By Horizon Investments

Equity markets rallied across the globe last week, driven higher by two interrelated narratives:

  1. More stimulus is coming regardless of who wins in November.
  2. A Blue Wave scenario is likely bullish for markets, because Democrats would stimulate much more than Republicans.

We’re skeptical of this latest price action. But lacking a good fundamental anchor due to economic uncertainty, we think it would be unwise to fight it in the short-term. Perhaps earnings season, which starts on Tuesday, will provide that anchor.

The S&P 500 rallied 3.9% last week, its biggest weekly gain in 3 months. International shares lagged (MXEA +3.0%, MXEF +3.8%), as all the action is around U.S. fiscal support. Small caps performed very well (RTY +6.4%), building on recent gains in what feels to us like continued short covering and position-squaring after a year of extreme price divergence. Further collaborating that view, despite the optimism on stimulus, growth led value last week and the tech-heavy NASDAQ outperformed [Figure 01]. These areas had already seen positioning decline.

Market very optimistic on stimulus deal

Erratic stimulus headlines drove whippy price action last week. The market is very optimistic on a deal and it feels a bit vulnerable here: Senate Majority Leader McConnell, not the President or the Speaker of the House, is the one that matters, and he’s been circumspect. His push to fill the vacancy on the Supreme court began with hearings on Monday, October 11th, and that tells us where his priorities are at the moment.

Election odds shifting in favor of a Blue Wave

Odds are rapidly shifting in favor of a Blue Wave in the upcoming election [Figure 02]. A Democrat in the White House and a change of the guard in the Senate are, as of this writing, almost 30-point favorites in betting markets, a shift of about 15 and 25 points, respectively, since the end of August. Neither the President’s recovery from Covid nor last week’s Vice Presidential debate changed the race materially, and time is running out for Republicans.

Amazingly, this development is being welcomed, not feared, by equity investors. That’s because of the market’s focus on stimulus and its belief that Democrats will spend first and tax later. We’re not so sure, especially if a large margin of victory allows for some defection from moderates. We’ll be watching close Senate races, in particular.

Risk of contested election decreasing

If polls and betting markets are to be believed, then it does reduce the risk of a contested election. Last week’s 5-vol plunge in the VIX future that covers the November election is further collaboration of the market pricing in a Blue Wave [Figure 3].

Yield curve steepened last week

Sticking with the theme of more and greater fiscal stimulus, the yield curve steepened again last week, led by higher long-end yields, with the U.S. 10-Year Treasury up 7 basis points (bps) and the 30-Year up 9 bps. The 5-Year versus 30-Year spread touched its highest level since December 2016, when optimism around tax cuts and infrastructure spending by the incoming Trump administration drove the 30-Year just north of 3% in yield [Figure 04]. It closed last Friday at 1.57%.

Credit had another strong week

Credit had another strong week as optimism abounded on stronger growth prospects from more spending, without the associated hurt to profitability of additional taxes. Investment-grade (IG) spreads fell 8 bps and high-yield (HY) fell 41. That’s a 68-point fall in HY spreads in just the past two weeks, which we think is a poor risk/reward set-up going into the upcoming election and cold and flu season.

Fed reveals disagreement over implementation of new framework 

The Fed minutes last week indicated more disagreement than previously believed on the details of the implementation of their new policy framework. While we think this debate is largely academic — the Fed is dovish no matter what and will support asset prices if they drawdown — it does shed light on whether their policy will actually be effective in generating sustained inflation above their target.

If they can sustain that level of inflation, then steeper curves, a weaker U.S. dollar, and value equities can outperform. If they can’t? We expect more of the narrow market we’ve seen already, with tech leading and long-end rates remaining depressed. This is an important distinction that, to us, too few are discussing in the market today.

China’s currency continues to rally as Covid grips Europe

China’s currency continues its rally and the USD is on the backfoot. New regulations announced by the People’s Bank of China over the weekend to make it less expensive to hedge against currency weakness have reversed some of last week’s strength, but the medium-term effectiveness of such policies remains to be seen.  Fundamentally, China’s manufacturing is booming, supporting its trade flows and leading to currency strength. But Covid is playing an impact too; European cases continue to spike and localized lockdowns, once completely off the table, are being discussed again in the UK, Spain, and France, while the Asia region continues to maintain control over the virus.

What to watch now

Stimulus Talks
Stimulus talks are hands-down the most important thing we’re paying attention to in the short-term. While the White House and Secretary Mnuchin continue their negotiations, we will be watching Senate Republicans. Leader McConnell holds all the cards here, and proposals from his camp have all been piecemeal and below 1 trillion, a far cry from the headline negotiations reported in the media. If anything can pass before the election, it is something in that ballpark. As November 3rd approaches, the odds of even a package in that range decrease every day.

Presidential Debate
While this Thursday’s Presidential debate has been cancelled, each campaign is planning to hold an event that night. And we will likely get some clarity this week on the fate of the final debate, currently scheduled for October 22nd in Nashville.

Covid Cases
Covid cases have skyrocketed in Europe, as last week the continent saw 100,000 daily reported cases for the first time ever. With no sign of relief in sight, countries and cities across Europe are now contemplating new lockdowns. Here in the U.S., Covid cases are also on the rise, especially in the upper Midwest, a key voting area in the upcoming election. The market is not paying attention to this – stimulus overweighs everything – but it could become a focus if a major European nation reinstitutes broad lockdowns similar to March and April.

Earnings Season
The official start of Q3 earnings season kicks off on Tuesday. Little has been said about what earnings could look like, but expectations have been increasing all quarter. Typically the trend is the opposite – expectations are pared down ahead of time only to be exceeded by actual results. With a lot of optimism built up around earnings, it feels similar to the market’s view on the stimulus talks.

U.S. Retail Sales
The September U.S. Retail Sales Report comes out on Friday. Consensus is for a modest gain over August. Retail spending has underpinned this U.S. recovery so far, and the market will need to continue to see strength to confirm the optimism built into markets.

University of Michigan Consumer Sentiment Survey
The consumer is still the hero in the U.S. recovery story, but for how long can we expect consumers to remain resilient without additional stimulus? The UMich Consumer Sentiment Survey for October comes out on Friday. Consensus is for a slight increase from last month’s levels.

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Originally published by Horizon Investments, 10/12/20


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