There is significant event risk around the US election and Brexit negotiations. These are very much “on the radar” for markets, as is the development of Covid-19 cases and deaths.
What’s flying under the radar? The clearest one to us is fundamentals, micro and macro. We are just about to enter the Q3 corporate earnings season, which will see an attempt to wrestle back the focus towards fundamentals, though in recent quarters this shift in focus hasn’t lasted for long. In terms of macro, the emphasis of late has moved away from inflation, with break evens (market expectations of inflation) falling, and towards subdued economic activity and the related push for more US fiscal stimulus.
As ever, these risks don’t exist in vacuums. For example, in simple terms, more Covid-19 means more downgrades to GDP and corporate earnings. In contrast, an effective vaccine would feed through to improved confidence and activity, and eventually to upgrades.
Very much on the radar for asset allocators is whether growth will continue to outperform value, which links to the question as to whether the US, with its growth bias, will continue to outperform the rest of the world. Central to this question is inflation and bond yields, as moves higher are generally consistent with value outperforming growth.
Take a look at this chart, which shows that US Treasuries have been taken out of the game by the US Federal Reserve since March. US Treasury 10 year yields (red line) have flatlined, reaffirmed by the volatility of US Treasuries (black line), which has been at record lows.
The importance for equity markets is underlined by the performance of S&P banks, a traditional cyclical, relative to the S&P 500 Index (orange line), which has moved in line with Treasury yields, behaving broadly as the textbooks would suggest. Note that all three have picked up relatively recently, on a perceived higher probability of Biden winning the election and more fiscal stimulus. There have been numerous rotation attempts over recent years and all have failed; without stating the obvious, at some point this won’t be the case.
US Treasury yields are flatlining, and so are bank shares.
It seems too superficial to say inflation doesn’t matter, even if inflationary pressures look like they might be abating in the short term and even if we have been in a multi-decade disinflationary environment. If inflation picks up materially, will the Fed want bond yields to remain low? What will replace the market-adjusting impact of higher yields that traditionally help reign in higher inflation? Quantitative tightening maybe? That’s a question for another day.
Back to inflation, we note that broad money growth has picked up materially, in a way that it didn’t in the QE programmes post the Global Financial Crisis. This reflects a change in the nature of the stimulus, from QE for financial markets to QE for the people.
Even so, it is still the velocity of money that is key, i.e. economic activity relative to money growth, which is largely being held back by a lack of confidence. Confidence is difficult to quantify (see last week’s Perspectives). For example, insight into consumer confidence is normally provided by employment, housing and financial market prospects, but this time we have vaccine prospects in the mix too.
Bringing all that together, our lower for longer base case remains intact, further supported, in the short term at least, by the Fed’s new monetary framework. That said, we are keeping a close eye on fundamentals such as, inflation (and bond yields) and business and consumer confidence, as these could well herald a change in market dynamics. Meanwhile, event risk is on the market’s radar, while macro and micro risks are dampened by policy, though policy risk itself is always a risk to consider.