- Elements of the election remain in question, but expectations of a divided government have the markets expecting less change under a new administration.
- Surging COVID-19 cases, election uncertainty, and doubts on additional stimulus all contributed to a spike in volatility and a roller coaster October for equities.
- Q3 earnings have surpassed expectations but failed to overcome the markets’ macro concerns.
- Bonds drift lower and long-term interest rates are on the rise, as the yield curve steepens to its highest level since early 2018.
- The U.S. dollar has been weakening since a pop in March—could this be the beginning of a new long-term trend?
What Piqued Our Interest
This year has been plagued by uncertainty, and to no one’s surprise, the U.S. elections fit squarely into that box. As we write this, questions still linger regarding final vote tallies and the unique circumstances of a large contingency of voters casting their ballots remotely. However, major media outlets are declaring Joe Biden as the President-elect, and markets are cheering that there will likely be a balance of power between Congress and the White House, as the Senate looks like it will remain in Republican hands. A balance of power or gridlock tends to lead to more sensible legislation that doesn’t become unglued as the pendulum of power swings from one party to the other. While fiscal spending may underwhelm in this scenario, this development is likely to continue to favor the status quo regarding capital gains and corporate tax rates.
We believe that there will be another stimulus package; it’s more a question of “When?” and “How large will it be?” The stimulus package will likely come in on the smaller end of the range discussed prior to the election—but still in the vicinity of $1 trillion. While less likely in this scenario, if COVID-19 cases and hospitalizations continue to rise nationally, and the approval is prolonged until after inauguration, the package could grow to a larger level and include or be followed by much more spending in infrastructure.
Judging by early stock market reactions, sectors that were potentially subject to higher taxes and more regulation under a Democratic sweep are benefitting from the potential gridlock, as Information Technology stocks rallied in the days after the election. And as it appeared that Republicans would retain the Senate and hold the line on the size of a stimulus package, markets also quickly priced in the likelihood that low interest rate policies will remain in place for the short-to-intermediate term—if not the long term. That scenario tends to favor stocks that often require access to capital, such as growth stocks.
So, where do we go from here? With new daily COVID-19 cases reaching all-time highs, reservations on the timing of a safe and effective vaccine, and threats of more government-mandated closures, we still have an abundance of uncertainties.
Building up to the election, volatility had risen to its highest levels in months and could remain elevated as COVID-19 cases surge or if election uncertainty lingers on. According to the CBOE Volatility Index, implied volatility is now near its highest level since late May and has been on the rise since the middle of summer. We contended for some time that volatility was likely to reemerge—especially given the stark differences in election outcomes we may be facing and the inevitable second surge of the pandemic and possible forced closings.
However, economic normalization also continues in many areas of the economy, and the Bureau of Economic Analysis recently reported that U.S. GDP came at an annualized rate of 33.1% in the third quarter. Again, we recognize this was on the heels of the second quarter, which saw the worst decline since the Great Depression, but when coupled with strong earnings recently (more on that to follow), there is reason for optimism regarding American business overall.
Figure 1: CBOE Volatility Index
In corporate news, third-quarter earnings results have far exceeded analysts’ expectations, although the market reactions have been mixed. As is usually the case, most of the good or bad news for company earnings is largely priced in by the time earnings are announced, and in this quarter, investors have been clearly more focused on macro trends like the election and pandemic. In aggregate through October 30, with 64% of S&P 500 companies reporting, 86% have surpassed analyst expectations—marking the highest level recorded since 2008, according to FactSet. For the most part, companies that beat estimates have mostly underperformed in the days after earnings release, and vice versa for those that missed, according to research by Bank of America. This is not shocking, as the uncertainty we’ve been navigating in 2020 still has companies in the S&P 500 estimated to report their largest yearly decline since 2009.
It was a roller coaster month for U.S. equities in October, as the broad market indices rallied after the September selloff but then forfeited those gains in recent weeks. A rapid increase in new COVID-19 cases, hospitalizations, and fears of increased lockdown measures were all attributable to the market’s late-month drawdown. For the month, the S&P 500 finished lower by 2.66%, which was the lowest return for the large-cap index since March. For the first time this year, Technology was the worst-performing sector, falling by -5.1%, followed by Energy, which declined -4.4%. On the positive side, Utilities rose by 5%, and Communication Services edged higher by 0.8%. It was a rare occurrence that value stocks performed better than growth stocks—particularly for companies further down the market cap spectrum.
Small caps notably outperformed large caps in October, as a trend of relative strength has become more evident. Figure 2 below clearly shows that large caps performed better versus small cap stocks from the middle of 2018 (when the China trade war escalated) up until March 23 of this year, when the Fed came to the market’s rescue. But since that time, small caps have outperformed large caps by almost 7%, as the Russell 2000 is up about 53% compared to 46% for the Russell 1000. Only time will tell if this trend continues, as it is not unusual for small caps to lead the way out of a recession. The real question is whether the recent strength in small caps will carry over into other cyclical stock sectors—most notably Energy and Financials, which have lagged the rest of the market for several years running.
Figure 2: Price Return of Small Cap Relative to Large Cap
Another area of strength recently has been emerging markets, which increased by 2.06% in October and is now positive on the year (+0.87%). Perhaps this is a reflection of the market’s outlook on the election, as emerging market stocks are often seen as a proxy for global growth, and many felt that Biden’s policies would be less antagonistic for global growth and trade. Most of October’s gain was attributable to China, which makes up almost 42% of the index, as the MSCI China index rose by 5.29% in October and is now up 22.61% YTD. Taiwan and South Korea, who make up about 25% of the EM index, have rebounded as well, with Taiwan up 1.3% in October (+15.98% YTD) and South Korea up 0.64% (+5.28% YTD). Meanwhile, MSCI EAFE, the international index for developed countries, has continued to lag other domiciles, primarily due to weakness in Europe.
The broad fixed income indices were modestly lower in October, mostly because of weakness for long-term U.S. Treasuries. While short-term rates remain anchored close to zero, rates for bonds with 10 or more years of maturity have spiked, as the yield curve is now at its steepest level since 2018. This led the long-term U.S. Treasury index to fall by 3% in October, which was the worst performing of all major fixed income sectors. The U.S. Aggregate Bond Index was down -0.45% in October but remains positive 6.3% YTD. Corporate spreads drifted a bit lower during the month, as the yield on a AAA corporate bond now fetches about 1.55% more than a 10-year Treasury bond, while the spread for a BBB bond is roughly 2.6%. As we observe below-investment-grade debt, spreads widen to about 5.2% above the 10-year Treasury, which is slightly below the 20-year average of about 5.47%. The High-Yield index was one of the only fixed income sectors that recorded positive performance in October—up 0.51% and 1.13% YTD after being down roughly 20% in the first quarter.
The U.S. dollar has generally been weak since peaking in March at the height of the market selloff. Sustained periods of improving global growth often correspond to a weaker dollar, and there is a widely held belief that the dollar is somewhat overvalued. Though, this isn’t to say the dollar is likely to crater from its current level, especially given the uncertainty of COVID-19 and the likelihood that increased volatility will cause another flight to the quality of the greenback.
However, in the medium to long term, there are several factors that support the dollar’s decline. For one, the U.S. has higher interest rates and inflation expectations compared to most of the developed world (albeit both are still low). Of course, several other factors impact exchange rates, including growth rates, debt levels, political stability, capital flows, and myriad other considerations. If we do see further depreciation of the dollar, historically, this has been a tailwind for emerging market countries with dollar denominated debt, as well as U.S. exporters.
Figure 3: GDP & Market Returns Since 1950
Source: LPL Financial
Though former Vice President Joe Biden appears to be returning to the White House, the markets may continue to be volatile and fluctuate. We will likely see reversals of popular trades that were predicated on one party winning, but in the long run, we believe the overall results may not be so consequential.
As you can see in Figure 3 above, going back to 1950, many of the best-performing years in the market occurred under a divided government. And regardless of who is in charge at the time, the U.S. economy and the market have proven to be resilient over the years. Companies will adapt to the new regime once it has been established, and from there, the economy will continue its recovery. We can only hope that the results come sooner rather than later.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Series 7 & 63 Securities Registrations,1 Series 65 Advisory Registration† Chris has advised high-net-worth families and institutions since 2001. In his role, he incorporates his extensive knowledge managing public and private investments, including private equity and real estate. Prior to joining Wealth Enhancement Group, Chris was a portfolio manager and principal for a Dallas, Texas-based RIA, where he oversaw due diligence and portfolio management and...Read More