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Animal Spirits and the US Election: Will Momentum Stall?
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September 18, 2020
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Animal Spirits and the US Election: Will Momentum Stall?
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September 18, 2020
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Animal Spirits and the US Election: Will Momentum Stall?
Animal Spirits and the US Election: Will Momentum Stall? |
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Momentum has been driving markets throughout most of 2020, with market participants losing focus on fundamentals and pushing valuations higher. The pullback at the beginning of September may have broken this momentum, but we will have to wait and see whether it will build once more. A few large stocks now dominate the S&P 5001 , meaning high concentration and stretched valuations in parts of the market. This all points to a market correction and persuades us to hold our cautious positioning.
Many regions across the globe are experiencing a resurgence of COVID-19, just as US politicians appear to falter on providing further stimulus. This, combined with the looming US election which is barely six weeks away, could stoke animal spirits and we could be in for a volatile final quarter. In this piece, we examine these factors which could finally cause the house of cards to fall:
Momentum has run wild
The following charts illustrate how dramatic the momentum has been for US growth stocks and the FAAMG complex, which have seen a substantial re-rating of their P/E multiples since March 2020. However, in our opinion, market exuberance has caused excessive valuations and with momentum so concentrated in a few names, there is increasing risk of a volatility shock. If the market moves back to focusing on fundamentals, the change is unlikely to happen quietly.
US politicians’ appetite for fiscal stimulus may be faltering
One of the key factors which has supported the momentum and the sharp economic recovery since March 2020, has been the enormous fiscal stimulus deployed by governments across the globe. However, in the US it appears that political support for more stimulus is faltering, with the prospect of a package being agreed before the election fading fast. Whilst consumption has until now been increasing2, the expiration of the extra $600 per week unemployment payment from the CARES Act3 at the end of July and the closure of applications for the Paycheck Protection Program4 at the beginning of August, is bound to start impacting the economy.
US election: Elephants versus Donkeys
The US Presidential election is another potential catalyst for market volatility. Our base case is that Democratic Presidential Nominee Joe Biden will win and the polls support this. However, we acknowledge that polls have not always been accurate in the past and President Trump does have a reputation for being the “comeback kid”. We believe that volatility is likely to come, not solely from the policies of the winner of the election, but the uncertainty of outcome. If Biden does win, but the election results are to be close, it is unlikely that President Trump would concede defeat easily, which could cause a great deal of market volatility.
Besides this, overall a Biden win could be positive for markets given his reputation for being predictable, which could provide some stability. The Democratic Presidential Nominee could also be positive for foreign relations as he is likely to take a different approach from President Trump, especially with respect to China, but the policy direction towards China should remain hawkish. In addition, Biden’s policy agenda includes fiscal stimulus such as infrastructure spending on renewable energy and he has an aim of achieving a Carbon Pollution-Free Power Sector by 20355. This would of course be negative though for the oil and gas industry.
There are also some potential market negatives under a Biden administration such as tax rises, though they do not appear at present to be extreme5. Biden is proposing to increase corporation tax to 28%. However, this is likely to be a longer term goal and he is unlikely to unwind President Trump’s tax bill6 if the economy is struggling. Our initial analysis suggests that the total corporate tax plan could lead to a 7% - 10% reduction in S&P 500 profits. However, markets could experience a shock from an increase in regulations and a revamp in anti-trust rules, particularly for market favourites such as technology companies.
Dovish Fed remains supportive, but what does this mean for inflation?
The Federal Reserve (the Fed) has certainly played its part in supporting the economy. In the past the Fed has acted in anticipation of a rise in inflation. However, in support of markets the Fed recently announced a significant philosophical shift in how they determine policy. The new Average Inflation Targeting (AIT) framework7 would allow higher inflation during recovery periods. US inflation has been more resilient than expected, but in line with this change in the monetary policy framework, the Fed has not responded to expectations of rising inflation. Rather they have remained dovish and assured markets that they will continue to be accommodating, helping to anchor the volatility. In their update7 they announced that their target inflation is an average of 2% over time, meaning that after periods of low inflation (below 2%), they would allow inflation moderately above this for a period6. We expect core inflation to move back towards 2% over the next 12 months. However, there is a longer-term risk that inflation will rise due to excess reserves.
Investment positioning as animal spirits awaken
Investors’ animal spirits may be beginning to wake up to the fact that the momentum driving the market cannot continue forever. This is given the underlying fundamentals, the severity of the economic backdrop and an apparent lack of appetite on the part of US politicians to continue to deploy stimulus, which means we will not receive the same scale of support we have seen. With what many anticipate will be a contentious US election battle and an incumbent President unlikely to concede a loss, significant volatility could be ahead and we believe this warrants defensive positioning.
RISK CONSIDERATIONS
There is no assurance that the Strategy will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this strategy may be subject to certain additional risks. There is the risk that the Adviser’s asset allocation methodology and assumptions regarding the Underlying Portfolios may be incorrect in light of actual market conditions and the Portfolio may not achieve its investment objective. Share prices also tend to be volatile and there is a significant possibility of loss. The portfolio’s investments in commodity-linked notes involve substantial risks, including risk of loss of a significant portion of their principal value. In addition to commodity risk, they may be subject to additional special risks, such as risk of loss of interest and principal, lack of secondary market and risk of greater volatility, that do not affect traditional equity and debt securities. Currency fluctuations could erase investment gains or add to investment losses. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Equity and foreign securities are generally more volatile than fixed income securities and are subject to currency, political, economic and market risks. Equity values fluctuate in response to activities specific to a company. Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets. Exchange traded funds (ETFs) shares have many of the same risks as direct investments in common stocks or bonds and their market value will fluctuate as the value of the underlying index does. By investing in exchange traded funds ETFs and other Investment Funds, the portfolio absorbs both its own expenses and those of the ETFs and Investment Funds it invests in. Supply and demand for ETFs and Investment Funds may not be correlated to that of the underlying securities. Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the portfolio’s performance. A currency forward is a hedging tool that does not involve any upfront payment. The use of leverage may increase volatility in the Portfolio.
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Managing Director
Global Balanced Risk Control Team
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Managing Director
Global Balanced Risk Control Team
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Executive Director
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