Macro Research: August 2020

August 31, 2020

We believe the market is well positioned to go higher. To be clear, when we think about the long-term, we are concerned about the potential return profile of both the debt and equity markets. The COVID-19 pandemic has caused a rapid and extreme policy shift. While the virus may prove to be temporary the consequences of the monetary and fiscal response will be felt for years to come. Through unprecedented stimulus, and open market purchases, governments around the world have synthetically fixed short-term interest rates. The result has been record high valuations in the equity market, and historically low yields in fixed income. Said another way, policy response has brought forward future asset price returns.

Absent sizeable and sustained nominal growth it is difficult to predict outsized public market returns in the long-term. However, it is this exact scenario that leads us to be constructive in the short-term. We struggle to imagine a scenario where short-term interest rates will meaningfully increase. Deficits have exploded, and central banks have lost faith in their own ability to create inflation. Any increase in rates would cause significant funding issues at the expense of government sponsored social services. We do not see this as a likely scenario. In fact, the Fed’s balance sheet has recently breached the $7 trillion mark, making further gains in the S&P more likely as the S&P 500 P/E trades in lock-step with the balance sheet of the Federal Reserve.

The Bank of America Fund Manager Survey is a valuable tool in gauging institutional investor sentiment. According to the survey, the biggest “tail-risks” in the market are (1) COVID-19 second wave, (2) a US-China Trade War, and (3) the upcoming election.

While a resurgence of the virus in certain regions seems inevitable, we believe that any meaningful revival will be met with further unprecedented stimulus and subsidies. In fact, the US government seems to be on their way to announcing another large stimulus program – surely a positive short-term signal for equities. The US presidential election may cause a risk to the market through tax legislation, and certain sectors (e.g. Healthcare), but not meaningful enough to detract from the positive momentum.

While flare ups relating to the US-China trade war could temporarily dislocate markets, we believe the largest risk is an unforeseen credit event. Delinquencies are rising and the employment situation remains unclear. An unforeseen bankruptcy, or a tranche failure in the loan market, may cause a significant panic and draw out a significant amount of liquidity which would undoubtedly cause a volatility spike and a concern about stability. At the moment, however it is essential to remain invested. There is still a significant amount of cash on the sidelines, and with yields at all-time lows, there is still room for a sizeable rotation into equities. According to the fund manager survey, long cash is still the fourth largest crowded trade. While we know these are uncertain times, we believe it is not the time to stand in the way of momentum.