Investment Strategy:  Third Quarter 2020 – Market Outlook – Don’t Fight the Fed

It’s the oldest cliché in the book. Ever since the ‘Greenspan put’ of the 1980s and through the years of Bernanke and Yellen the US Central Bank has always cowboyed up and ridden to the rescue. Jerome Powell is cut from the same cloth and it is the mighty wave of liquidity unleashed by the Central Banks as soon as the pandemic struck that has proved so crucial to the market’s strong rebound and enabled it to settle into something of equilibrium for now. The positives are that the rate of infection in developed economies is now well past its peak and the easing of lockdown restrictions has begun, government and Central Bank policy remains very supportive, and there is some optimism regarding the development of a vaccine. The negatives are the possibility of a ‘second wave’ of infections as global lockdowns ease, notably in the US as we have seen in the last week, and we remain very much in the unknown regarding the long-term effects of the virus in terms of public health, economic damage and social and business behaviour.

As we have discussed, the market is ‘looking through’ the current deep recession and anticipating a relatively robust recovery in growth and earnings. Only time will tell if this proves to be wishful thinking because the market direction in 2021 will be principally driven by earnings growth. Ongoing policy support is a given but can’t in itself defy the laws of gravity and push water uphill forever. FactSet is the bible of US consensus earnings forecast and currently projecting a fall of 21% in earnings this year but back to the races with a 29% rebound in 2021. Earnings forecasts need to remain firm and companies need to meet or exceed these estimates for markets to remain in a bullish frame of mind, not least because equity market valuations are now so expensive.

Skeletons in the Cupboard

Ever since February, this has been a ‘one story’ market driven by the pandemic and subsequent policy response. However, other issues are lurking in the background, centring on China and Europe, which could resurface and become strong headwinds.

US/China trade tensions have worsened considerably during the pandemic. Pre-COVID China was increasingly seen as stealing intellectual property and breaking agreed trade rules with impunity, luring the gullible to become increasingly dependent on cheap Chinese goods and services. With China also being blamed for a lack of transparency in its handling of the pandemic and it being an election year in the US, China-bashing will be an open sport in the US, for both Republicans and Democrats. At a Goldman Sachs ‘virtual conference’ we attended last week, former Secretary of State Condoleezza Rice stated that there was currently over 300 pieces of anti-China legislation being discussed on Capitol Hill. China is also flexing its muscles regionally, skirmishing with India and re-asserting its dominance over Hong Kong with the imposition of the national security legislation, which is the first time a Chinese law carrying criminal penalties has been imposed in HK. This marks the end of the ‘one country, two systems’ agreement and end of the promise that HK could maintain its way of life until 2047. It is also a sign that China, like Russia, no longer feels the need to heed global treaties and is increasingly going to be flexing its economic, diplomatic and military muscle.

A no-deal Brexit on December 31st is looking increasingly likely. There is no good outcome here, as the UK exits into a world that, post-COVID, could increasingly be one of trade barriers and tariffs as countries retreat into nationalistic self-interest. Mind you, if we had remained, we would have been on the hook for paying part of the huge Eurozone fiscal bailout. The second half of the year will be full of the bluster, rhetoric, claims and counterclaims that have blighted our lives for the last few years. As usual, all the action will be at a minute to midnight, with a flimsy agreement of some sort likely to be reached, as politically neither side will wish to be seen failing to find an agreement with their largest trading partner in the current environment.

The Eurozone itself is facing the most testing of times. The lack of a common fiscal policy denies it the best tool for combatting recession and the gulf is widening between the ‘haves’ in the north and the ‘have nots’ in the south. Maybe Lazarus can rise though, Mme Lagarde is channelling her inner ‘whatever it takes’ by doubling up the original ECB QE programme to €1.35bn. More significantly, Merkel and Macron have proposed a €750bn ‘recovery fund’ fiscal package raised by the EU on the financial markets, then distributed as grants, not loans, to the weaker countries. This involves a transfer of wealth and would be the first instance of the previously anathematic ‘debt mutualisation’. This is being presented as an extraordinary ‘one-off’ package not a first step on the way to a common fiscal policy and faces very strong opposition from the ‘frugal four’ of the Netherlands, Sweden, Austria and Denmark as well as the German Constitutional Court. Nevertheless, the extraordinary has become the ordinary in government and Central Bank policy over the last decade and this has the sense of a Rubicon being crossed.

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