Across developed countries there are signs that the recovery is slowing and the evidence of a second wave of the COVID-19 virus is likely to check the return to normal. September flash PMIs mostly held above the important 50 expansion figure, however, Services PMIs declined, especially in Europe where the reading fell into contractionary territory under pressure from growing new cases. Conversely, China seems to have weathered its own second wave quite well with statistics suggesting that domestic flights have returned to pre-COVID levels and consumer confidence seems to be growing[i]. The National Bureau of Statistics announced third quarter GDP grew 4.9% year-on-year and retail sales in September were up 3.3% from a year earlier. China is expected to be the only major economy to post positive growth in 2020 which could be good news for other countries in the region.
Although demand for capital goods continues to support the global recovery it is unlikely, in our opinion, that this can be sustained in the fourth quarter as fiscal stimulus is reduced and employment comes under pressure. The recovery has been uneven across countries and although the demand for goods and residential housing has been strong, the services sector remains severely depressed. There is a limit to how far the consumption of goods can substitute for lost consumption of services and the momentum looks likely to slow into the fourth quarter. Activity should start to level out after the post-lockdown bounce as localised lockdowns are introduced to help combat a second wave and the US Presidential election in November adds to uncertainty.
We believe the fundamental outlook for growth and earnings will be challenging for risk assets and, although valuations eased over the past month, growth stocks still hold historically lofty valuations and traditional value sectors remain in deep value territory. The equity rally has become increasingly concentrated, with Technology stocks the clear beneficiaries, while the stocks and sectors most affected by the pandemic are still significantly lower than pre-crisis levels. There have been attempts to rotate into undervalued assets during the recovery but the growing fears over the spread of new cases means such moves have not been sustained. However, it is difficult to see past equities as an investor with so many asset classes on stretched valuations. We continue to favour a cautious approach to equities based on valuation, cash flow, and the ability to navigate a changing landscape.
The level of support offered by government bonds in an environment of weaker equity prices has been somewhat compromised due to low yields. The extra premium offered by corporate bonds may therefore seem attractive even though they are historically tight. The US corporate bond markets have been supported by Fed purchases which have kept certain borrowers from default. However, the US High yield trailing 12m default rate was above 6% in August[ii], with speculation that it will move significantly higher over the next nine months as the recovery slows. It is our opinion that this plausible increase in the default rate is not properly priced into credit markets.
Some are calling this a K-shaped recovery because while there have been some spectacular winners equally there have been clear losers. We see that the hospitality sector is struggling to cope with social distancing and the industry employs many young people on lower incomes who have relied on government support to survive. Therefore, as emergency fiscal support is withdrawn, we would expect to see a score of people, who are currently listed as temporarily unemployed or on furlough, transition to full unemployment during the fourth quarter with its inevitable effect on growth.
It is difficult to see how the service industry will be able to recover under social distancing measures until a vaccine can be approved and mass-produced, but the efficiency of the vaccine will also affect the return of consumption to pre-COVID levels. With two frontline trials being temporarily suspended this week the path to approval remains as uncertain as always, but market sentiment seems to remain linked to vaccine news flow.
The full extent of economic scarring may become more evident as fiscal stimulus is tightened, negotiations between Republicans and Democrats seem to have hit an impasse that is unlikely to see a new US package agreed before the Presidential election. The markets are likely to remain volatile in the run up to the election with further anxiety over the possibility of a contested result. In our opinion the market has priced in a Biden win and Democrat “sweep”, which would be less likely to be contested, and the likely larger fiscal stimulus injection. This result would add further support to risk assets as it seems to us that a Trump victory would now see an adverse reaction by equity markets.
September was touted as a decisive month for Brexit and an EU trade deal because both sides have previously stated that any deal would have to be finalised by mid-October. However, little progress has been made and the issues surrounding fishing waters and fair competition policies remain unresolved. We have increased the risk of the UK leaving without a deal to high. Even if a deal can be struck, we expect the result to be minimalist providing little support to businesses, leaving the UK economy to suffer under significant levels of uncertainty.
Finally, the Fed’s move to average inflation targeting has substantially increased the inflation risk premium in markets even if the expected slowdown in the fourth quarter reduces the pricing pressures within real economies. We continue to favour the defensive qualities of commodities as one of the only asset classes to benefit from inflation. The recent dollar weakness has favoured emerging market equities particularly in countries that benefit from rising commodity prices. However, more recently the dollar’s safe haven qualities have seen it strengthen and the expected slowdown in the recovery will place pressure on emerging markets once more.
[i] Barclays Global Outlook – Glass Half Full – 24th September 2020
[ii] Absolute Strategy Research – Investment Committee Briefing for October – 02/10/2020
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