Wealth Management: Market Perspective – While we were away
Kevin Gardiner, Global Investment Strategist, Wealth Management
“The point is that the media likes to predict impending doom, preferably with a firm date attached. And there is something about human psychology that makes us want to believe it.”
False Alarm, Bjorn Lomborg
Contagion varies widely. China has recently been reporting fewer than 100 new cases a day (Wuhan held an eyebrow-raising mass musical pool party in mid-August), but India is reporting around 80,000.
The global picture shows new cases stabilising but not falling much since late July (figure 1 is adjusted for population). The developed world profile reflects a long first wave in the US added to a fading in Europe. More recently, US contagion seems to have turned down in August, as Europe’s second wave emerged. However, developed world fatality rates have fallen materially since the spring, reflecting a younger age group being infected, better treatment and/or more testing.
Ongoing social distancing – which has not stopped economic recovery – may restrain contagion. Governments are understandably reluctant to reintroduce tougher measures: costs are more visible, voters less compliant and the virus a little less dangerous. Global reopening may continue even without a vaccine (which will take time to distribute anyway).
Uneven but ongoing economic recovery
In August, some indicators suggested the recovery was weakening. However, growth rarely proceeds in a straight line even in normal times. More recent data have been firmer, despite that disappointing contagion picture.
The US has replaced half the jobs lost. Reduced unemployment pay has not yet hit US consumers’ spending, and may even have spurred the return to work (many workers had been better off out of work). That said, as noted, the US rebound is very uneven. Retail spending has hit new highs, but some services continue to languish (figure 2).
Global indicators have risen further, and many estimates of the damage done to GDPs and corporate earnings in the second quarter turned out to be overly pessimistic. You wouldn’t know it. Whatever you think the media’s political bias might be, it is firmly tilted towards the sensational.
For example, in reporting the 20% fall in second-quarter UK GDP, the news factories quietly forgot their mid-April headlines in which the unlucky Office for Budgetary Responsibility predicted a 35% drop. To mislay almost a fifth of current-quarter GDP may be the biggest and gloomiest short-term forecasting mistake ever, but there were no headlines proclaiming “Economy was an order of magnitude less grim than we told you it was”. Easy to miss too was the detail showing a sharp turnaround within the quarter (though as in the US, recovery is highly uneven).
Specific anecdotes can also mislead. If a firm makes 1,000 people redundant, it issues a press notice; but if 100 small companies hire (or re-hire) 10 people each, they don’t.
Overall, we still think this alarming downturn, already unusual in so many ways, may prove a relatively short one. As we suggested a month ago, things may be “moving on”.
Sector rotation: are we there yet?
We suggested a month back that US technology and growth stocks overall were expensive, but not a bubble. They rose sharply further in August, and the market rally – led by the famous five (FAAAM) stocks – became even more concentrated. We buy the idea of “looking across the valley”, but this was looking a long way rather quickly.
A setback unsurprisingly arrived. Is this the big rotation we discussed? The US market, growth stocks and the dollar have had multi-year runs, and no tree grows to the sky. Are other regions, sectors and currencies about to take the lead? Or is this just more short-term volatility and profit-taking of the sort seen several times already?
Safe-haven assets like bonds and gold have not responded much. The dollar has actually rallied: it often does when stocks fall, but doing so now argues against a wider rotation, for the time being at least.
Derivative trading (by big institutions, not just retail investors) seems to have been especially active. Implied volatility indices, which reflect the cost of traded options, rose alongside stocks, which doesn’t happen often. Was the derivatives tail wagging the market dog, with option writers buying cash securities as hedges? Hardly edifying, but not suggestive of a bigger picture either.
A rotation is likely at some stage, and may not be as friendly as it sounds. If profits are taken before funds are reinvested, the overall market may be hit. But without crazy valuations, a trigger may be needed – such as a rethink on interest rates (as we said last month, good luck with that), a change at the White House (see below) or a vaccine. We get there when we get there.
Even with interest rates low and bond-buying high, central banks have been looking for new ways of stimulating demand. Now the Fed says it will target an average inflation rate, and worry about employment only when it is unusually low, not high.
This means that if inflation has been running below the 2% target for a while, the Fed will not tighten policy as soon as it returns to target, but wait for it to overshoot for a while too. And it will only be influenced by economic activity (that is, employment) if it has been weak.
Arguably, the Fed has always targeted average inflation: the issue is over what period. Effectively, it will now aim to allow inflation, and the real economy, to run hotter for longer.
Intent is not outcome. As (Lord) Mervyn King notes: “Above all, there’s the question of credibility. If the Fed has tried hard and failed to push inflation up to its 2% target, why would markets believe it would succeed in going further? Olympic high jumpers who fail to clear 2 metres on their first two attempts do not then ask for the bar to be raised to 2.5 metres.”
We have deeper misgivings. Nobody understands inflation very well, and monetary credibility is easier to lose than to gain. The risk may feel small right now, but central banks don’t need to take it. We might sympathise if economies were not reviving – though even then, what could any monetary policy achieve if consumers are not allowed out to work and spend? But recovery is underway.
We can imagine another non-inflationary cycle, like the last. We would relish a late-1800s mix of supply-led growth and deflation, which could boost both bonds and stocks. But for now we think longer-term inflation risks remain, and are positioned for them by holding few conventional bonds. Central banks are taking their targets – even as averages – too literally. Inflation cannot be fine-tuned in the way their models suggest, and it could be dangerous as well as unnecessary to try.