Friday, 16th of October 2020
“Nothing is so permanent as a temporary government programme.”
– Milton Friedman
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The pandemic continued to ravish the US, Europe, and much of EM Asia this week, driving significant dispersion across (and within) equity indices. Europe, in particular, is now very much in the coronavirus crosshairs, with the Old World staring down the barrel of a winter wave that has already pushed case numbers up above those across the pond. On Thursday, the pan-European STOXX 600 Index took a big hit (-2.1%) as investors finally confronted this new reality. And, initially at least, the S&P 500 looked like it would participate in the sell-off. But after an ugly open, the index finished the day roughly flat overall. This means that it remains positive for the week ahead of Friday trading… and October is fast becoming yet another month of strong gains for US blue chip stocks. Whether they can keep this rally going ahead of the US Presidential election on 3rd November seems doubtful, but stranger things have happened. Either way, we are quite content to have our portfolio hedges in place for the time being.
The resilience of the S&P 500 in the face of the covid-19 calamity has been remarkable – and peculiar. As of this morning, the index is up more than +7% for the year despite the hurt being unleashed on the US and global economy. The IMF now expects global GDP to collapse -4.4% this year, with a +5.2% pick up in 2021. This means that covid-19 will have cost us all (at least) two years of growth. What’s more, the world on the other side of the pandemic will be more indebted, unequal, resentful, and divided, as well as less educated, free, and competitive. This seems like a recipe for disaster, not one for large stock market gains. But the market today is not trading on fundamentals. Central banks have conjured up a false financial reality to ease the burden on struggling corporates and households, and investors should be wary of cracks emerging beneath the surface. Life support can only last for so long, but with each passing week removing it will become more painful. This is the catch-22 facing all of us, and it is at the heart of discussions in Congress over the US fiscal package. No wonder they seem to be going nowhere.
From an allocation perspective, fixed income is probably the biggest potential risk to portfolios today. IG and HY credit spreads have retraced sharply since the March blow-out and the former are now close to their pre-pandemic levels. At the same time, rate cuts have driven a significant rally in government bonds and made adding duration as a means to find yield even less attractive than before (particularly if the copious money printing by central banks around the world drives a pick-up in inflation in the wake of the pandemic). To be sure, there are many interesting opportunities in special situations distressed credit, while pockets of EM Debt (both local and hard) continue to offer an attractive risk-adjusted return. But traditional DM credit and government bonds just do not look well-priced. Investors are wholly reliant on the Fed and the ECB’s ability to keep a lid on things. And perhaps they will succeed. But for what exactly? A couple extra percentage points of PnL. Great. We are happy to run a little underweight fixed income and look to other parts of the book to generate returns.
On the political front, the most important news this week is that the UK and EU will miss PM Johnson’s mid-October deadline for the end of Brexit talks. Big surprise. If there is but one certainty amid the chaos of the current era, it is surely that Brexit deadlines will be broken. The two sides remain at loggerheads over (1) EU access to UK fisheries, (2) the extent to which the UK can deviate from EU state aid rules and still have access to the single market, and (3) how the whole agreement will be enforced. After so many meetings and summits, it is surprising that there is much left to discuss about these issues so another extension to talks seems a tad pointless. But the optics of a big agreement struck at the last minute after a gruelling final leg are probably too good an opportunity for either side to miss. At the end of this (now 4-year) negotiation, both the EU and the UK will want to claim victory – and that necessitates a large dose of political showmanship. Just this morning, the UK PM has claimed that unless the EU fundamentally changes its approach to the talks, the country will go for no deal on 1 January. Fighting talk. But with only a few issues left to clear up does that really seem likely? The pound has slipped as investors weigh the odds – but not by much. Our baseline view is that a Brexit deal will almost certainly be done and that the end of the transition period will be fairly smooth. However, we are not complacent about the downside risk to sterling (particularly given the hit the UK economy has taken from covid-19). As such, we are not getting long the pound just yet.
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