Stocks struggled overnight, ending the session lower as surging COVID-19 hospitalisations in the US weighed on sentiment, with restrictions increasing in various US states, overshadowing positive vaccine news. New York City reached a 3% positive infection rate threshold, leading to the school system announcing the closure of schools which sent US futures tumbling.
The result in FX overnight, another choppy session, but any real flight to safety tepid. The dollar gaining modestly in Asia trade with COVID concerns fuelling a haven bid and AUD/JPY continuing to rollover on risk-off sentiment.
10yr Tsy yields, whilst broadly range trading, rose overnight following a weak 20yr auction, also reflective of a limited rush to safety and the spectre of persistent issuance. More broadly though, with a lengthier time horizon in mind, a reminder of the diminishing importance of Treasuries in portfolios, with the end result being risk for little reward, yields can head to 0, perhaps negative but on the flipside, inflation can surprise to the upside (it’s not set in stone but the building blocks are there). Although at some point the Fed would clearly step in and cap yields so as not to quash the fragile recovery. This dynamic has implications for traditional 60:40 allocations – it’s time to find a new hedge – as we have written several times since earlier this year where we have suggested larger weightings to real assets (Precious metals, Agricultural commodities, Base metals, and even Bitcoin). Traditional allocation models are shifting (or should be shifting) as fiat debasement continues and the opportunity cost of holding non yielding assets is diminished in the current environment. And there is little doubt that central banks will continue to deploy ammo whilst their targets remain a long way off.
Despite the overnight action, markets generally continue to climb the “wall of worry”, looking towards the light at the end of the tunnel, which is shining a lot brighter with the reduced political uncertainty and recent vaccine news. Although the good news on vaccines comes now with a diminishing marginal impact following initial burst of positivity. The big kicker has been the vaccines are higher than people expected in terms of efficacy. Giving equity markets more broadly the luxury of glossing over near-term risks and focussing on the prospects of vaccine rollout and activity normalising next year. Hence, we continue to remain constructive on a more medium-term outlook and focus on using any corrections to add to reopening trades. On the sentiment side, despite US indices perched close to all-time highs, complacency is far from records. Equity-fund flows have not been positive on the week since September and investors are still positioned for heightened volatility. The gap between 3-month and 1-month implied vol has climbed since the beginning of November as investors continue to price risk in the coming months with uncertainty over a fiscal package and a winter of COVID-19 weighs.
Of course, vaccine news doesn’t mean we are out of the woods. The rollout will be some way off and there are clearly hurdles to manufacture and deliver. The pending vaccine also doesn’t change the fact that in the immediate term there is huge community spread in Europe and US and shutdowns/increasing restrictions are incrementally ongoing. This will undermine the economic rebound, particularly in the US with no co-ordinated public health plan until the Biden administration takes office and the ongoing stimulus stalemate a hurdle, which has the capacity to roil risk assets in the short term. No doubt a challenging period ahead for the real economy.
Volatility and choppy price action weighed by factor volatility will remain, until there is more surety containment of COVID-19 but the rotation has begun, as we flagged last week. Positioning wise markets are looking ahead to the post-pandemic world, increased immunity and potentially a vaccine. The powerful cocktail of economic optimism returning and ever-flowing easy money keeping dip buyers ready to engage.
The stimulus impasse, expiring benefits and the continued acceleration of COVID-19 cases puts the onus back on the Fed to act. Fed Chair Powell wants inflation generated by aggressive fiscal spending, but he won’t get it yet with the likely Republican senate and the chances of deadlock easing in the lame-duck session are slim. The Fed must balance the immediate risks that are set to accelerate as COVID-19 continues to spread through winter and the potential for a vaccine in 2021. Although markets have reacted quickly, the real economy is a different story, in order to minimise labour market scarring and bridge the gap to a potential vaccine next year the Fed are likely to step up and increase size and duration of monthly purchases. The Fed will also be watching recent rise in long end of yield curve and may wish to slow down the pace of rise in 10yrs so as not to hamper recovery prospects whilst the US is still in the throes of virus wave two. Expansion of monetary policy measures will be no substitute for a decent fiscal stimulus package. However, the Fed may be left with few options if lawmakers cannot put their differences aside.
Immediate risks aside, for pro-cyclical stocks there is more room for normalisation and these sectors can look past immediate risks through to benefits a vaccine can provide. Rendering opportunities to play the ‘economic reopening’ and cyclical rotation, adding assets that will be beneficiaries of economies reopening further next year. Providing a relative opportunity for outperformance given the valuation starting points provide better outlook for gains, expectations have been low and can therefore surprise to the upside. Relative to growth/tech and momentum names that have front-loaded several quarters of gains. The best opportunities in the coming months are likely to come from those most leveraged to economic activity normalising that have low expectations like industrials, materials, travel and leisure, and energy. In addition, commodities with the trifecta of drivers supporting the outlook through to 2021 – Supply deficits, policy tailwinds from infrastructure spending and green electrification trends and on the macro side tailwinds from a weaker USD and rising inflation. We also remain of the view that Asia as a region will outperform – more on that here.
That is not to say to the ultra-long-term secular trend for technology and growth stocks is voided, but rather taking a breather. We have just witnessed years of disruption condensed into a 9-month period and those gains are well reflected in the way the sector has traded, with gains very much front-loaded. Expectations are high, positioning is extreme and rising yields will weigh. Economic optimism works against the long duration tech trades, and supports pro-cyclical allocations tactically, where there are opportunities for catch up. So the question really depends on investment horizon.
In the long run a vaccine is no panacea for long-term growth and the secular mega trend of growth stocks not going anywhere unless we transition to more MMT-lite style regime that might have come with the blue wave scenario – off the cards now. Without that aggressive fiscal shift, the onus is on central banks, and the trend of slower, lower growth and productivity will resume beyond the initial rebound in economic activity. Long term inhibitors to growth like spiralling inequality which have been supersized by this crisis and resultant policy responses remain. Perpetuating zombie companies and killing productivity, fuelling everything K shaped. And within this everything K-shaped paradigm, mounting social unrest and populism remains part of the picture. Thus, the aforementioned collectively promoting an eventual return to lower potential growth and secular stagnation.
This means that taking a longer term view, beyond the initial optimism that comes hand in hand with a vaccine and post COVID rebound, until there is a serious shift toward demand side inflationary policy and redistribution the secular growth trend remains intact.