Stocks sold off in September following a rally led by the tech giants, causing Robeco’s multi-asset portfolio managers to maintain the more cautious, more neutral approach that was initiated in August.
“While global real activity levels are still well below pre-Covid-19 levels, financial markets have already come full circle,” says Van der Welle, strategist with the multi-asset team. “After the sharpest post-recession rebound since the 1930s, equities were running low on fuel in September.”
“Within the riskier segment of the fixed income market, spreads had already compressed to levels that are normally observed years after a recession peak. Supported by the massive crisis relief issued by central banks and governments, risk premiums compressed much faster than in previous post-recession rebounds.”
“At this juncture, investors face several short-term risks that could derail the current recovery in both the economy and asset prices.” These risks are led by the increasingly rancorous US presidential election, now less than a month away, with the waters further muddied by President Trump’s positive test for coronavirus, Van der Welle says.
“US election risk has clearly become top of mind for investors, next to the Covid-19 pandemic,” he says. “Measures of volatility such as the VIX index show that the market is worried about the aftermath of the US presidential election on 3 November.”
“First, it is unprecedented that the incumbent US president is unwilling to give guarantees about a peaceful transition of power, saying instead that every election outcome that does not show Donald Trump as the winner is rigged.”
“This raises the odds of a contested election. An additional source of uncertainty is Trump’s positive test for Covid-19 as it raises more questions than it answers for the market.”
“Second, markets had expected to see successful negotiations about a fourth fiscal stimulus package between Democrats and Republicans after Congress returned from recess. The logic of the situation dictated that both parties had a strong incentive to agree on a package to appease their voters ahead of a general election. Instead, a stalemate ensued.”
Van der Welle says bipartisan sentiment in the US Congress then worsened following the death of Supreme Court liberal judge Ruth Bader Ginsburg. President Trump ignored pleas to allow the winner of the presidential election to choose her successor, and instead nominated the conservative judge Amy Coney Barrett.
“This has raised the bar for a bipartisan agreement in the US Senate about future financial stimulus to combat the economic effects of coronavirus containment measures,” Van Der Welle says.
“Even the recent plea for more fiscal support from Fed Chairman Jay Powell has not created the sense of urgency in Congress needed to prevent a fiscal cliff – a duration gap opening up between the immediate crisis relief and the onset of a self-sustaining recovery.”
Meanwhile, the ability of central banks to prop up markets with multi-trillion stimulus packages is waning, Van der Welle warns.
“Excess liquidity is still ample, but it is plateauing, and no longer accelerating,” he says. “It was the acceleration of excess liquidity that supported the expansion of price/earnings multiples which drove stock prices higher.”
“The focus of investors will therefore now shift more to underlying earnings growth capacity and thereby to potential risks to the ongoing economic recovery.”
“In the face of these near-term risks, it seems tempting to scale down risk further. The options market’s implied probabilities for both the S&P 500 and high yield market clearly show that risks are skewed to the downside for the next three months.”
Then there is the continuing influence of rising coronavirus infections as a result of restrictions being eased, leading to new economically damaging lockdowns.
“In our view, the Covid-19 resurgence in advanced economies is worrisome, but seems a far lesser risk to us than the first wave,” Van der Welle says. “Better tracking, better testing and better treatment mean fewer hospitalizations, with a lower fatality rate reducing the odds of new total lockdowns.”
“There has been a clear negative correlation between the number of deaths and the economic impact of containment measures in the second quarter of 2020. Lower fatality rates in the second wave would also imply a lower hit to economic momentum. In addition, we are getting closer to the announcement of a working vaccine that can be produced and distributed globally.”
In summary, it is too early to pile back into equities or the higher-returning parts of the bond markets, Van der Welle says.
“Our base case remains that the global economy will continue to improve, even as the low-hanging fruit has been picked,” he says. “We expect activity levels to continue to increase, albeit at a slower pace, and monetary conditions to stay extremely accommodative, with central banks willing to act if necessary.”
“Nonetheless, a cautious stance is still warranted, as the nature of the near-term risks is important. In a market that is running on fumes, the near-term outlook is clouded. The US election aftermath could be a ’tail that wags the dog’ type of risk. We await more attractive entry points to shift further out on the risk curve.”
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