Affinity Market Commentary September 2020
Technology profit-taking hits US equities
After a sustained rally, US equities ran out of steam in September, with the S&P 500 Index falling by almost 4%. A major feature of the hiatus was technology stocks, which have been the driving force behind the positive index returns this year. The major technology companies each lost around 10% as investors took profits, and the broader market sagged, as investors contemplated the upcoming US election on 3rd November.
Investors seek safety in government bonds
All sections of the global fixed income market returned gains in Sterling terms, as investors adopted a more cautious stance. The poor news flow from Brexit talks, the uncertainty of a US election in November, and the reality of a second wave of Covid-19 becoming evident, meant that money coming out of equities was ploughed into bonds. Government bonds, performed particularly well, in contrast to previous bond market rallies in recent times, which have tended to be dominated by the riskier high yield corporates.
Currencies volatile on Brexit and US election
The pound was noticeably weak during the month, as traders saw the fallout from the Internal Market Bill as potentially setting back the chances of a free trade deal with the EU before the end of the year. This was exacerbated by a stronger dollar, which saw strong gains as the presidential election campaign got properly underway. The dollar remains more than 3% down over the year however, and the consensus expectation from currency traders seems to be that the recent strength will not last much beyond the election on 3rd November.
After five months of recovery, following the February/March falls, global equity markets finally paused for breath in September. With no further news on a possible Covid-19 vaccine, economic data providing no upside surprises and the uncertainty surrounding the US presidential election in November, shares moved mostly sideways. There was no sense that the ‘Fed put’ had disappeared, but with growing case numbers pointing to a second wave, there was little enthusiasm to make further investment into equities after such a strong and sustained rally as we have seen between April and August, and markets drifted.
European stocks generally performed poorly in September, as the major markets, including in the UK, saw virus cases rise sharply back to their highs. The start of a new university semester saw local lockdowns in some major UK cities, and the threat of Paris also being locked down again led investors to focus on the plight of the retail and leisure-related sectors. The end of the UK’s furlough scheme in October fuelled fears of a spike in unemployment, and Germany’s infection rate is also back up to April’s levels, with restrictions being reimposed. There is also a perception that the ECB has not been quick enough in reacting to developments.
Sterling fell sharply in September, as the government introduced the ‘Internal Market Bill’, concerning how the UK government can exercise power over trade with Northern Ireland. The bill is effectively reneging on part of the Brexit agreement, and is seen as making a free trade agreement with the EU less likely, leading to a harsher departure from the Brexit transition period at the end of the year. Amid volatility ahead of the US election, the dollar rose against the pound and euro, but remains down by more than 3% this year. Improving economic data from China saw the Renminbi achieve small gains against the major currencies.
Weaker Sterling and more buoyant fixed income markets saw all sections of the global bond market return gains for unhedged UK investors in September. Unlike the bond market rallies seen in recent times, government bonds were the stand-out performers during the month, as the equity rally appeared to run out of steam, and investors looked to a more risk-off positioning ahead of the US election, and in the absence of any good news. Whilst rates remained steady around the world, the major ten-year government yields all fell, with the weaker EU sovereigns contracting by up to 1%. The major issuers’ yields fell further into negative territory.
*A Generic bond is a theoretical bond that always has the specified tenor, unlike a Benchmark bond, which is a physical bond, with a decreasing tenor.
The US Election
The US Presidential election takes place on Tuesday November 3rd. Joe Biden retains a significant poll lead and our analysis of the betting odds shows Biden increasing his probability of victory as the election date approaches.
In this note we map out 3 scenarios and discuss the likely impact on markets.
The 3 Scenarios are
• Biden wins
• Trump wins – but loses Senate
• Disputed election result
Biden wins – Given where polls currently are, this is the most likely of our 3 scenarios
The first point to make here, is that a Biden victory will almost certainly mean Democratic control of the House and the Senate, pushing the centre of political gravity firmly to the left. Biden is an old school Democrat centrist, in the mould of Bill Clinton. But the party has moved firmly to the left, with the ‘progressive’ wing in ascendancy. A Democratic Congress will be to the left of the President and that could well shape both his policies and his key appointments – watch out who he appoints as Treasury Secretary and see what role he offers to the likes of Elizabeth Warren.
Biden has an extensive platform, certainly more radical than his previous political positions as he faces the difficult challenge of keeping the progressive wing on board. One factor that sank Hilary Clinton in 2016 was her failure to get the Bernie Sanders supporters to come out and vote for her. Biden has moved his platform to the left to keep them on board this time.
Repealing the Trump Tax Cuts seems a certainty. Back in 2017, Trump slashed corporate rates from 35% to 21%. Biden has called for raising the corporate rate to 28%. This will cut earnings significantly as a one-off impact but will be offset by a larger fiscal stimulus package passed by Congress and better trade relations with countries in Europe as well as with China. Wealth taxes sound simple in principle but are very difficult to enforce and may be deemed unconstitutional by the conservative dominated Supreme Court. But personal taxes on the top 1% are certain to rise.
Biden has vowed to expand the Affordable Care Act, the health care overhaul that former President Barack Obama signed into law in 2010. Lower drug prices, at least when it comes to Medicare, are a clear priority for the Democratic nominee. Medicare is the federal health care insurance program for people aged 65 and older, and for those with certain disabilities.
“The Biden plan will repeal the existing law explicitly barring Medicare from negotiating lower prices with drug corporations,” the campaign site reads. This would be a negative sign for healthcare stocks, even more so if someone like Elizabeth Warren was in charge. Healthcare and Biotech stocks are vulnerable as previous comments by Democratic candidates testify.
Back in 2015, candidate Clinton tweeted “Price gouging like this in the specialty drug market is outrageous,” with regard to a life-saving drug that had surged from $13.50 a pill to $750 a pill overnight. She vowed to lay out a plan to combat it. In terms of biotech, iShares Nasdaq Biotechnology ETF (ticker: IBB), the largest biotech ETF on the market, fell almost 5% on Sept. 21 on the day of that tweet. The day after Clinton was defeated, IBB rose 9%, sparking a strong rally in biotech.
Although Biden’s plans in health care may be a bit more nuanced, drug companies are certainly sensitive to politics. That said, health care is a diverse sector, and Biden’s policies may benefit other corners of that sector. Biden will be under pressure to offer the progressive wing some ‘red meat’ in terms of policy and healthcare reform might be it.
Biden’s platform has a focus on infrastructure spending and investing in sustainability and clean energy. This ‘green deal’ is wildly popular with Democrat activists. We could see an infrastructure package totalling over $1 trillion which would benefit the industrial and material sectors that produce heavy equipment or produce materials for roads and bridges and Democrat control of Congress would guarantee its passing – so more Treasury issuance.
Biden would also drive further ESG trends around regulation and support for renewable energy. Less happy would be the Oil and Gas fracking industry which would face much tougher environmental regulations.
The impact from Biden on Tech is less clear. Trump hates the perceived politics of Big Tech, (it is an article of faith for conservatives that social media platforms are biased against them) but Democrats hate their practices. The need for Increased regulation, control of ‘fake news’ context, tax avoidance, lack of competition (Facebook/Google/Microsoft/Amazon) and the impact on ‘Main Street’ (Amazon again) would all be areas that might well see a Democrat Congress take action.
Trump Wins – given where polls are, this seems the least likely of our three scenarios.
The market knows what to expect from President Donald Trump; business-friendly policies, less regulation, tax cuts, tariffs on imports – these are the forces that have helped define the Trump stock market.
Prior to Covid-19, the level of the stock market was Trump’s key calling card in terms of how he rated his economic performance. Whilst initially dubious, (remember the big fall in S&P Futures as the 2016 result unfolded) the market has learned to live with Trump, even his tweets against the Fed and the Chinese.
A Trump victory would mean a continuation of these business-friendly policies and the likely loss of the Senate to the Democrats may even temper some of Trump’s more unusual policy suggestions. The latter may be a double-edged sword. If the Democrats take the Senate but lose the election (particularly if the result is close or disputed), there will be an enormous amount of bad blood between the President and Congress. Not only will bi-partisan politics be impossible (unlike Reagan in the 1980’s and Clinton in the 1990’s), but Congress could then go on the offensive in terms of impeachment, debt ceiling approvals etc, which would be bad for market sentiment as Congress and the White House would be engaged in a war of attrition.
A disputed result – the worst possible outcome
America has a federal system, which means that each state has its own rules around elections, in terms of how votes are cast and crucially how they are counted. The 2000 election is a prime example (remember the ‘hanging chads?’), but maybe 1876 offers an even more extreme portent of what might be coming down the tracks. It is possible that the result may not be known in the days after the election and it could eventually go to the conservative majority Supreme Court.
If the result looks too close to call and if Trump ramps up the rhetoric about mail-in ballot fraud and we see examples of voter suppression, then we can expect to see increased volatility across the financial markets and not just in the USA.
Back in 2000, George W Bush used legal arguments to stop recounts in Florida – Trump might use other methods. A disputed election, particularly where the incumbent refuses to accept the result, would be by far the least palatable of results for the market.
What Does History Say?
Markets tend to perform best when the party in the White House has some opposition in Congress. Markets like moderation and between 1950 and 2017 the two best-performing combinations for the S&P 500’s performance were: a Democratic president with a Republican-controlled Senate and a Democratic president with a Republican-controlled House.
From 1952 through to June 2020, annualized real stock market returns under Democrats have been +10.6% v +4.8% for Republicans, but whilst the data shows this, it does not prove cause and effect. Clinton had the best returns, George W. Bush and Nixon the worst – but it is a big leap to claim that the market returns specifically reflected the policies of the President. Whilst historical correlations are interesting, they are not predictive.
Biden remains sufficiently ahead in the polls that a Biden victory remains the most probable outcome. Biden’s stated policies, if enacted, would doubtless impact sectors like health care, energy, industrials and materials. There are some general winners, like companies with large exposure to sustainable energy, and losers, like pharma stocks selling drugs to Medicare at large mark-ups. But as ever, it comes down to policy specifics and what can get passed. In that sense, the Senate results may have just as much of an impact on markets as the race for the White House.