Stuart Katz, Chief Investment Officer, November 11, 2020
Overconfidence refers to the phenomenon that people’s confidence in their judgments and knowledge is higher than the accuracy of these judgments. For example, a person who thinks their sense of direction is much better than it actually is. Before the election, both the prediction markets and capital markets direction of travel priced a 65% likelihood that Joe Biden would win the presidency and a roughly 55% probability Democrats would also control the House and the Senate.1 As a result, many investors tried to time the markets and increase cash holdings in advance of massive tax reform, huge fiscal stimulus and substantial regulatory reform across the economy.
However, the “Blue Wave” did not happen on Election Day. Following the surprise result, the S&P 500 rallied and rotated. Many popular “Blue Wave” trades fell while “divided government” trades rallied. Additionally, the pharmaceutical industry’s announcement that a COVID-19 Phase 3 vaccine trial achieved 90% efficacy is helping to support markets. But what if the “Blue Wave” outcome has only been delayed by two months until the two Georgia Senate run-offs on January 5th? What if the COVID-19 conversation shifts to focus on the complex distribution logistics that rely on super-cold storage technology, infrastructure and geopolitics to deliver it globally?
In the near term, the positive vaccine news has helped value and cyclical stocks lead the way, along with those tied to industries that had been severely disrupted by the pandemic. Simultaneously, some of the secular growth and work-from-anywhere stocks lag behind. Treasury yields increased sharply where the steeping yield curve is an indication of increasing risk appetite and crude oil prices appreciated anticipating more economic activity.
The Investment Office previously published the deciding issues for markets will be the COVID-19 path, government stimulus impact, central bank support and corporate earnings outlook. The rate of change is what matters most to markets and we now have several positive catalysts addressing the aforementioned issues. The cocktail of both stimulus and vaccine will help to revive confidence in business fundamentals and hope that a solution for this pandemic-driven crisis is finally in sight.
However, President-elect Biden will likely have to work with a Republican Senate majority, limiting his ability to implement the Democratic fiscal agenda. Nevertheless, the Investment office expects a $1 trillion stimulus package which should be sufficient for a small positive accelerant to US growth in the coming quarters to help the uneven economic recovery.
More importantly, the second wave of coronavirus infections are offset by better medical treatments to address mortality risks and the prospect of a vaccine to help limit the severity of renewed lockdowns around the world.
Key Investment Considerations
Investors need to be aware of not only the “Blue Wave” and “C-19 Second Wave” but also a wave of corporate and personal debt defaults and asset price impairments because of the uneven economic recovery. As households continue to struggle, loan defaults may rise. Corporate debt has risen sharply as businesses increased borrowings to weather the period of weak cashflow weakening their ability to service these obligations.
Our view of this credit cycle is that the near-term opportunity is primarily in the private markets because of the response in the public markets by the global central banks encouraging excessive risk taking. We believe certain alternative managers can find and manage those private market stressed and distressed opportunities in corporate credit and real estate while utilizing the public markets as an exit tool. With diminished expectations for fiscal help coming from a Republican Senate and several million people still unemployed there will be limited near-term inflationary pressure. The Fed will have no choice but to keep propping up the credit markets.
The better solution to address duration risk is in the equity markets rather than credit. Low discount rates make future earnings streams ever more valuable especially when investing in companies with quality balance sheets and strong business models competing in a bifurcated world of winners and losers. As a result, we expect certain healthcare and technology companies to perform well over time under a Biden divided government. Emerging Market (EM) assets, especially in China, should also continue to perform on improved trade sentiment, weaker US dollar and growing middle class.
While Biden has many proposals, it is important to remember that there is a finite amount of political capital to allocate in his first year in office. We expect the pandemic, economy and social inequalities to be front and center for Biden. With various competing priorities and divided government, his administration will likely focus on regulatory changes where Biden doesn’t require Congressional approval. As a result, the financial services industry could expect some headwinds that shine a spotlight on areas such as (i) fair lending laws, (ii) affordable housing finance, (iii) consumer protections and (iv) bankruptcy reform. Additionally, the fossil fuel energy sector and corporations could expect changes that facilitate the longer-term durable trend towards clean energy. For example, the US is behind the curve in the use of electric buses. According to CleanTechnica, China already has 420,000 e-buses in operation, whereas Europe has around 2,000. The US is a laggard, with only about 600. As a result, we anticipate an increased focus on sustainability under a divided government, but through regulatory actions, rather than via tax policy or spending on green infrastructure. Finally, further investigation of Big Tech companies is likely in 2021, but it’s difficult to see the two parties reaching consensus on how to deal with them. Strong action by Congress or the regulators to break these companies up seems less likely with a divided Congress especially as the geopolitical landscape lead by China is increasingly partnering with its tech leaders to develop global champions.
A divided government scenario is about limited tax reform and fiscal stimulus. In essence, it is about small policy changes that won’t change secular fundamental trends and continues to put more macro pressure on the Fed whose tool kit is less expansive than February 2020 although not exhausted. Ultimately, it’s the time in the market – not timing the market – that will help investors achieve their long-term goals. A thoughtfully prepared financial plan is critical to constructing a prudently diversified portfolio that addresses both near term capital preservation and long-term growth. The use of certain asset classes, active managers and thematic exposures will help build investor confidence to stay invested across various market drawdowns, economic cycles, political regimes and other sources of uncertainty.
2 Morningstar as of 6/30/20. U.S. stocks represented by the S&P 500 Index, an unmanaged index that is generally considered representative of the U.S. stock market. Past performance does not guarantee or indicate future results. Index performance is for illustrative purposes only. You cannot invest directly in the index.
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