Heading somewhere

Everybody should have an argument with themselves and with others now and again. Arguments rarely end in absolute agreement. Instead, there are compromises. It’s the same for making investment decisions. There is no right or wrong, ex-ante. The argument today is about the risks – viral and economic. The truth is elusive. Uncertainty always has to be priced and a good investment strategy needs to be prepared to have both winners and losers. In the long-run the bulls win, and markets go up. For now, though, some kind of set-back to recent performance would not be a surprise.

Clouded outlook 

The outlook for market returns in Q3 is less clear than it was (with hindsight) at the beginning of Q2. All the policy support and valuation arguments were much stronger three months ago than they are today. Investors had the initial recovery bounce in activity to get excited about. Now the focus is on how the economic outlook evolves. Companies will soon have to make the decision about whether to retain jobs or let workers go as job support schemes are wound down. It is not encouraging that the day after the UK Chancellor announced another large fiscal package, much of which was targeted at employment support, there were announcements from two well-known retailers of up to 12,000 job losses in Britain. Retail, travel and hospitality look as though they will remain very challenged for a long-time. Companies, facing uncertain demand, are not likely to bump up capital spending just yet. There is a continued need for policy to support the real economy, but the immediate post-crisis support will inevitably fade. Central banks can keep the markets operating but maintaining jobs and incomes might be much more difficult if economic activity continues to be constrained by the global pandemic. Yes, there is a bounce and there is some pent-up demand, but we can’t rely on spending if people are still cautious for health reasons. The big hope is we get on top of or learn to live with the virus. However, there is a risk that the divergence between a gloomy economic outlook and unexpectedly strong returns from equity markets is reconciled by some pull-back in asset prices rather than a surge in economic optimism.

Wait or invest? 

Investors are in different positions. Some may have remained fully invested all year-long, in which case their portfolios would not look too bad. Others may have taken fright and sold in March, possibly then missing out on the recovery in April-June. Others still could have been in cash and stayed in cash and now face entry points in credit and equity which are much worse than they were on March 23rd when the market bottomed. The latter group are faced with a difficult decision between waiting for a market correction or deciding which asset class is worth putting money into now. Waiting and watching the market continue to go up may be uncomfortable, but if there is a dilemma now between the economic outlook and the market, it is only likely to get worse.  Unless we get a vaccine.

You want to win?

The US election is also looming. The political atmosphere in the US has deteriorated as a result of the pandemic, the massive rise in unemployment and the highlighting of social issues. While incumbent Presidents tend to benefit from a strong stock market, the economic situation does not bode well for President Trump. I would suggest that election uncertainty will be a major source of potential stock market volatility in the weeks ahead, especially if the reversal in the economic recovery in some parts of the country continues. In a sense this is an election you would not want to win. There will be the ongoing challenge of managing public health in the US, an unemployment rate that will be higher than it was four years ago and a need for some reversal of the fiscal stimulus and rise in government debt. That will mean tax increases and revived political arguments about balanced budgets and debt ceilings. Austerity is not a term usually applied to the US, but fiscal policy will have to become less expansionary at some point over the next political cycle. This will need to be factored into medium-term expectations for corporate earnings growth. In the short-term I would expect that “the election” starts to impact on short-term market moves as much as “the virus” in the weeks ahead. 

Fed remains key 

It is likely that there is additional support for the US economy before the election. After all, both Democrats and Republicans have a vested interest in providing more voter help. Yet there will possibly be a hiatus in Q4 if Trump were to lose. With that in mind the consistency provided by the Fed remains an important factor, alongside the boost that has already been given to household income as a result of fiscal initiatives. There is no question that there is a link between the growth in the size of the Fed’s balance sheet and asset price performance and it is very likely that if markets do start to weaken there will be pressure on the Fed to ramp up further. The Fed has already reduced the risk-free rate and the credit risk premium. It has ensured plentiful liquidity and its forward guidance is that support will remain in place until their recovery is guaranteed. In most economies the policy framework remains the most powerful support for markets. More important than the managed re-opening of economies which we have seen is not straightforward.

Similarities and differences 

I took a quick straw poll of the views on Q3 returns from some of my colleagues this week. There was no expectation that returns would be as strong as they were in Q2 and a view that returns from risky assets would be negative was more prevalent than the “still positive but lower” option. Yet there is a wide spectrum of sentiment out there. There is a rather niche TV comedy in Britain called Derry Girls, set in Northern Ireland at the time the troubles were coming to an end. In one episode, the “girls” – who attended a Catholic School – were invited to a retreat with boys from a Protestant school. They were asked to list differences and similarities between the two communities. Try as they might, they couldn’t come up with any similarities. Bulls and bears might well find it equally difficult to agree on any common drivers of risk today. Is the evolution of the virus bullish or bearish? Bulls might say most of the economies that it has passed through are returning to normal and activity is bouncing back (look at the ISM and the IFO indices). Bears would argue that the pandemic is still alive and kicking and can easily cause recovery to reverse (look at the global infection rate, high frequency activity monitors in Texas and Arizona). As always, you believe what you want to believe. Robert Shiller, writing on Project Syndicate (here) this week suggests that equity investors mostly respond to how they think other investors will respond, and that is unpredictable particularly in an “unprecedented” time. We don’t know how to process a lot of the news (scientists are still in the dark about a lot to do with the coronavirus), so we react emotionally, we react to what we do understand (data bouncing) and we react to others. With so much uncertainty it’s hard to attach a huge level of confidence to any forecast of near-term market returns.

Behaviour 

Investors have to try to understand their own psychology. Expectations need to be anchored by something or there has to be a readiness to acknowledge that some investment choices have to be set with a range of possible outcomes. Government bond returns are well anchored today and despite rising debt and central bank driven monetary growth, there is little chance of rates or inflation rising enough to create major capital losses.  Corporate bond returns are also reasonably anchored given that central banks have recognised the importance of keeping credit markets working – companies need to raise finance and refinance debt. However, credit spreads can widen still in response to a deterioration in fundamentals and that will be more sensitive the further down the credit rating spectrum. Equity returns are less well anchored when there is uncertainty about growth and earnings. Analysts are starting to increase their 12-month forward earnings expectations but the level of earnings – for the S&P500 for example – is still expected to be some 18% below their forecast peak.

Long-term positive 

There is a case for caution. The stock market has not really suffered a secondary correction. There might be an opportunity to buy stocks at cheaper levels and lock into a wider credit spread.  However, I am bullish for the longer-term. The world will need growth and the world needs to address issues like climate change and pandemic risks, as well as water and food security. That means investment and technological progress in areas like alternative energy, carbon capture and more efficient agriculture. In turn, this needs global cooperation between governments and between governments, business and investors. A new, kinder, gentler globalisation. That might require a different kind of leadership. The US election is important for so many reasons.

Good news from M6  

Finally, how good are Manchester United? They have won all their games since the re-start and are top of the re-start league. The defence might be a little suspect and De Gea might be past his best between the sticks, but the mid-field and forward line are pretty dynamic now. Imagine what they will be like next season with 70,000 people inside Old Trafford (if that will ever be possible again). And they might even end up with two trophies and a place in next year’s Champions League. Not a bad driver that Ole.