We sounded an optimistic note last month, despite an uptick in volatility at the tail end of a heady summer. Low interest rates suggested that technical demand for both bonds and equities would continue, while US and European markets looked set to benefit from the transformative change wrought by the pandemic.
Now, as the days get shorter and a winter season dominated by the coronavirus looms, there is a distinct chill in the air. Markets have been spooked by evidence of a second wave of infections across Europe and news that two large clinical vaccine trials were paused. As governments attempt to preserve economic activity while reducing gatherings and social contacts, striking a balance becomes ever harder and the FTSE 100 recorded its worst day in three weeks in mid-October.
There has also been a steep drop in European inflation, which came in at -0.3% in September. While this could be a temporary phenomenon, it does suggest that more stimulus will be on its way. The picture is similar in the US, where inflation in September was 1.4%, compared to 2.5% at the start of the year.
Meanwhile, deadlock around the US stimulus plan and the upcoming presidential election have acted as occasional breaks on the upward momentum in markets (and particularly in the technology sector).
Reason for hope?
Yet there is evidence of greater breadth within the NASDAQ index, currently the stock market darling of 2020, which suggests that the trajectory of markets is more sustainable. Much has been made of the rising interest in value stocks, as well as materials, industrials and financials. As we near the end of the year – and the US election, which is likely to be followed by substantial stimulus regardless of the outcome – the time seems ripe for a rotation.
For every action, there is an equal and opposite reaction. Despite the uncertain macroeconomic backdrop, certain indicators have been steady. US Q3 GDP – which will be released just before the election – is expected to rise by 34%, compared to a decline of 31.4% the quarter before. The number of initial public offerings has also been high, with a focus on special-purpose acquisition companies. This suggests that cash has been hoarded for acquisition activity, even driven by bottom fishing as certain companies tackle unprecedented distress.
Meanwhile, the number of US companies saying that analyst earnings estimates are too low is three times that of the number saying they are too high. In a similar vein, the ongoing demand for high-yield credit suggests a more bullish outlook. Credit spreads have largely normalised, while bank lending standards have tightened notably. However, this gap has been filled by the proliferation of private credit lenders in recent years and access to capital has not yet been raised as a red flag (see figure 1).
Figure 1. Credit spreads and lending standards
Source: Federal Reserve Bond, Bank of America Merrill Lynch, Goldman Sachs Global Investment Research, as at October 2020.
Equities: a note of caution
Our European Equity team believes that technical analysis shows that markets are in a consolidation pattern, but that momentum remains positive as investors are largely focusing on next year and will likely ignore upcoming company results – particularly poor ones.
There is also concern that the recent enthusiasm for story-led investing may result in a focus on trends, rather than individual stocks – something that can result in troublesome bubbles which are divorced from underlying corporate fundamentals.
Our Asia ex-Japan team also sees this exuberance for stories reflected in the China A share market. Traditionally dominated by retail investors, the market is now seeing more institutional interest. While the industrial-heavy Hang Seng index has been one of the region’s worst-performing indices, the A shares index has recorded some of the best results – in part because it includes more growth names, including technology companies (see figure 2).
Figure 2. China’s A Share market surges ahead
Source: Bloomberg, as at October 2020.
Regardless of the outcome of the US election, the team believes that a new cold war is set to emerge between the US and Chinese technology sectors. This suggests there is considerable potential for homegrown Chinese technology firms, which should flourish as US competitors are precluded from entering the market or exit of their own accord.
Real estate: dispersion remains
Divergence between real-estate sectors continues. The UK market is down 8% year-on-year, while retail has fallen by 19%, offices by 4% and industrials are broadly flat. Rents have fallen by 9% in the retail sector, while office rates have been steady. This is largely due to long leases in the office sector and the fact that occupation by technology firms has held up.
In China, official efforts to lean against a potential property bubble have crystallised around a new traffic-light system that measures developers’ net gearing, leverage and liquidity and nudges them to de-risk their balance sheets. This is a positive development in the medium term, as it will result in healthier balance sheets and lower interest costs. It should also support higher margins, favour quality growth in the region and will likely accelerate consolidation in the sector.