Friday, 4th of September 2020
“Marry the spirit of your own generation and you will be a widower in the next”
– William Ralph Inge
The market melt-up came to a sudden stop on Thursday when US equities sold off sharply and investors simultaneously rotated into value and cyclical sectors at the expense of ‘stay-at-home’ economy stocks. The S&P 500 Index fell -3.5% in its biggest single day decline since mid-June, while the NASDAQ sunk -4.9% on the day as well. Big Tech had just capped off a remarkable run of share price appreciation in August as household names like Apple (+21.7%) and Tesla (+74.2%) soared. Both companies executed stock splits on Monday, right when market optimism peaked, to facilitate even greater participation by retail investors put off by the rising cost per share. However, on Thursday, the two stocks collapsed a whopping -8.0% and -9.0%, respectively, as prices finally collided with reality. Tesla, in particular, which began to fall somewhat earlier in the week, and is now down -18.3% since the end of August, embodies the perilous hype around ‘disruption’. The company’s market cap had flown past S&P stalwarts Visa and Walmart in recent days, despite it producing a mere handful of cars and having seen no more than four consecutive profitable quarters to date. Should future earnings growth fail to meet the extraordinary expectations that are required to justify current valuation metrics, shareholders could be in for a very rude awakening indeed.
To be sure, disruptive technologies are transforming traditional industries and creating whole new ones from scratch. However, hyperbolic forecasts about future prospects and corporate presentations stuffed with the latest technology buzzwords are not a reasonable basis for investors to attach eye-watering valuations to companies with little else to point to. As the coronavirus ravishes the global economy and pushes many traditional sectors to the brink of collapse, it is easy to focus solely on those few that only appear to have grown stronger through the pandemic. But all of them ultimately rely on a real economy, composed of real people, facing real hardship. Moreover, much of the future is inherently unknowable, and diversification is an essential feature of proper portfolio management. The narrowing of the market before this week’s correction was a clear warning to investors that something was amiss. It should have been heeded. With second waves of the coronavirus now well underway in Europe, the US and Asia – and a menagerie of geopolitical risks to the outlook as well – volatility before year-end seems all but inevitable. We are glad to have our portfolio hedges in place.
Besides the economic havoc wrought by the pandemic, one of the biggest risks to the outlook between now and 2021 is the US Presidential Election on the 3rd of November. As things stand, most polls point to a Biden victory. However, Trump has the advantage of incumbency and has been making ground in recent days – including in several swing states. Moreover, the probability of a covid-19 vaccine being approved before the election is increasing. As such, this remains a highly competitive election in which the outcome is far from certain. For markets, both candidates’ platforms have negative and positive aspects. Biden has promised to reverse a number of the Donald’s signature tax cuts (which would be negative for Wall Street), but also to take a softer line on China (which would be positive). Trump, meanwhile, has promised to cut taxes (positive), but also to have a hard-line China policy (negative). Nevertheless, on balance we think that a Trump win would be a better outcome for markets, and equities in particular. For a start, the President is less likely to alter his position before the election because his policies are red meat for his base. Biden, on the other hand, has a position on China that is increasingly out of step with many Democratic voters. We feel that Trump is likely to drag the debate on China so far in his direction in the coming weeks that relations are unlikely to improve materially in the wake of the vote whoever wins. This would more or less neutralise any benefits to Wall Street from a Biden Presidency. In addition, the Donald has suggested that he may not recognise a Biden win and is creating a narrative that the election is already being stolen. A period of political drift could therefore accompany a Biden victory – and this could sow confusion and add to any sell-off in stocks.
A ‘no deal’ Brexit is another substantial risk to the outlook that could crystallise before year-end. The last round of talks ended with no meaningful progress on what have been the main sticking points for months: (1) the role of EU regulations in underpinning the ‘level playing field’ that governs competition between UK and EU companies; and (2) how EU access to UK fisheries is negotiated. New talks are planned for next week, but a resolution must be reached before the end of October for ‘no deal’ to be avoided at the end of the year. Brinksmanship is to be expected at this point in the negotiations when both sides seek last minute concessions from the other – and a Brexit deal still seems more likely than none. But there is a chance that common ground is simply impossible to find. We are watching closely.
Despite the dual risks of a Biden Presidency after a less-than-peaceful transfer of power and a messy no deal Brexit just as covid-19 picks up through winter, the enormous stimulus being provided by central banks and governments around the world will remain a significant prop for markets. What’s more, the Fed has now officially shifted to so-called ‘average inflation targeting’. Essentially, this means that the Fed will now seek to push inflation above its 2% target if inflation has been well below that level for some time. Since inflation is nowhere near target today, and has been depressed for some time, the change of policy signals a dovish bias even if inflation picks up as the virus recedes next year. That means more liquidity for investors who were worried the party would end soon. And equities could yet break new records if and when a vaccine proves to be effective.