In market terms, Q3 was a positive one for nearly all assets. Stock markets felt some summer relief as stimulus programs continued, the virus eased off and re-openings became more widespread (although some of this is reversing now, unfortunately). Bonds continued to grind out small gains as investors pushed prices higher and credit spreads lower.
We are underway with the Q3 earnings season, but all eyes are turning toward the upcoming election. The polls have been wrong before, but the market is getting more acclimated to the possibility of a Biden victory and possible control of Congress tipping to the Democratic party. There may be medium- and long-term implications of this shift, especially in tax and anti-trust policy. However, for as long as the economy remains weak and the pandemic persists, we would expect to see ongoing (market-friendly) support and a hesitance to pass disruptive legislation, regardless of who wins the election. Fiscal support and the target of government spending may vary in size between the two parties, but all things considered, stimulus and support are likely to persist in one form or another. Again, the polls have been wrong before and we do not want to prematurely assume any outcome to this uniquely complicated election season.
Market Outlook and Q3 Summary
Overall Asset Allocation
Global stock and bond markets rose further in Q3, but it was not a uniform rally. There continues to be dramatic dispersion across markets and within benchmark indices. Therefore, active management remains critical in these times.
Active management does not mean heavy and frequent trading. Instead, prudent application of active management simply means shifting portfolios to the individual stocks, bonds, sectors, asset classes and countries that are in the best position to benefit and ride out current trends, valuation distortions and uncertain news flow. This approach means overweighting the best members of benchmark indexes while underweighting the weaker members. This can be done by specific security selection as well as specific sector selection. In our current holdings, this includes tilts toward quality growth (over value), technology (over energy and others), and US stocks (over international). While we have material active risk in portfolios via these tilts by sector and region, we remain modestly underweight stocks on a dollar basis. We are neutral on bonds on a dollar basis and hold relatively conservative positions within bonds. We have an overweight to cash as dry powder for new investments as opportunities present themselves.
The pandemic has ushered in an era of “borrowing from the future”. Sometimes this borrowing is pulling forward demand (and earnings) in a generally favorable way—for example, companies like Amazon, Zoom, and other related e-commerce and work-from-home enablers have grown their customer base much faster than expected. Their challenge will now be how to retain and continue to monetize those customers in 2021 and beyond. On the other hand, there is also a nerve-wracking level of federal borrowing that has been necessary to nurse the economy through to the other side of the pandemic.
The bond markets have so far comfortably absorbed this additional debt issuance (with some help from the Federal Reserve as needed). This debt will eventually have to be paid back which will be no easy feat. The payback choices available will likely involve a combination of fiscal austerity (via budget tightening and tax increases), growth-fueled surpluses allocated to debt reduction, and inflating some of the debt away (which can erode purchasing power for savers). Per recent research from Fidelity Investments, escaping federal debt burdens via inflationary policies has historically proven to be the most potent and effective of the three options. This path is also coincidentally compatible with the Federal Reserve’s adoption of an average inflation target of 2%, rather than the former limit of 2%, which would imply the tolerance—and encouragement—of higher inflation for some length of time.
Global Equities
The S&P 500 was up 9% in Q3. Despite some spurts of rally for value stocks, growth once again outperformed (+13% versus +5%). On a sector basis, technology stocks, consumer discretionary and all things related to working-from-home and online commerce continue as the market leaders. In Q3, they were joined by sectors like industrials, materials and consumer staples as those sectors saw some bounce on re-opening and recovery optimism. Energy was the only sector with negative performance (-20%). The Dow Jones Dividend Select Index was up 2% in the quarter but continues to materially lag year-to-date. Real estate remains a vulnerable sector, but even there, pockets of opportunity and long-term compounding investments are still available in things like distribution warehouses, digital data centers and cell towers, though hotels, restaurants, and traditional retail and commercial office space have endured ongoing distress.
International indices (as measured by the MSCI All Country World ex-US) were up 6% for the quarter, and the MSCI Emerging Markets Index was up 10%. International equities continue to lag US equities on a headline level. However, active management and regional tilts within global exposure is proving valuable for outperformance. For example, in Q3, the MSCI Asia ex-Japan index was up 11% while MSCI Europe was only up 4%.
Fixed Income
Bonds were up modestly across most markets. Treasuries were generally up less than 1% while subsectors with more credit risk did better, with high yield up 5% and emerging markets debt up 2%.
One of the current debates in the bond market is about the shape of the yield curve. The curve has been extremely low and flat for some time now. As the Fed announces a greater inflation tolerance along with heavy new issuance still coming, the “low and flat curve” could steepen as longer-dated maturities start to command a greater yield compensation over shorter-dated maturities. Q3 saw some tentative steepening and we will continue to monitor changes in curve shape. A steeper curve environment would make adding duration a better risk-adjusted trade-off and would generally offer better re-investment opportunities for client portfolios.
We are unlikely to add any US Treasury positions at these levels. We favor keeping some basic cash along with government agency debt, mortgage-backed securities or high grade corporates given the government support that already exists in these sectors or has been extended via the stimulus programs. Lastly, we expect there will eventually be more opportunities in the high yield market as dislocations, bankruptcies and defaults work their way through the system. In perhaps an early sign of stress, a few particularly unattractive high yield companies were not able to successfully issue debt in recent weeks.
Conclusion
We are nearing the election which could bring volatility and unrest, particularly in a disputed or drawn out result. While this poses serious market risk, we are also getting closer to a resolution of this long-awaited event and the market always craves certainty. Historically, global markets and investors have shown a remarkable ability to adapt once the outcome of any major event is resolved. In this case, an eventual resolution to the US election, the relief that a vaccine would bring and the Fed’s ongoing pledge to keep interest rates near zero, should all combine to allow the global markets to compound higher over the long term, even while moving along a volatile path of intermittent drawdowns. Investors should tactically adjust at the margin to manage risk during short-term volatility, but overall be patient with the core holdings of portfolios built for the long term.
The key challenges ahead will be as much about properly rotating and rebalancing factor exposures within portfolios as it will be about the overall markets. The major rotations that will likely play out once the pandemic era ends are a revival of the value sector as investors rotate out of the crowded growth sector, a recovery of sectors punished by the pandemic (such as travel, leisure, energy and parts of financials and healthcare), relative recovery of international stocks in relation to the US and a rise in bond yields on a recovery in economic activity alongside the Fed’s greater tolerance of inflation.
We have made some preliminary moves to prepare for these rotations and are researching more investment candidates to have at the ready, but we do not see conditions as sufficiently stable to justify dramatic moves yet. We prefer keeping existing themes in place while staying well diversified and maintaining some additional cash for future opportunities. We are hopefully closer to the end of the pandemic than the beginning, but the world is by no means out of the woods yet. There are still credible downside threats to be considered such as the potential for a double-dip recession should the virus remain untamed, especially in a difficult northern hemisphere winter, as well as the potential for political gridlock that holds up additional fiscal support.