Two roads diverged in the woods.
Dear Friends,
The third quarter saw bond and equity markets remain at opposite extremes in response to continued difficult economic conditions. Bond markets are signaling a long recession ahead, with interest rates projected to remain below 1% for the next several years. Equity markets, in sharp contrast, are priced near all time highs, despite a 20% drop in corporate profitability over the past two quarters, high unemployment and widespread business closures.
So why the divergence? In our view, it’s the continued unprecedented levels of fiscal and monetary stimulus that has been pumped into the economy and markets (and the implied promise of more to come). Excess liquidity has kept asset prices elevated and this is playing out in both the stock and bond markets.
Equity markets continue to hover around the highs reached in late summer after the remarkable rally from the bottom of the March lows despite economic activity remaining well below pre-pandemic levels. The S&P 500 trades at 29 times trailing 12 month earnings and over 31 times normalized (10 year) earnings. These are peak levels, and unless there is an enormous rise in profits for companies of all stripes, these levels will be difficult to sustain.
Never has the adage that stocks trade on hope and bonds on fear rung more true.
The third quarter also saw municipal and state finances partially recover from the free fall of the second quarter. The impact on business sectors, however, has been highly variable. Residential construction appears to be a bright spot, presumably due to anecdotal reports that people working from home are investing in building comfortable working conditions. In contrast, commercial real-estate has not recovered to any material degree and many retail sectors, apart from consumer staples continue to struggle. Travel and leisure services are also hard hit, while technology products and services seem to be benefitting from the current work from home environment.
The Federal Reserve announced they would keep rates close to or at 0% at least until 2023, an indicator of how much medium and long-term damage the Fed believes has been done to the US economy by COVID-19. Low rates do help a recovery, at the cost of bond investors and ordinary savers. In our view, low interest rates alone will not be enough to help the economy recover; in fact, as evidenced by current stock valuations, low rates often encourage speculation, widen the already enormous wealth gap between the rich and the poor and create asset bubbles which can ultimately delay a cleansing of the economic system. So in addition to an accommodative interest rate policy, we believe there needs to be a clear, effective strategy for the public health crisis that continues to hobble much of the country. The current administration appears to be banking on miracle cures which will resolve the crisis overnight. While there is a possibility that a vaccine will be available next year, and a smaller one that it will be over 70% effective, neither is assured. Meanwhile, the public health toll continues to mount on vulnerable Americans and industries.
Though most other countries have managed this public health crisis better, global economic activity remains depressed and the world bank estimates global GDP will contract over 5% in 2020, a decline we have not seen in decades. In such an environment, with no imminent resolution to the public health crisis or its economic impacts, we continue to maintain a cautious allocation strategy, limiting exposure to risky assets.
We are now three weeks from a consequential presidential election in the US. A change in administrations is likely to bring about a reset in the US’s pandemic containment policies, with a stronger focus on preventive public health measures and clearer communication on the pandemic. If Congress and the government end up under Democratic control after November, we are likely to see another stimulus spending bill, tempered by broader restrictions to control the pandemic. If the current administration wins re-election, we would expect there to be a smaller stimulus bill, and a lengthier public health crisis. Neither of these events would have a material impact on the stock market. The bond market has the capacity to absorb large amounts of public debt, we do not expect increased debt issues to impact medium terrm rates while inflation is in check and the Fed keeps short-term rates low.
There is, however, a third possibility, that of a contested result and litigation over the presidential election. If this were to happen (as it did in 2000), we expect a lop-sided Supreme Court to side with the RRepublican candidate. This will have then been the second time in 20 years that the Supreme Court decided an election (against the winner of a popular majority). Such an outcome would result in lasting damage to the legitimacy of the court, and other public institutions in the country. This outcome is also the
We are now three weeks from a consequential presidential election in the US. A change in administrations is likely to bring about a reset in the US’s pandemic containment policies, with a stronger focus on preventive public health measures and clearer communication on the pandemic. If Congress and the government end up under Democratic control after November, we are likely to see another stimulus spending bill, tempered by broader restrictions to control the pandemic. If the current administration wins re-election, we would expect there to be a smaller stimulus bill, and a lengthier public health crisis. Neither of these events would have a material impact on the stock market. The bond market has the capacity to absorb large amounts of public debt, we do not expect increased debt issues to impact medium term rates while inflation is in check and the Fed keeps short-term rates low.
There is, however, a third possibility, that of a contested result and litigation over the presidential election. If this were to happen (as it did in 2000), we expect a lop-sided Supreme Court to side with the Republican candidate. This will have then been the second time in 20 years that the Supreme Court decided an election (against the winner of a popular majority). Such an outcome would result in lasting damage to the legitimacy of the court, and other public institutions in the country. This outcome is also the one most likely to be negative for investors in all asset classes. An uncertain outcome will hit US equity markets, and spook bond investors further.
Regards,
Subir Grewal, CFA Louis Berger
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