A View from the Yield Curve

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Equity markets are painting a confusing picture, trading at all-time highs despite the ongoing pandemic and its impact on the real economy. Indeed, the jobs report last week posted a larger than expected decline in non-farm payrolls.

This month we seek to situate current markets within historical business/monetary policy easing cycles and evaluate its implications for forward looking market returns.

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A Persistent Conundrum

Imagine being told on January 1, 2020 that the coming year would be plagued by a highly infectious global pandemic leading to global lockdowns, 14% unemployment at the peak, and over 22 million jobs lost. Very few would have guessed that the S&P 500 would end the year in the black, much less above its average long-run return of 10%. Yet as of writing, the S&P 500 total return index stands at +16.27% year-to-date, defying all expectations. This month we explain why we believe this to be the case and propose allocation strategies for the coming year.

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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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Election Day Jitters

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In the past months, COVID-19 has dominated both headlines and markets, overshadowing the coming U.S. presidential election in November. We expect this to change as fall arrives. This month, we examine market behavior around presidential elections as a guide to when and how this year’s election may have a discernible market impact.

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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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Gold in the Time of Money Printing

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Money, money everywhere

A consequence of the extraordinary speed, breadth, and magnitude of the monetary and fiscal responses to COVID-19 is that money supply has increased at an unprecedented rate. The most commonly-used measure of money supply, the Federal Reserve’s M2 measure, has grown by over 12% ($1.9 trillion) since the beginning of this year and is expected to grow even more as the Federal Reserve implements the asset purchase commitments that it announced last month.

Investors concerned about the potential impact of this monetary impulse may be interested in assets whose prices are responsive to an increase in money supply. In this month’s market commentary, we examine how one of humanity’s oldest stores of value—gold—may behave in the current environment.

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Charting the Course for COVID-19

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March saw the COVID-19 pandemic explode across developed market economies, most notably in the United States and Europe. Governments imposed lockdowns that brought consumer travel, leisure, dining, and entertainment activities to what is essentially a total halt of indefinite length. Markets crashed precipitously: at its extremes, the S&P 500 fell over 30% from its February peak.

Gauging and pricing the impact of COVID-19

We view the market decline in March as pricing in the first-order effect of higher risk premiums associated with a series of upside surprises to the spread of COVID-19 and its impact on developed markets. In a recently released draft paper by the National Bureau of Economic Research (Alfaro et al., 2020), the authors show that changes in aggregate stock returns are forecasted by day-to-day changes in the predictions of simple models of the spread of infectious diseases. For this month’s commentary, we produce a simplified model of the same using data from the Johns Hopkins Center for Systems Science and Engineering. 

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