In this week’s market update: the point of maximum uncertainty as investors focus on a tight US election, widespread lockdowns in Europe, volatile markets, central bank meetings and third quarter earnings season.
There’s no doubt about the main story this week. Investors are focused on the US Presidential election although there is a long list of competing market influences in a particularly unsettling and uncertain period.
As we finally arrive at election day, it is clear that turnout will be huge in what everyone sees as a pivotal vote. The polls continue to point towards a victory for Joe Biden and the Democrats but the margin of error is large enough that any number of outcomes remain possible. Either candidate can plausibly win the White House and it is anything but a given that the Senate will go the same way as the Presidency.
That matters to investors because markets have focused attention on a likely big fiscal stimulus after the election that will only really be possible if there is either a Red Wave or Blue Sweep, in other words a big win for respectively the Republicans under Donald Trump or the Democrats with Joe Biden.
Fidelity’s in-house analysis points to government spending of as much as $8trn over four years if the Democrats control the White House and both the Senate and the House of Representatives with unassailable majorities. That could fall to maybe $5trn in the case of a narrower victory. And maybe only $2trn over the same period if government is divided.
In any of those situations fiscal spending would most likely be supported by suppression of the yield curve by the Federal Reserve which would look to keep interest rates and so bond yields low. There are two benefits to doing this. First, it keeps the cost of funding historically high borrowings manageable. Second, it would be likely to stimulate a return of inflation which in time would reduce the real value of those borrowings.
Usually, Wall Street cheers a split government because it implies that the constitution’s checks and balances will keep the White House under control. This time, however, the market’s post-Covid rally has been premised on a more radical spending solution so there is scope for disappointment if the result is not decisive. These are unchartered waters for US politics.
What is not clear at this late stage is whether we will actually know the outcome tomorrow or indeed within the next few days. With around 100 million people having voted early, more than 70% of the entire 2016 vote, postal votes could have a big influence on who occupies the White House. However, electoral rules in some states mean that counting of those votes won’t even be started until election day or even later. It is thought that the majority of early voters support Joe Biden, so Donald Trump will be relying on a big turnout in person on election day itself.
That opens up the possibility of disputes, challenges and legal action, with the President talking even before election day of consulting the lawyers. In extremis, the Supreme Court could be called upon to adjudicate making the recent shift in the political balance of America’s top court all the more important.
The US electoral system is complicated, and it is entirely possible for one of the two candidates to win fewer votes than their opponent and still land the Presidency because the votes they do receive are in the right place to influence the casting of so-called Electoral College votes. Essentially the election could come down to a handful of key battleground states where a high number of these votes can swing the result one way or the other.
On this side of the Atlantic, investors are keeping one eye on Washington and the other firmly on the deteriorating Covid situation which is seeing widespread lockdowns across Europe. Governments in all the biggest European countries are concerned that their health services will not cope with any further increase in infections and are reverting to the measures they took in the spring to contain the pandemic.
In the UK, this has led to a four-week national lockdown from Thursday in England, although different rules apply in Scotland, Wales and Northern Ireland. The job-protection furlough scheme has been extended by a month and new measures to protect the self-employed as the government faces criticism that it has once again been too slow to act and too reluctant to protect those directly impacted by its stay at home order.
The pre-Christmas lockdown could not have come at a more challenging time for the UK government as it simultaneously engages in last minute negotiations with the EU over the terms of Britain’s departure from the single market. The date of leaving is the only thing that is certain about Brexit, with a trade deal or no-deal exit hanging in the balance.
The central banks on either side of the pond have chosen an interesting week to hold their respective rate-setting meetings but both the Federal Reserve and Bank of England will announce their latest thinking and measures on Thursday. The Fed is expected to sit on its hands so close to the Presidential election. Here, however, the Bank of England is now forecast to extend its quantitative easing programme although probably not to move yet to implement negative interest rates.
With so many negative influences on the markets it is unsurprising that last week was one of the worst for investors since the spring rout. The S&P 500 lost 5.6% over the week, its worst performance since March and markets in Europe were hit just as hard.
Yesterday, as is often the case after a sharp fall, markets rebounded reasonably strongly. The S&P 500 ended 1.2% higher after a 1.4% rise for the FTSE 100. This morning in Asia, shares were also positive with the Hang Seng in Hong Kong 2.3% higher and China’s CSI 300 up 1.2%. That volatility is likely to continue given the unusually large number of known unknowns at the moment.
Investors are concerned that the V-shaped recovery in the early summer was too optimistic. The gloomier view prevailing today is that markets face a solvency challenge, in which companies struggle to survive, rather than a liquidity issue which can be, and was, solved by massive intervention by central banks and governments.
A solvency problem would make the current situation look a lot more like the Financial Crisis, with deep and long-term economic scars, than a natural disaster from which the economy can bounce back quickly and relatively unscathed. The jury remains out on what we currently face.
It’s not all bad news, however. One very bright spot in the outlook has been provided by the third quarter earnings season. With around 60% of results now in on the US side, something like 85% of companies have reported better results than analysts expected. The fall in profits year on year has been about 11% which is twice as good as the 21% fall predicted at the start of earnings season.
Driving that performance in large part have been the tech stocks, many of which reported strong growth in sales and profits last week as Apple, Amazon, Facebook and Alphabet among others all reported numbers on one day.
One interesting aspect of markets today is the way in which bond and equity markets are moving in lock step rather than acting as offsetting influences in a balanced portfolio. This negative correlation between shares and fixed income has been the intellectual underpinning of so-called 60/40 funds, in which investors hold 60% shares and 40% bonds. Over the long run these have delivered a smoother return for investors and have been a core strategy for many advisers.
Other diversifiers, such as gold, have also struggled recently, with the rally in precious metal prices having ground to a halt in recent weeks.
Finally, looking at the technical influences on stock markets, shares certainly look very oversold at the moment. Just 12% of shares in the S&P 500 are currently trading above their 20 day moving average. Back in September around 90% were. It is now more than two months since the US market last posted a new high and analysts are watching nervously to see in which direction shares break out of their recent volatile sideways moving pattern.
The key driver of that may well turn out to be the large, mainly technology-focused shares which have driven the market higher in recent years. A measure of their influence is the proportion of the market’s overall capitalisation represented by the 50 largest shares. It currently stands at 58% which is not far from the 61% they accounted for at the peak of the dot.com bubble in 2000.
Despite this, however, it is hard to see what the trigger for a meaningful reversal of the tech boom might be. Bubbles are usually characterised by excessive valuations. This time around, however, the earnings performance of these big tech stocks has been so strong that it has justified their share price outperformance. The gap between the PE ratio of the 50 biggest shares and the 450 smallest is currently just 5 points (the difference between 30 and 25). In 2000 the gap was 21, the difference between 40 and 19.
The so-called Nifty Fifty could maintain their lead for a while yet.