Treasury yields advanced on expectations for a Blue Wave and the ensuing fiscal expansion. The recent bout of volatility has reined in Treasury yields, but that gap between regions is likely to remain as the health situation – and therefore the growth outlook – continues to deteriorate in Europe, while the US is holding up.
Moreover, if we see a Blue sweep, US yields may rise again, though I believe they will ultimately remain contained by the Federal Reserve’s action or potential actions.
Overall, I believe the relative calm of bond markets is likely to persist and we maintain a preference for credit over sovereigns, even if spreads can remain range-bound in the short term. Indeed, credit spreads have held in through the latest equity market volatility, showing resilience. I remain more cautious on high yield, as the extent of the damage from the crisis is still unknown and default risk remains elevated in 2021.
I continue to see opportunities in emerging market hard currency corporate debt that has potential for spread tightening. However, given difficult situations in many countries, selectivity is key.
Recent uncertainty has extended the dollar’s recent gains, though we believe the upside is relatively limited as we expect risk-on sentiment to gradually recover ground. That said, the virus and growth concerns in Europe suggest the upside for the euro is more limited than previously anticipated. Sterling volatility is likely to continue with Brexit negotiations. Emerging market currencies should benefit from a softer USD, but idiosyncratic risks remain.
Oil prices remain under pressure as the growth outlook deteriorates with the health situation. Demand is likely to remain subdued for some time, but should eventually recover as the recovery outlook improves again. Prices could remain capped by ongoing oversupply, but there is room on the upside. I expect demand for gold to continue given low real yields, medium-term inflation expectations and central bank QE programs, even if it has paused for now.
I continue to see a place for alternatives in portfolios, as we look for de-correlating and diversifying strategies to complement traditional asset classes. Real assets can also help provide income in a lower for longer world.
2 Quantitative easing (QE) refers to monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed are as of October 29, 2020 and may change based on market and other conditions.
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