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The Unreality of Uncertainty

Nov 2, 2020

• A range of possible outcomes of US elections has the markets on edge
• A Biden win with a Democrat Senate still the most likely outcome – but there is no certainty
• A Trump win is an improbable but possible outcome
• Europe back into lockdowns – waiting for policy makers to respond
• October saw correlated negative returns across asset classes

“As far as the laws of mathematics refer to reality, they are not certain; and as far as they are certain, they do not refer to reality.” ― Albert Einstein

Uncertainty from the minute the polls close…
As we go to press, financial markets face heightened uncertainty and nervousness. November 3, 2020, is the official date of the US Presidential election, but it would be a surprising outcome indeed if we knew the result of the election within a day or two of the polls closing. Each state has a different process for counting votes. Given the enormous mail-in vote and much higher turnout early indications of who is going to win could prove misleading. Adding complexity to the process is the fact that despite lagging in the polls, Mr Trump is a statistical shoo-in to win at least some states, while others are too close to call using poll data currently available. In many states, voters are eligible to be counted as long as it has a date stamp before the cut-off date and time. Many of these will arrive well after poll closing data. Where the state in question had a closely run election, delays are a given.

…aggravated by an army of lawyers
Both parties have hired banks of lawyers to argue about the voting process. The only modern-day precedent we have is the contested 2000 election, where it took until December 12 for the matter to be settled. The Supreme Court ruled in favour of George W.Bush, and Al Gore conceded gracefully. But that argument was only about one state. There is a good chance this time will see a multi-state series of legal disputes.

The uncertainty of complex outcomes
Apart from uncertainty about when we will know who has won, there is the additional complication of several potential outcomes. All of them have wildly diverging implications for the USA but also markets. In short-

President Trump plus Republican Senate – more of the same, but more concentrated (if that is possible) as he will know there is no re-election to try and win. On current form, we expect additional fiscal support to be modest. It will be the end of immediate uncertainty but the continuation of long-term geopolitical uncertainty.

President Trump and Democrat Senate – oil and water and probably another go at impeachment! Fiscal support will be up in the air. Anything deemed overly generous emanating from Congress will be vetoed. Markets and the real economy could suffer.

President Biden and Republican Senate – gridlock! Markets will likely be lukewarm at best.

President Biden and Democrat Senate – sigh of relief at the arrival of the blue wave. A solid fiscal package is approved promptly, and markets recover their poise.

The Blue Wave is not the Only Wave out There- Europe faces Lockdowns. Europe is once again taking up its traditional role as a purveyor of gloom as it enters its second lockdown; its edge sharpened by a sense of shock given the confidence emitted by regional governments over the summer. Last week’s third-quarter GDP releases are already looking dated, but they do attest to resilience in manufacturing and exports to the key Asian region. GDP increased by 12.7% quarter on quarter in the euro area, according to a preliminary flash estimate from Eurostat. Output is still 4.3% below the level of the same quarter last year, weaker than the US rebound. Spain, on this basis, looks dire with its 8.7% decline over the previous year. The latest ECB survey of economic forecasters signals a slight upgrade to the contraction in GDP through 2020 from -8.3% to -7.8%, but this will almost certainly be reversed as lockdowns take hold in November.

Labour market trends better capture the underlying loss of confidence with the Eurozone unemployment rate moving up to 8.3% in September as compared to a low of 7.4% in July, even as job support measures remain in place. Meanwhile, the region remains mired in price deflation for the third successive month as fears of secular stagnation (inflation has averaged only 1.2% per annum since 2012) intensify given the pandemic shock and euro strength.

Despite disappointment post the latest ECB Executive Council Meeting last week, markets are clearly being primed for further stimulus in December to address the latest trends in the pandemic as well as a noted tightening in lending standards by domestic banks. This is likely to comprise extended ultra-cheap funding of banks’ loan books and an expansion of the central bank’s asset purchase programme. Where we do think the latest adverse news may have a sobering impact is in accelerating the implementation of the eurozone COVID-related recovery programme which has been bogged down in bickering in the European Parliament.

Assuming a Biden victory next week, based on the latest polling, the euro does look vulnerable into the final months of the year- with a real fear of there still being a total breakdown in Brexit negotiations as the transition period ends.

The Correlated Month of October
A quick look at returns from the past month reflects the growing uncertainty in the market. The two main factors at play are interrelated: the risk of the damage that a second COVID wave brings, coupled with a lack of fiscal action in the US, driven by political paralysis.

A recent increase in volatility reflects the nervous state of play in the market. After the upheaval of March and April of this year, the VIX a measure of equity market volatility has remained at a level above 20, rising occasionally and most recently getting close to 40. Pre-COVID its level was below 20 for extended periods.

Fixed income volatility has likewise risen markedly towards the end of October.
The index jumped above 60 to where it started the year, but a significant hike from the low of 40 seen only a month ago. While the yields on treasuries were dropping, volatility was following suit. Despite the recent rise in yields not being too much more than a brief reversal, it has prompted many market players to pay up for hedging.

Equity markets were generally having a hard time of it, especially towards the end of the month as sentiment become challenged by the two-pronged attack of COVID and stimulus paucity. The S&P 500 ended the month down 2.8%, eroding the gains made post-April and leaving it with a thin gain of only 1.2% so far this year. For once, technology stocks were not the saviours, as the Nasdaq dropped by 2.3% over the month.

It is almost a forgotten afterthought at the moment, but big tech has just released a set of earnings that were solid in most respects. However, forward-looking statements couched in cautionary tones undermined investor confidence at a time when it was already fragile.

It is little surprise that Europe is still the laggard and struggled very badly at the end of the month. Its confidence in dealing with COVID is freezing over as winter approaches. Christmas might not bring much more cheer than the 9.4% drop suffered by Germany’s DAX index in October, followed by the UK’s FTSE which was down 4.9%. The DAX is down more than 12% from its peak. The early part of the month saw investor optimism and talk of a growing European recovery. The UK market remains in the doldrums despite having fallen -26.1% year-to-date. The catalyst for a recovery is not visible at the moment.

In Asia, the broad direction was similar, namely lower. However, in Japan, the decline for the month was 2.8%, much the same as in the US. In China, the CSI 300 index managed to end higher by 2.35%. It is tempting to ascribe China’s resilience to its COVID success: the economy is open again, and the market has returned 14.62% so far in 2020.

Fixed income markets, credit and government, presented an altogether quieter picture in October. Global government bonds rose 0.13% despite such a large proportion of the bonds being on negative yields. US government bonds dropped by 0.94%. However, in both cases returns have been very good in for the year to date, rising 6.25% and 7.88% respectively as bond yields kept on grinding lower despite a very low starting place in January.

USD-denominated credit markets were almost unchanged for the month. High-grade bonds were down by 0.18%, high yield rose by 0.07%, and Emerging Markets were down all of 0.12%. These were minute shifts in the context of the overall market. High-Grade bonds have had a good year thus far, producing 6.45%.

Despite being down 0.51% YTD, the performance of high yield is remarkable in the context of the sheer level of stress the market has had to endure. Default rates have not yet reached the peaks that were possible if the Fed had not intervened. EM USD debt has returned a modest 1.81% so far this year. Local currency debt had a better October, gaining 1.33% on the back of a weaker USD, but is still down 0.3% for 2020.

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