11/16/2020 | News release | Distributed by Public on 11/15/2020 15:58
Having personally lived through the New York lockdown, then hotel quarantine as I relocated home to Australia, I thought the days when time stood still might be behind me. However, October turned out to be a long month - waiting for the first Tuesday in November felt exhausting.
My inbox overflowed with scenario analysis, expert commentaries and alternative data tracking sources. We now know that most of that proved to be worthless as the widely projected 'blue wave' didn't materialise. Nor did the eventual 'worst outcome' of a gridlocked Washington (Biden plus a Republican Senate) result in a market sell-off. One prediction that does look to be validated was Republicans keeping hold of a Senate majority (at least until the Senate run-off for Georgia in January) which, while not decisive, did swing in the Republicans' favour from mid-October, dragging risk assets lower as the odds of an enlarged fiscal stimulus in the US fell.
Under the shadow of the US election and rising COVID-19 infection rates, markets struggled in October, with the most cyclically-sensitive areas hit hardest. European equities (DAX −9.4%) and oil (WTI −11%) were among the poorest performers as investor concerns focused on falling demand and renewed shutdowns across Europe. US equity markets were not immune to this negative sentiment, falling for their second consecutive month (S&P 500 −2.7% and Nasdaq −2.3%). In fact, apart from fixed income markets eking out small positive numbers, the only markets to register gains were those linked to China. Emerging market equities were a beneficiary, rising 2.1% during October.
Growing certainty among the geopolitical risks
Geopolitical risk is a chronic problem that is likely to remain for the foreseeable future. We will continue to see periods of elevated tensions around flashpoints like elections. However we believe that we are unlikely to return to a world focused on globalisation in the nearterm. No matter what the outcome of the election, we were positioning for more stability and certainty. The mere fact that a potentially volatile event has passed leads to a level of increased confidence. Combining this view with the principle that we had no information edge on the outcome, we did not position the portfolio for any single result.
One trade we did add to the portfolio during October was to sell out-of-the-money S&P 500 puts. The trade was designed to benefit from the higher implied volatility around the November election which, no matter the outcome, we expected to diminish once the result was known.
October delivered more positive news on Australian lockdowns, with considerable easing of restrictions in Victoria and state border re-openings. Unfortunately, after a relatively successful summer, Europe is now experiencing a second wave as it enters into the colder months. This second wave appears to be worse than the first, with daily infection numbers eclipsing those seen in the first wave and as yet no signs of stabilisation. These numbers could be impacted by higher levels of testing today; however, the double-digit positive test rates are still cause for concern. Despite higher infection rates, the death rates are not rising by the same magnitude, still sitting below first wave levels. While this is a positive, European countries including Germany, France and the UK were forced to re-institute lockdowns to contain infections as hospitalisation rates soared, pointing to ICU capacities being reached in a matter of weeks.
The market outlook
Dovish messaging continued from central bank policy makers, including negative rates chatter from the Bank of England and the Reserve Bank of Australia, telegraphing further interest rate cuts and the inception of quantitative easing (QE). While the RBA stopped short of negative rates at 0.1%, their announcement of a six-month AUD$100bn QE program will be stabilising. In this ongoing low rate environment, we undertook three main actions in the portfolio. We moved our Australian government duration 'out the curve', favouring 10-year maturity which will benefit from additional QE. We also continued to deploy cash into higher quality investment grade Asian credit, which is offering a considerable yield pickup versus western peers. Finally, we reduced our exposure to Australian mortgages, as their yield is now less than 1%.
With the US election now effectively out of the way, the outlook for markets is somewhat clearer. We know that monetary policy will remain supportive across both developed and emerging markets. Fiscal stimulus will remain in large and increasing scale across much of the world; however, the significant increase in budget deficits for the US expected in a 'blue wave' scenario is no longer realistic. Instead, a split US Congress signals no material change to current market conditions. Any significant increase to the US budget deficit will require an additional, substantial economic shock - otherwise Senate Republicans are likely to resort to the usual Washington politics of partisanship and horse trading.
As far as US policy goes, we expect a move back towards realignment of global allies through the likes of re-signing of the Paris accord. We do, however, see a continuation of a harder stance against China, as that policy has always had bipartisan approval. We may see the current trade tensions subside; however, we expect Biden to continue to hold firm against China, especially in the areas of technology and intellectual property.
Our portfolio position
Most developed equity markets pulled back in October, impacted by uncertainty around the US election and a potential fiscal package, as well as a continued resurgence of COVID-19 throughout Europe, which resulted in lockdowns across a number of European nations. There were some bright spots, though, with Australian and emerging market equities both producing positive returns. The Q3 earnings season in both the US and Europe is about 80% reported and has generally been quite positive, with a majority of companies beating analyst expectations and large surprises to the upside on average - though the market reaction has been more muted, as it had already priced in much of the upside.
While we remain moderately cautious on equity markets given extended valuations, we have continued to add to risk at the margin, through selling additional out-of-the-money S&P 500 put options. That allows us to collect a premium while the VIX is still trading at a relatively high level of over 30, while ensuring we effectively buy back into the market should the S&P 500 fall to the 3000 level.
October saw a divergence in global bond markets. In the US, long end yields increased as the market began to price in the prospect of a Democratic sweep in the US elections and a subsequent increase in projected fiscal expenditure. Meanwhile bond yields in core European markets moved in the opposite direction as a number of countries moved towards another lockdown. The Australian market was little changed. Credit spreads tightened moderately at the global level, while in Australia they were flat.
Over the month we made a few changes to our fixed income positions, though overall portfolio duration remains at 1.75 years. We continued to add to our diversifiers by adding 1.5% to Asian credit, taking the total allocation to 5%. Meanwhile, we have sold down our Australian mortgage holdings to 2%, given sub-1% yields and limited liquidity. Finally, we tweaked our Australian duration holdings to hold more of our exposure on the longer end in anticipation of the subsequently announced RBA QE program, as opposed to the shorter end which is already anchored.
The AUD was sold off during the month as markets priced in the prospect of an RBA rate cut and a QE program, while the US Dollar (USD) saw some moderate strengthening against other developed market currencies. While our overall portfolio level FX exposure remains unchanged, we have shifted some of our USD exposure to Japanese yen (JPY) as it has greater valuation support and is expected to perform strongly in a risk-off environment.