The news that President Donald Trump and First Lady Melania Trump tested positive for COVID-19 has reinvigorated the world’s focus on the pandemic. Equity markets reacted slightly to news of the diagnosis on October 2, while credit markets remained comparably still. Generally speaking, higher volatility heading into the US elections is not surprising, but a number of developments in recent weeks have raised questions about growth prospects as we look to the last few months of the year. The first is whether US consumption will hold up without the next phase of US fiscal stimulus. The second is whether the European recovery will survive the new wave of virus infections across the Old Continent.

US Recovery Should Hold
Economic data has been robust in recent months, particularly in the US. Retail sales softened in August, but the housing market continues to boom and overall consumption has held up. However, with the passing of Supreme Court Justice Ruth Bader Ginsburg, the fight over her replacement has likely reduced the odds that the CARES Act 2 will be agreed on ahead of the elections. The market has reacted in consequence, with a glass-half-empty outlook in recent weeks. However, even if the CARES Act 2 does not pass before November, we believe that the US economic recovery can, and will, continue. The initial “V” might be over, and consumption might taper off, but the recovery should hold. Nonetheless, bouts of volatility are likely to keep markets on their toes in the coming weeks.

Europe’s Second Wave
In Europe, we have seen PMIs1 weaken with the rise in cases, but confidence remains solid so far, at least in Germany. However, as new “soft” measures continue across Europe, data is likely to soften further, although it should not stall completely. Indeed, we believe that policymakers will avoid generalized lockdowns at all cost, suggesting the recovery will slow, not stop. However, sentiment could still suffer and growth is likely to be weaker than anticipated, removing one of the recent supports for European assets. Integration and cooperation – thanks to the Recovery Fund – will remain a long-term support, but might not suffice for now. We therefore have reduced our overweight to Europe, bringing it in line with the US. That said, as confidence in the recovery eventually returns, Europe should benefit from the reopening trade.

Finishing the Year
Today, we believe these developments are priced in. There is little optimism left about additional COVID-19 aid ahead of the elections, which are expected to be complicated. As such, markets are unlikely to collapse. Indeed, we have seen inflows after some of the bad weeks in September, suggesting investors might be looking for entry points. There is also still plenty of cash on the sidelines, and ongoing central bank support. We therefore remain overweight equities, though we expect a bumpy ride into the coming weeks.

On the bond front, calm continues to prevail. US sovereign yields are behaving as if yield curve control has already begun or could start at any moment. Credit spreads are proving relatively resilient in light of the September volatility, and appetite for emerging market debt has held up. We maintain a preference for investment grade (IG) over high yield (HY) as default risk remains and high yield is more sensitive to equity moves. We also maintain some exposure to emerging market hard currency corporate debt for potential spread tightening.

While we maintain a constructive view on equities, we believe that October could prove bumpy. Indeed, between questions about US elections, US-China tensions, Supreme Court tensions, US Phase 4 fiscal measures, and European virus cases, headlines are likely to keep investors alert.

That said, we believe that many of these concerns are now priced into markets – or at least expected. Cash remains plentiful, sentiment is bearish and that central bank support isn’t going anywhere. As such, the downside should remain relatively limited, but volatility elevated.

Moreover, while valuations remain high, they are still not extreme compared to recent weeks and especially compared to bonds. Additionally, while markets are focused on the risks, a positive surprise cannot be excluded.

Given concerns about Europe, we have reduced our overweight to the region. We still believe there is plenty of room for catch-up to their US counterparts and European assets should eventually benefit from renewed confidence in the reopening trade, but short-term challenges remain. In a more risk-off setting, the US should hold up with its more defensive, growth bias. We maintain our preference for emerging Asia within our emerging market allocation.

Fixed Income
While German bond yields retreated towards the lower end of their recent trading range, US sovereign yields have virtually not moved. Indeed, markets are already behaving as if the Federal Reserve had started yield curve control. Overall, though, bond markets have remained calm in light of the equity volatility, a trend we expect will continue for some time. Indeed, inflation expectations have even retreated with the recent growth concerns.

Credit spreads have held in well, with US IG widening only 10bp (EU IG 6bp) and US HY 53bp (EU HY 32bp) in September. We maintain our preference for investment grade credit and some European peripheral sovereigns, where we can get a pick-up in carry and spreads have potential for compression, though they might range-trade in the short term. We remain more cautious on high yield, as the extent of the damage from the crisis is still unknown and default risk remains elevated, continuing into 2021.

We 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.

The dollar has regained some footing with the recent market volatility, taking its position as a safe haven. This could continue in the short term, but we believe that the dollar is likely to resume its weakening trend further out as the global recovery continues. The euro has stabilized following its recent slide and is likely to range-trade before gaining upward momentum again. Some volatility on sterling is likely as the Brexit deadline approaches and the UK and Europe remain far from an agreement. Emerging market currencies should benefit from a weaker USD, but idiosyncratic risks remain.

Oil prices continue to swing with the outlook for global growth. Demand remains subdued, but supply cuts have held. As the recovery progresses, prices should recover, though they may remain capped by ongoing oversupply and a soft economic recovery. We expect demand for gold to continue given low real yields, medium-term inflation expectations and central bank QE2 programs.

We continue to see a place for alternatives in portfolios, as we look for de-correlating and diversifying strategies to complement traditional asset classes. We believe that real assets can also help provide income in a lower for longer world.
1 The Purchasing Managers' Index (PMI) is an index of the prevailing direction of economic trends in the manufacturing and service sectors. It consists of a diffusion index that summarizes whether market conditions, as viewed by purchasing managers, are expanding, staying the same, or contracting.

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 September 29, 2020 and may change based on market and other conditions.

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