Monday Digest 5 October
Posted 5 October 2020
Overview: October begins with the most unsurprising of surprises
October announced itself in truly dramatic fashion. In the US, COVID reality appears to have finally caught up with the reality-show president, although – somewhat characteristically – confusion and misdirection over the seriousness of his condition continues to swirl. Meanwhile, in the UK, the month began in an equally unnerving, yet predictable, manner, with public divisions over the most appropriate reaction to the second COVID-19 wave growing by the day, and with economic pressures ratcheting up from seemingly never-diminishing uncertainties over a ‘deal-or-no-deal’ Brexit. It never rains but it pours. If there is one thing capital markets investors dislike, it is uncertainty, which we have in abundance.
On balance, however, we can see improvements in what will drive economic and market fortunes beyond the immediate short-term time horizon. The noises coming from Westminster that negotiation progress with the European Union (EU) is being made, reconcile with our observation that 1) both sides have an even bigger economic interest in reaching amicable economic divorce terms than before, given the imperative of swift economic recoveries on both side, and 2) because of the UK’s regrettable underperformance – both in terms of public health and economic damage sustained from the epidemic – there should be less appetite from the UK government to risk a ‘Brexit crash’ scenario.
With continued substantial fiscal support from governments around the world coming into sync with central banks’ monetary support policy measures, the argument that the so-called ‘reflation trade’ will lead the world back to economic expansion (and thereby improving corporate earnings) is gaining validity. Should the US change political direction, and regain its former status as the world’s preeminent growth engine, this will increase the possibility of a meaningful upswing in the global trade cycle.
This may sound like a very bullish scenario for stock markets, but investors should remember that much of the effectiveness of recent monetary policy has been to bring forward future capital return potential from yielding assets by suppressing the yield of the secure alternative investment – fixed interest bonds. While an economic rebound would prompt a further upward movement in share prices, the really substantial moves are more likely to be found when investors begin to rotate their interest from the darlings of the low growth past – that profited most from the low yield environment – to those that benefit most during cyclical recoveries and perhaps even rising yield expectations.
Why economists are increasingly positive about a Biden victory
Last week was an extremely good one for the Democratic presidential nominee. After a decidedly ugly TV debate, Betfair Exchange puts the odds of a Joe Biden victory at around 60%, up a meaningful 5%. Last Friday morning’s news that Trump has contracted COVID-19 and is now hospitalised, is unlikely to turn things around for him, given he has always portrayed the danger of the virus as exaggerated and often refused to wear a mask. Given this now also robs him of about one-third of the remaining campaign time, the only way this could slightly play into his hands is if his course of infection turns out to be very mild.
Barring any more October surprises, a Biden victory has become the most reasonable base case. At first glance, that seems like a negative for capital markets. Trump has made deregulation and tax cuts a central part of his economic policy, while Biden’s plans involve an estimated 12% hike in the effective corporate tax rate – roughly back to where it was under President Obama. But in our view, economic growth would drive up corporate profits, and would likely more than offset the effects that tax hikes might have on equities over the medium-term. We would expect fixed income bond markets to remain orderly, and therefore a re-rating of equity valuations should not outweigh the benefits of improved profit growth. Indeed, it might mean that real yields move further down, the scenario which has historically been supportive for risk assets.
That said, should US corporate taxes increase while inflation runs hot, US bonds and large cap equities would become relatively less attractive compared to their global peers – pushing down the value of the dollar. That situation – a booming US economy with a weak dollar – has historically been a major boon to the world, even if US equities themselves do not reap a benefit relative to other regions. Emerging market assets would do well out of this, particularly if a Trump loss led to a less impulsive US trade policy. In particular, the US tech superstars could face tougher times. If the Democrats do indeed sweep the election (winning the Presidency, House and Senate) we see better investment opportunities in sectors like materials and industrials – the classical cyclical winners.
September PMIs reveal the key stumbling block for the global economy
Throughout the middle of this year, we saw an impressive bounce-back in economic activity. Purchasing Managers’ Indices (PMIs) published in June were all firmly in positive territory, indicating expansion from the lockdown lows, and showing that firms were indeed optimistic about the speed of the recovery. It may not have come as a complete surprise, but that quick rebound tempo has slowed since. Survey numbers for September – while still in expansionary territory – have slipped, suggesting the road back to normal may be longer than it looked previously. What is particularly concerning, however, is the fall back in the services sector, which has shown a clear deterioration from the summer.
To see more upside from here – both for the economy and for markets – we will need to see further signs of positivity. But without another short-term fiscal boost, things could get difficult over the coming months. We have already seen additional fiscal expansion in Europe and the UK – even if the furlough replacement scheme has proven somewhat disappointing relative to its predecessor – but the key market mover would be further fiscal action in the US. Both sides agree that more spending is needed, but the details – and bitter political differences – keep getting in the way. With fiscal support measures now dwindling, individuals have begun drawing down their savings – pulling liquidity out of the system. This is happening just as economic positivity is also tailing off. These two factors combined – in the absence of a significant fiscal boost – would be bad news for investors.
China confirms that reports of globalisation’s demise are greatly exaggerated
Fiscal stimulus showdowns in the US stand in stark contrast to activity on the other side of the Pacific. China’s policymakers have shown considerable fiscal resolve throughout the crisis, and show no sign of letting up. Although monetary policy has been far from loose compared to other major markets, China’s recovery is going strong, aided by a generous fiscal drive and a surprisingly positive global trade environment. China is also clearly boosting other emerging markets in Asia, with export demand greatly benefitting manufacturers.
China’s economic recovery – particularly the growth in exports – is significant. At the onset of this crisis, there was much talk about the threat that COVID posed to global supply chains, and how this would affect economic policy going forward. The coronavirus has undoubtedly laid bare the dangers of globalisation: by relying on foreign industries for goods or vital services, nations can find themselves cut off in times of crisis. And yet, the supposed shift away from global trade towards greater self-reliance is not playing out in the data – if China’s export figures are anything to go by at least. The status quo clearly benefits China’s exporters, and, indeed, manufacturers around the world. The fact that manufacturing has held up well – despite the apocalyptic warnings at the onset of the pandemic – is a good sign. But manufacturing strength cannot compensate for the deepening weakness in services.
This is somewhat to be expected. Even if governments want to localise supply chains in future, the immediate problem is the recovery from the world’s deepest-ever recession. And, when businesses and consumers are struggling for solvency, they will opt for the cheapest option, regardless of where it comes from. The prophesised reversal of globalisation may indeed be one of the long-term effects of this pandemic, but while the global economic recovery is ongoing, this scenario it is unlikely to play out.
This material has been written by Tatton Investment Management and is for information purposes only and must not be considered as financial advice. We always recommend that investors seek financial advice before making any financial decisions. The value of investments can go down as well as up, and investors may get back less than originally invested. All calls to and from our landlines and mobiles are recorded to meet regulatory requirements.