A confluence of winter headwinds
In direct contradiction to the Fed’s view that its emergency credit programs should be continued, outgoing Treasury Secretary Mnuchin surprised markets last week by declining to extend most of the Fed’s 13(3) credit facilities beyond the end of the year.
This negative surprise is taking place at exactly the wrong time as investors are facing a rapidly darkening winter with rising Covid-19 waves, an air-pocket of economic weakness exacerbated by the disappointing lack of fiscal support in the US, and rising risks of a major default or bankruptcy which could negatively hit sentiment.
While the governments in US and Europe are unlikely to re-impose complete lockdowns, the increase in restrictions will hurt their nascent economic recoveries.
In the US, the recovery is losing momentum: retail sales rose only 0.3% MoM in October after gaining 1.6% in September, and initial jobless claims unexpectedly increased to 743k in the last reading from 711k in the week before.
Daily mobility data as tracked by Google’s activity index has rolled over in recent weeks and suggest that global consumer goods spending will be negatively impacted in November.
Question is whether market looks through to vaccine-driven recovery in 2021
We should remember, however, that the market is forward-looking.
If the Covid-19 surge or winter economic slowdown is much worse than what the market expects, or if there is a surprise major default or bankruptcy which triggers sharp risk-off sentiment, then we would see near-term volatility.
Otherwise, it is more likely that the market would look through these near-term headwinds to the 2021 vaccine-driven recovery.
We can take a clue from how the US market remained relatively supported in September and October, despite the sharp disappointment against expectations that Congress would pass an important relief aid package before the end of the year. Eventually, the market looked through to the fact that a new fiscal relief package will likely come in 1Q 2021 regardless of a Biden or Trump win.
Today, a vaccine-driven economic recovery in 2021 seems increasingly clear. The results from the Pfizer, Moderna, AstraZeneca, and Gameleya Phase 3 vaccine trials have all been positive, and we expect updates from the Novavax, Johnson and Johnson, and the Sanofi trials in the coming months.
Our base case is that there will be more than one effective vaccine globally, and we expect at least one major drug-maker to receive FDA regulatory approval by 1Q 2021.
Maintain constructive stance through near-term challenges; we are buyers of major dips
Directly after the US election, we upgraded our overall equity views to overweight, and our timely increase in risk exposure captured the post-election and vaccine news driven rally.
We believe that the long-term risks for markets have eased significantly with a favorable US election outcome, meaningful progress on vaccine development, and global monetary policy still very supportive of risk asset prices.
Despite some reversion in the underperformance of value versus growth stocks over the last two weeks, the fact that value stocks’ valuations still look skewed suggests to us that the vaccine-driven recovery ahead is not fully priced into markets.
We also see higher odds of further Fed easing ahead after Treasury Secretary Mnuchin’s refusal to extend the Fed’s 13(3) programs. In the event of market volatility, we believe that the Fed will be likely to expand asset purchases to support sentiment, safeguard normal market functioning, and sustain the economic recovery. As we have seen so many times since the GFC, asset purchases ultimately boost risk asset prices.
We will maintain a constructive stance through the near-term challenges discussed above and will be buyers in the event of a major dip.
In equities, we prefer Asia ex. Japan, which will benefit from further US dollar weakness ahead and a resurgent Chinese economy which is leading global growth.
In fixed income, we are underweight Developed Markets Investment Grade bonds as we expect the yield curve to moderately steepen ahead.
We are overweight Emerging Market High Yield bonds, particularly Asian High Yield. Despite default rates rising from a low base as the Chinese government is selectively allowing weak companies to default to reduce moral hazard issues, we have a favorable long term view on this asset class which provides attractive carry.
It is also a beneficiary of a weaker US dollar, the strong Chinese economic recovery, and the global search for yield as rates are expected to stay ultra-low for a prolonged period.
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