Markets power higher while the global economy stalls


Markets continued to rise in August, with global equities reaching new highs and the MSCI ACWI delivering just over 5% year-to-date (YTD). The strength of the rally places 2020 third for the best equity performance during a recession over the past century, lagging only the post–World War II rally and the bounce during the Great Depression. However, this still remains concentrated in a few mega cap US tech stocks. The S&P 500 has risen almost 10% year to date, with the NYSE FANG+ Index up over 80% over the same period. Markets like Australia and Europe remain more subdued, returning close to −7% and −11% so far in 2020.


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Economies around the world posted their second quarter GDP, which across the board were the worst results experienced since the Second World War. After almost three decades of uninterrupted growth, Australia was not immune, and officially fell into a recession in the second quarter of 2020. The economy shrank 7% over the June quarter, or 7.2% (YTD), which is the worst result since the country started keeping records in 1959. This was a full percent worse than the RBA’s prediction for 6%, but better than their original assumption of 8% back in May (perhaps they should have gone with the average).

While dire, relatively speaking this places Australia in pretty good stead. The UK lost a staggering 22% YTD, with Europe and US down 15% and 10% respectively. Some may say Australia has taken a heavy-handed approach to locking down the economy, considering the relatively low number of deaths from COVID-19 so far (26 deaths per million). But that places the country ahead of Sweden (GDP −8.1% YTD), which never officially locked down and has a current death rate of 577 per million. While third quarter GDP will continue to fall given Victoria’s second wave (23% of the country’s economy), Australia should still remain relatively well placed overall.

Rates lower for longer as Fed targets higher inflation

As the world tries to get its infection rates down, Jerome Powell was busy trying to get the inflation rate up. He announced (as expected) that the Fed will move to average inflation targeting, meaning they will be more inclined to allow inflation to run above 2% before hiking rates. This goes against decades of Fed doctrine to raise interest rates at the earliest signs of creeping inflation. Although inflation tracked 2% for two decades before it became the Fed’s official target in 2012, it has since lagged by 6% cumulatively. Therefore, if the Fed expects to regain lost ground, inflation will have to run hot for quite some time to catch up.

This has effectively given a green light for lower rates for longer and potentially even more quantitative easing (QE). By leaving rates so low, it will allow the government to borrow cheaply and finance increasingly deeper deficits. As we saw earlier during the COVID-19 pandemic, when treasury issuance ballooned and no natural buyers arrived, the Fed was forced to absorb the excess on their balance sheet to avoid a liquidity crisis. Unlike prior episodes, QE is no longer a discretionary choice, but reactionary. The Fed’s balance sheet grew by US$3.5tn over six years to combat the GFC, but has risen by US$3tn in 3 months during 2020. Government spending is typically reined in as financing costs rise over either a lack of bond demand or the central bank raises rates to combat inflation. Both these brakes have now been removed. We appear to be crossing the Rubicon where monetary dominance is being overtaken by fiscal dominance.

Political uncertainty puts markets on edge

That is, if the government can ever come to a decision on how to spend their money. The initial unemployment benefit from the first fiscal package has expired and negotiations over the CARES 2 Act have stalled as both parties dig in to old partisan positions. Unemployment remains high, GDP continues to fall, monetary stimulus is maxed out and the support cheque is not in the mail (the post office may not have enough funding to deliver it anyway). As the country becomes even more divided in the lead up to the election, politicians are playing politics when the country needs support the most. We expect social divisions and political divisions to grow deeper in the lead up to November.

Trump’s re-election odds have significantly improved since COVID-19 cases have come under control. What originally looked like a Biden landslide is now narrowing at a pace that may make it a close call. As we learnt in 2016, don’t underestimate closet Trump voters coming out in force and upsetting the pollsters. If Biden wins, we expect geopolitical stability and supportive fiscal stimulus (including the doubling of the minimum wage), but the catch is his corporate tax reform plan is expected to wipe 12% of S&P 500 earnings per share in 2021. That should put already stretched price-to-earnings ratios under pressure. A Trump victory should see more of the same – that is, uncertainty over just about everything. The one thing we know is he will continue to try to support the equity market, but realistically I’m not sure what’s left to throw at it.

In our view, the real risk is if there is no clear winner and the election is contested. Whoever wins under this scenario will have no mandate at a time when a mandate is needed the most. Valuable time will be lost fighting at the Supreme Court, rather than focusing on restarting the economy. Not to mention half the country will be outraged and assume the other side don’t deserve to be in power. In this scenario, political and social instability could skyrocket. The country is far more divided now than during Bush v Gore. Based on the volatility market, investors believe this is the most uncertain election in US history. Typically, markets hate uncertainty.

Our portfolio position

It is for this reason we continue to remain cautious on risk assets as valuations remain stretched and uncertainty continues to rise. We remain biased towards Australia over the US. US multiples will come under pressure in a Biden victory or if inflation rears its head (although the latter would be good for value stocks). The market is vulnerable to a shock if fiscal stimulus fails to arrive, but liquidity can keep stocks elevated for now. For these reasons, we hold around average equity weights but hedged with put spreads to protect from any market shock, along with positions in the USD and JPY. After such strong gains and relatively calm markets over the past few months, we may be in for another bout of volatility.

Equities

Equities continued to deliver strong returns in August, with the S&P 500 reaching an all-time high during the month, though we are concerned that this rally has been narrow with performance being driven by mega cap tech and consumer stocks. The rally in equities was spurred by a stabilisation in COVID-19 cases and a strong Q2 earnings season in the US and Europe relative to consensus expectations – in the US over 80% of reporting companies beat their expectations, though absolute EPS figures remain well down from 2019 levels. In Australia, the earning season also saw more companies beat their expectations than those that missed, but EPS revisions going forward are more mixed – over the last few months, Australian equities have diverged in performance relative to the US and remain about 15% off their pre-COVID highs.

The strong performance of US tech stocks has meant that growth stocks continue to outperform value stocks. Year to date, global growth stocks have now outperformed global value stocks by around 35%, based on MSCI indices.

We have maintained our cautious positioning in equities and have left our overall equity exposure unchanged. We have however rolled up out S&P 500 put strikes so that they are closer to where the S&P 500 is trading. Where we do hold equities, our preferences are still to Australia and arguably emerging markets, with the US our least preferred market.

Fixed income

Longer-end bond yields moved higher through August, while shorter-end yields were relatively stable, resulting in steeper curves. The US Fed outlined its change in policy to average inflation targeting, which helped to drive the aforementioned changes in the bond market. This also resulted in breakeven yields continuing to move higher in the month, as investors priced in the possibility of higher inflation. Credit spreads also continued to tighten during the month, though at a slower pace than we saw in previous months.

Over the month we made a few changes to our fixed income positions, with overall portfolio duration being trimmed by 0.25 years, while we also closed a US 2s30s flattener given the concerns around a steeper US curve. In the credit space, we deployed some of the cash that we had built up in our portfolio through June and July, and invested that in topping up our Asian credit exposure. We also made a small allocation to US securitised credit as a way of providing the portfolio with some additional yield, while also to some extent diversifying from developed market corporate exposure.

Currencies

The main thematic in FX markets continues to be USD weakness, while commodity currencies like the AUD, NOK and CAD performed strongly. We have mixed views on the USD going forward as it remains overvalued against other developed market currencies (with the exception of the AUD), while the Fed’s accommodative stance is also likely to be supportive of a weaker dollar. However, speculators have piled on to USD short positions and this now appears to be a consensus trade, which could result in some consolidation.

Similar to the last few months, our long USD position in the portfolio has hurt us; however, we are maintaining our exposure as a defensive hedge.

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