“Angle the deflector shield”

That was what Han Solo said to Chewbacca when they were escaping from the bad guys. In September, investors were also angling their deflector shields while trying to prepare for some uncertain events. This led to a sell-off in risk assets, especially equities. However, the traditional assets for hedging, such as U.S. government bonds, offered limited offset to the latest bout of correction. The deflector shields did not really work. This makes asset allocation more challenging going into the final quarter of 2020. 

The virus, the cliff and the vote

The U.S. and global economies rebounded robustly in 3Q 2020 on the back of containing the virus and aggressive monetary and fiscal stimulus from central banks and governments. The U.S. has recovered over 10.6million (mn) jobs in the past four months, compared to the 22.2mn jobs lost in March and April. However, investors are concerned with three things as we approach 4Q 2020. 

The pandemic is still the dominant factor. The number of new infections in the U.S. is off the peak in July, but has not returned to the lows in June. It has rebounded in recent weeks as more states re-opened for business. Europe has been hit by a second wave of outbreaks, although less severe than the first wave in March. Nonetheless, some governments, such as the UK, are re-introducing social distancing policies. Then there are concerns that another round of outbreaks could come as winter approaches. This could combine with the traditional flu season and add to the pressure on the public health care systems. This would extend the economic hardship for many economies, especially those sectors that are already damaged by lockdown measures. 

The economic pain from lockdown would be more tolerable if governments could offer some fiscal support. Compared with the onset of the pandemic, governments are trying to be smarter on the stimulus. Many governments in developed economies are already running huge fiscal deficits, and they need to be mindful of their debt levels. Moreover, the pandemic is looking more like a marathon, instead of a sprint. Therefore, policymakers will need to balance the need to support their economies with fiscal sustainability. In the U.S., there is the added complication of partisan politics in the Congress in passing a new round of fiscal stimulus. The previous round of fiscal support, such as extra unemployment support, mostly expired in August. At the time of writing, the House Democrats have passed a USD 2.2trillion package, but this is likely to be rejected by the Senate, where the Republican Party has a majority. This “fiscal cliff” could undermine the recovery momentum going into October and November, raising the risk of another economic contraction. 

Finally, investors are also monitoring the U.S. elections on November 3. While former Vice President Joe Biden is still enjoying a sizable lead in national polls and some key battleground states, there is still time for U.S. President Donald Trump to close the gap. This means the presidential race is far from a done deal. President Trump testing positive for COVID-19 adds more twists to this race. Moreover, if more voters decide to cast their ballots by mail, vote counting could take longer than expected and prolong the uncertainty, as well as leave the election open to candidates contesting the results. 

All these factors put together have persuaded investors to take a more defensive stance, especially given the strong momentum enjoyed by equities since the trough in March. The U.S. technology sector was the most impacted given previous worries over extended valuations. The NASDAQ index lost 6.1% in September, compared to 5.6% for the S&P 500. The same correction applied to corporate credits and emerging market fixed income, albeit in a much smaller magnitude. For example, U.S. high yield generated a negative return of -0.8% in the month. 

Despite the correction in risk assets, traditional safe havens, such as U.S. government bonds, did little to offset the downside. The 10-year U.S. Treasury (UST) yield remained stubbornly range bound between 65 basis points (bps) and 70bps for much of the month. This breakdown in relationships is partly brought by the expensive valuations of developed market government bonds, and should prompt investors to rethink how they should construct their portfolios so that they can remain resilient when risk assets are under pressure. Gold again proves itself to be an unreliable hedge against such a sell-off, with price of gold down 4.2% in September. In our view, gold would only move in the opposite direction of risk assets if real interest rates are moving down. Since real interest rates were well anchored in this correction, gold did not provide any offset. 

Global economy:

• Economic recovery momentum in the U.S. and Europe is slowing. In the U.S., another round of questions over another round of fiscal stimulus is still hanging in the balance as Congress has yet to find a compromise. This is already impacting hiring decisions and household income. In Europe, a rebound in COVID-19 infections is pressuring governments to re-introduce lockdown measures, and this could get worse as winter and the flu season returns. Central banks in the U.S. and Europe have limited room to provide more support, but their current policies are expected to remain in place for an extended period of time. The Federal Reserve’s latest economic projection shows policy rates are likely to remain at zero at least until 2023. China’s economic recovery is in a more solid position. Investment and production have led an economic rebound since 2Q, and now consumption is also improving. This also means less stimulus would be needed from the People’s Bank of China.
  (GTMA P. 8, 13, 17-20, 29)
• As the November 3 presidential and congressional elections approach, investors are worried by the uncertainty. Ex-Vice President Biden is leading in national polls, as well as a number of key battleground states. However, President Trump tested positive for COVID-19, again adding another variable to this race. There are also concerns over potential delays in vote counting if a sizable number of voters decide to cast their ballot via post, and whether the results will be disputed and contested. All these are forcing investors to take a more defensive position entering 4Q.
  (GTMA P. 23, 24)

Equities:

• Slower recovery momentum, concerns of another wave of infections in the U.S. and Europe, and uncertainties from the U.S. elections in November all prompted investors to take a more conservative position in equities. The S&P 500 was down 5.6% in the month and NASDAQ was down 6.1% given elevated valuations of the U.S. tech sector. Europe followed the U.S. lead on correction with the Stoxx 50 down 4.3% in September.
  (GTMA P. 31, 34, 42, 43)
• Emerging market and Asian equity performance was mixed. China A-shares were down 5.3% in the month despite steady improvement in economic data and industrial profits, and Hong Kong followed. Corrections in India and Singapore were milder since they have enjoyed less of a market recovery than northeast Asia. 
  (GTMA P. 31, 37, 38)

Fixed income:

• The 10-year UST was largely stuck in a narrow range in September between 65bps and 70bps, despite the correction in the stock market. The lack of commitment by the Federal Reserve on more stimulus failed to deliver more direction to the UST yield curve, even as economic data reflected slowing recovery momentum. European government bond yields declined modestly as infection numbers started to rise again
  (GTMA P. 48, 51). 
• Equity market correction also prompted corporate credits and emerging market debt to consolidate in September. The U.S. high yield credit spread widened by 30bps in the month, bringing it back above 600bps. The same applied to emerging market fixed income, as the Asian corporate credit spread widened by 11bps for investment grade and 76bps for high yield. A rebound in the U.S. dollar has brought back some pressure on EM fixed income. China’s inclusion in the FTSE Russell government bond index in October 2021 helped to provide some positive momentum to Chinese fixed income.
  (GTMA P. 45, 47, 55-57)

Other assets:

• Oil prices remain stuck in a tight range between USD 39 and USD 44 per barrel for Brent crude. The slower recovery momentum continues to keep a lid on oil prices. Oil producers are also reluctant to cut output, with a small increase in September exports by OPEC, especially by Iran and Libya. Despite the reduction in risk appetite, the price of gold fell to USD 1870 per ounce in late September. We continue to see that real interest rates are a key driver to gold prices, and lower interest rates are needed to push gold prices back above USD 2000 per ounce. 
  (GTMA P. 63-65)
• The U.S. dollar (USD) index rebounded by 1.9% in September as risk appetite declined. High beta EM currencies, such as the Brazilian real (-7.2%), Russian ruble (-3.9%) and Central and Eastern European currencies were the worst hit. Yet, G7 currencies also gave up part of their 2020 gain, except for the Japanese yen (+0.7%), which is also a safe haven currency. Asian currencies were also relatively resilient, especially the Chinese yuan (+0.8%), given its more solid economic recovery
  (GTMA P. 60, 61).