How can we explain the extraordinary divergence between the economic and social crises the world is facing today, and the comparatively calm, continued appreciation of most financial markets? We ask what has caused this divergence, can it be sustained and what might trigger an unwelcome ‘reality check’.
One simple question has dominated our investment meetings this summer – how, in the midst of the worst economic downturn in living memory is it possible that the majority of global asset prices are higher than they were before the virus emerged last December? Global equities, corporate and government bonds and even most metal prices have all appreciated this year looked at from a UK perspective. Yes, many individual markets are lower (European equities and oil, most obviously) but, with positive returns across the American, Chinese and Japanese markets, the world equity index as a whole is higher. In just the last quarter, despite an upsurge in infections and the increasing risk of a contested US election, the S&P500 rallied more than 8%1, with every sector (except energy) in positive territory. Even more surprising, against such a fast-changing economic backdrop, the yield on the US 10-year treasury bond barely moved over the quarter2. Not even the admission of the US President to the Walter Reed Medical Centre has much changed these numbers – equity markets for the first few days of October were broadly flat.
So, why is the scarring from the virus so clear in the economy but not in financial markets?
First, unlike in 2008-9, COVID-19 has unleashed a ‘no-fault’ crisis. The virus is a natural disaster and there are no bad-actors (unlike say the banks in 2008/9) – this makes a rescue politically much simpler and leaves policy makers unconstrained in their response. It has for example allowed a hugely ambitious monetary policy agenda where ‘cover’ is effectively extended to every corner of the financial system. Credit markets, money markets – even the liquidity of US treasuries themselves – have all been buttressed by unlimited central bank intervention. In short, systemic risk across the financial system has been all but eliminated – this is hugely supportive of risk assets.
Second, politicians globally have moved with surprising speed to endorse massive fiscal programmes which have, until last month, been on a genuinely bipartisan basis. This has protected incomes and jobs and saved countless businesses. While of great value in itself this action has also protected the global banking system, limiting loan losses and personal defaults. As a consequence we have managed to avoid the sort of deep and synchronised banking crisis that wrought such damage on debt and equity markets in 2008 (note this is why today’s standoff between Treasury Secretary Mnuchin and Nancy Pelosi over the renewal of the fourth US stimulus packages could be so damaging). For the moment though, the world banking system, much strengthened over recent years, remains solid.
Finally, China has supported global growth once again, but in different ways to its huge fiscal spending after 2008. This time around, despite being first to experience the virus, it has in recent months all but managed to eliminate new infections. This has allowed mobility and business activity to recover to such an extent that the country may actually experience positive growth in 2020, of 1.5-2%3, according to our estimates. This has helped China avoid its own banking crisis and halted any damaging declines in the Chinese currency, while preventing raw material prices from collapsing globally. It has too allowed China to produce vast amounts of PPE and ‘home-working’ electronics that it has exported to the rest of the world.
Can asset prices continue to defy economic gravity?
The immediate news agenda is certainly challenging; a second spike in infections, a potentially contested US election and Brexit talks that are (unsurprisingly) running to the wire. All of these risks are though, potentially time limited. Rates of infection should ultimately fall if vaccine deliveries begin later this quarter, Brexit talks will end one way or another and despite what could be a ramshackle process the 46th US President will ultimately get elected.
Two longer-term questions remain for asset prices though: what does a possibly unconstrained Biden presidency mean for corporate earnings and, are today’s high valuations and low bond yields really justified?
President Biden’s first priority will be a stimulus bill to revive growth – seeking an economy that is significantly greener than today, with a more interventionist industrial policy and with borders more open to skilled immigration. Biden will seek an economy that is significantly greener than today, with a more interventionist industrial policy and with borders more open to skilled immigration. Protectionism will likely remain, as will much of Trump’s China policy. Like the current administration, the Democrats currently still have no proposals to resolve the country’s longer-term fiscal problems. There are of course risks – Biden is likely to pull the US further to the left than either Obama or Clinton, and taxes will certainly rise, but the latter is probably inevitable under any administration. In summary we do not yet see a need to materially alter our risk profile for a Biden win or even a clean sweep of both houses – especially given the substantial exposure we have to companies that are part of his climate change agenda across all our thematic portfolios.
Looking at the second question, we are convinced that there will be yet further measures by central banks to loosen policy over the coming months. We expect a further extension of ECB bond buying (inflation is now falling for the second month in a row in the Eurozone) and negative rates in the UK would be likely, following any no-deal Brexit. We also see the Federal Reserve’s new average inflation targeting regime being copied in various ways by central banks around the world delaying any potential tightening. As for any reversal of this policy, we believe that Chairman Powell’s June comments still stand, namely that he is “not even thinking about thinking about raising rates” – we see US and global rates on hold to 2023 and probably beyond.
An attractive backdrop for equities?
This of course is an attractive backdrop for global equities, but it involves a delicate balancing act. We need to carefully combine three stock attributes: visibility of profits and dividends in 2021, valuations that are not already at extreme levels, and robust ESG standards. We think these conditions can still be satisfied in many of our thematic equity holdings. For example, the top positions in our Endowments fund include three global utilities that have pivoted toward renewables (Enel, Orsted and Nextera), three pharmaceutical companies geared toward viral treatments and testing (AstraZeneca, Sonic Healthcare and Amgen) and four long-term defensive franchises (Reckitt Benkiser, Colgate, Air Liquide and Ecolab). This is in addition to core beneficiaries of the digital world, albeit, at higher valuations (UPS, Microsoft, Apple and TSMC). Together this combination offers a balance of defensive earnings with strong social and climate awareness, all achievable at still not unreasonable valuations.
Against this backdrop we will be using any market weakness during this quarter’s political fog to add modestly to thematic equities – with returns of less than 1% in government bonds and zero or below in cash deposits, actively managed portfolios can still perform.
1 Source: Macrobond, October 2020
2 Source: Bloomberg, October 2020
3 Source: Sarasin & Partners using Macrobond data, October 2020