Known Knowns: The Constants
This year has put risky asset investors through what may have been the most anxiety-provoking roller coaster in the history of modern finance. The COVID-19 pandemic continues to rage on, albeit at a slower pace, and appears to be a cyclical phenomenon with seemingly no near-term end in sight. Sovereign bond yields have lost their sheen, and investors have been pushed to fund the majority of their liabilities by investing down credit, moving into equities, and/or finding alternatives. With some exceptions, global economies appear to be reopening in a sustainable manner without significant health-related downside. Central banks have been vocal about their commitment to sustain accommodative policies, and the Fed in particular is anticipating interest rates to remain near zero through 2023. Labor force participation has steadily increased, particularly since the end of enhanced unemployment benefits. The recovery continues to take on the sought-out V-shape.
Known Unknowns: The Variables
The big question on the minds of many investors relates to the end of the COVID-19 public health crisis – including when and if a vaccine will become available. A second big question relates to the highly contentious US presidential election. Emotions on both sides are running high, and the election could have implications not only for who controls the White House, but which party holds a Senate majority. Partisan rancor will only become more intensified as the GOP moves forward to appoint a successor to the late Supreme Court Justice Ruth Bader Ginsburg. Finally, the effect of the election on global trade relationships and the potential for normalization or further trade wars could lead to an uncertain outcome for stocks both domestically and around the world. Another important known unknown relates to what I have now come to call “The Final Showdown” – whether or not Boris Johnson and newly minted European Commission President Ursula von der Leyen can succeed where their predecessors failed and reach consensus on a lasting and orderly British exit from the European Union.
Base Case: Stocks Higher within a Range and Increased Volatility
To put it plainly, our base case is that the accommodative environment, a lack of options for investors seeking to fund liabilities, and positive sentiment around the development of a vaccine should push the market higher in the near term. However, we expect that upside to remain range bound over the next 12 months, which could spell some volatility for investors. In particular, we see a phase of consolidation in the fourth quarter and some profit taking, after what has been a significant multiple expansion rally particularly within the technology sector. 2021 should bring a further move to the upside as investors rebalance their portfolios for growth, but volatility is likely as the market normalizes.
Gauging the Election Effect
In our view, the US presidential election will not have a lasting effect on US and global stock markets. Although fiscally both candidates appear to be in opposite universes (with a particular disparity on capital gains taxes), what matters to market participants at the end of the day is corporate profits. We believe the market will continue to do its job of serving as a discounting mechanism for future corporate earnings regardless of executive leadership. In fact, we could arguably consider former Vice President Joe Biden as a “known known,” given that he is former VEEP (binge worthy show!) and therefore less of a wildcard as a challenger to President Trump. Overall, this leads us to the hypothesis that a Trump or Biden administration would not have any immediate impact on the direction of the stock market. This hypothesis is bolstered by the fact that investors have few options to fund liabilities given the current state of interest rates and little to no expectation of rate changes in the near future. Unless investors begin to fund liabilities from sports betting or lotteries, it is a safe bet that the stock market will be the beneficiary.
Brexit has the potential for broader impact, though we expect this impact to be localized. The UK in particular would most likely feel the brunt of a no-deal Brexit, particularly in the early stages, as the cost of imported goods is expected to skyrocket and the availability of staples and food will be scarcer until trade agreements can be put in place with new suppliers. For the most part, this effect should be muted for most US-based investors who hold very little exposure to the UK. The UK makes up about 3.5% of the global MSCI ACWI Index, which may be more reflective of institutional ownership than individual exposure. In a recent UNCTAD Study1 the projected impact to the UK economy of a “hard exit” could amount to a $32 billion loss in EU exports (or about a 14% decrease), half of which may come from tariffs. A softer exit, which would put in place non-tariff measures (NTMs) may help reduce the impact to the UK economy, but the same study estimates Britain would still see its exports to the EU fall by 9%.
This brings us to maybe the most important variable, and that is a resolution to the global public health crisis. The US government has backed a vaccine development known as “Operation Warp Speed,” which aims to deliver 300 million doses of a safe, effective vaccine for COVID-19 by early 2021. As of mid-September, there are 35 candidate vaccines in clinical evaluation per the World Health Organization (WHO). Nine of these have reached stage three clinical trial, including four that utilize Non-Replicating Viral Vector (live virus), three using an inactivated virus and two others using an mRNA approach. These include a joint effort between the University of Oxford and AstraZeneca and a Moderna/NIAID joint venture. The staggering amount invested in the development of a vaccine by both the public and private sector has inspired confidence. It is likely that one or more of these efforts will be successful within the next 6–12 months. Production of the vaccine will be challenging, and experts agree that with prioritization a vaccine may not be available to all until next summer. But the potential for a vaccine is a tremendous catalyst for the market, which will likely welcome the news with record-breaking day(s) across global markets. The upside potential helps drive our base case expectation, but the economic reality – at least until a full scale distribution is achieved – may incur some speedbumps. Moreover, much of the upside has already been priced in, which may ultimately lead to a “buy the rumor, sell the news” scenario where the upside move is equally matched by subsequent volatility. In particular, it’s probable that any completed vaccine development leads to a rotation out of technology and towards cyclical sectors typically correlated with an economic recovery as the economy improves and the market normalizes.
Alternative Scenario 1: No Vaccine
A major setback in vaccine development would likely push the economy into a downward slope. The market has largely priced in a near-term vaccine, and the various vaccine types being trialed should make this unlikely, but medicine in many ways is a mix of science and art. Vaccine development in particular can be tricky as viruses can mutate and people differ in how their immune systems respond to them. Therefore, we expect this unlikely scenario would have the potential to drive the stock market and the economy back to retest some of the depths we had explored back in March/April. Although this scenario would be exceptionally difficult, its probability is low.
Alternative Scenario 2: Late Vaccine
Delay of widespread vaccine distribution to beyond mid-2021 could spell trouble for discounted future earnings. A late vaccine may also not mean late development; a vaccine that leads to adverse reactions could affect delivery and lead to further uncertainty. We expect that the probability of a delay is significantly more material than a “no vaccine” scenario, though its effect would also be more muted and transient as a subsequent resolution would yield a market recovery.
Unknown Unknowns: The Third Rails
Prognostication is notoriously difficult, and the reality is that “unknown unknowns” are by nature unpredictable. COVID-19 was one such Black Swan event. While Bill Gates may have foretold a devastating pandemic in a TED Talk, most of the world was caught by surprise. We did suggest in our 2019 year-end note that market technicals and fundamentals were showing signs of increased volatility and uncertainty. At the time, this led us to the conclusion that 2020 would be an up-and-down year for investors. Global markets look set to end the year flat overall, having experienced much volatility throughout the year.
Our base case for the next few months is optimistic and relies on certain assumptions that we outlined above, but outcomes can change and their effect is unpredictable. What could go wrong here? Downside appears to be the key word. In particular, one area of concern could be a Biden win, followed by a protracted disorderly transition of power. This is not something that we typically have to worry about in the US, but we are not in a typical world anymore and such an unknown unknown could be a third rail to the market and the economic recovery. In a similar train of thought, the politicization of a vaccine could spell trouble for the world order, with tensions building between the haves and have-nots. Although a global effort to fight the virus has materialized, investors shouldn’t discount the possibility of nationalism and geopolitics which may influence how a vaccine is produced and distributed. COVID-19 has weighed heavily on investors over the past several months, but a similar parallel could be made with issues relating to climate change. According to an Intergovernmental Panel on Climate Change, “the range of published evidence indicates that the net damage costs of climate change are likely to be significant and to increase over time.” Left unchecked, the net effects of global warming remain unclear and are similar to the pandemic in their unpredictability. Finally, the many issues that concerned the pre-pandemic world may come back to haunt investors, including trade wars, geopolitical conflicts, and terrorism.
As we ponder the end of 2020, one thought that remains is the overall sense of uncertainty that all of us have felt: uncertainty about the virus, about our lives, our health, our children’s education, our careers and the broader uncertainty over the fate of global economies and stock markets. The Era of the Great Uncertainty has arrived, and with it, volatility has made a vigorous return. However, we believe that the future is bright and that we will weather this storm only to return stronger than before. Until then, diversification will remain important for investors and we all would be well served to get back to basics and consider risk management and diversification in all aspects of our portfolios. Until next month, be well and stay healthy.
This material is provided for informational purposes only and should not be construed as investment advice.
The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.
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