The Die is Cast

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A rocky October saw U.S. equities drop -2.66% going into the U.S. Presidential election. Negative sentiment from rising COVID-19 cases in Europe and the U.S., combined with the breakdown of Phase 4 stimulus talks and general election risk contributed to the decline. Economic data, however, was more upbeat. Q3 GDP printed at +33% (annualized rate on the quarter) and strong demand for single family homes and durable goods contributed significantly to the snapback. Service sector demand, however, continues to suffer from pandemic restrictions.

Turning to perhaps the most anticipated event of the year, the U.S. Presidential election continues to hang in the balance with vital swing states still within 1% margins in favor of Biden. President Trump has already gone on the offensive, initiating legal action in Pennsylvania and threatening it in other states. Just as important, but much less covered, is the outcome of the U.S. Senate election results. Last month we covered the likely market reaction to a drawn out contested election and this month we focus on the potential impact of a unified government on market returns.

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Twenty Years After

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In September, election risk came to the fore with President Trump refusing to commit to an orderly transition of power while casting doubt on the legitimacy of mail-in ballots ahead of the first round of debates. Developments since the end of September, in particular President Trump’s admission to Walter Reed hospital after testing positive for COVID-19, have further increased uncertainty surrounding the election.

This month we review market action in the weeks following the Bush-Gore election in 2000 as a guide to what may happen in the event of an uncertain or contested election. In that contest, on November 8, 2000, victory in Florida was declared in favor of George W. Bush with a margin of victory of only 1,784 votes. This triggered a statutorily-mandated recount that saw that margin decline to a mere 327 votes. A legal battle ensued regarding whether time consuming manual recounts would be allowed and through what date, with the Supreme Court of Florida ordering a manual recount on December 8, only to be overruled by the  Supreme Court of the United States on December 12, a mere two days after hearing oral arguments.

With the use of mail-in ballots expected to rise significantly in response to concerns over the risks of a spread of COVID-19 in connection with in-person voting, President Trump is already beginning to cast doubt on the legitimacy of this year’s election by attacking mail-in ballots as susceptible to fraud. We look to the Bush-Gore election for guidance on how markets may respond to a contested election result next month.

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The Fed’s Open Secret

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At the annual Jackson Hole Symposium in August, Fed Chair Jerome Powell announced the outcome of the Fed’s multi-year monetary policy framework review. The Fed intends to adopt a “flexible form of average inflation targeting” (or FAIT) that (1) considers only “shortfalls” of employment rather than “deviations” to the upside and downside, and (2) seeks to achieve inflation that averages 2% over time, specifically by tolerating moderate above-target inflation to compensate for periods of undershoot. Powell’s announcement heralded an apparently significant shift from the Fed’s prior “balanced approach” framework, where its reaction function responded symmetrically with respect to the labor market and its inflation target was fixed at 2%, irrespective of the recent past, as described by then-Fed Chair Ben Bernanke in 2012.

Markets reacted with a sharp rise in long-term interest rates, higher market-implied long-term inflation rates, and a steeper yield curve. These moves subsequently reversed, for the large part, in the weeks following the announcement, reflecting a fundamental truth about the Fed’s framework review: as we explain below, we believe the much ballyhooed framework shift simply acknowledges what has been the Fed’s actual policy since at least 2006.

High Tides

Fool’s Gold?

Despite the worsening virus situation, U.S. equity markets posted a robust +5.64% gain in July, on the heels of a healthy June gain of +1.99%. We believe that examining the relative performance of the S&P 500 versus gold reveals a fundamental phenomenon: the flood of money supply resulting from the Fed’s unprecedented quantitative easing policies in late spring continues to drive the performance of all financial assets.

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Mask Off

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The first half of 2020 saw a growing disconnect between financial market performance and economic indicators. Stock market returns as measured by the S&P 500 have been resilient on a year-to-date basis, despite record unemployment and other headwinds dominating the news.

This month we analyze two potential causes of the disconnect and show that while the S&P 500 may be a good index to invest in, it is a poor representation of the broader economy. Specifically, we show that the COVID-19 pandemic has led to (i) heightened disparity of S&P 500 constituent returns and (ii) because of this disparity, S&P 500 index returns have been driven predominantly by a small subset of firms, namely Facebook, Amazon, Netflix, Google, and Microsoft (the so-called FANGM). Because these stocks have relatively low labor input, their outsize performance is not representative of the broader labor market and the overall economy.

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Cutting to the Bone

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February saw the COVID-19 epidemic progress into a global pandemic that now touches every continent except Antarctica. The virus is expected to take a toll on growth not only in Asia, but also in developed markets in Europe and North America. Equities dropped steeply in response to this grim outlook, with the S&P 500 down nearly 16% at the extremes. In response, the Federal Reserve stepped in on March 3 with an unscheduled cut of 50 bps to the overnight federal funds rate (known as an “intermeeting cut” because it occurred between scheduled Fed meetings). Markets rallied briefly on this news before moving on quickly to continue their journey downwards. Lower interest rates may help corporate investment, but they will not get consumers back out to the movies or onto cruise ships.

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