In early November a contagious optimism has led to a strong acceleration of markets despite the evidence of a GDP contraction in Europe in the fourth quarter and a worrisome COVID-19 dynamic in the US. A powerful cocktail composed of politics and healthcare is pushing investors to look beyond short-term challenges and to price in a better outlook in 2021.
Has political risk disappeared? The US election delivered our base case scenario and with a more limited margin than what polls mentioned, as expected as well. The attempts of Donald Trump to contest the election will probably go nowhere. Political risk seems to have dissipated, along with a now lower probability of both a corporate tax hike and an ambitious fiscal stimulus.
Have all uncertainties vanished though? In our view, there are three low-probability elements to monitor. First, the run-off election in Georgia for the Senate which is critical for Republicans to secure the Senate. Second, the transition of the oval office will be by no means a smooth process and Trump appears to intend to bully other countries until his last day as President. Thirdly, with a pandemic that continues to accelerate, how are markets to react to a political gridlock with a Congress incapable of agreeing on emerging measures?
Is the vaccine a game changer? Not in the opinion of Christine Largarde when it comes to the European Central Bank (ECB) economic forecasts. But the reality is that it is improving significantly the outlook for 2021 with lower probabilities of further lockdowns, and a greater chance of a broader cyclical rebound. So maybe Ms Lagarde’s comments refer to the short-term risks that would justify injecting additional stimulus.
From a market perspective, the vaccine is a real game changer; investors and traders may have overreacted to the Pfizer surprise announcement by dumping violently quality and momentum stocks and rushing to cover their short positions on value and cyclical sectors.
The succession of reflation/goldilocks1 regimes these past weeks has been a source of headaches for portfolio managers, as they had just been removing their hedges on technology on the back of a divided Congress.
Nevertheless, this positive news flow will not lead central banks and governments to stop the stimulus any time soon. Credit markets are positioned for an extension of the ECB stimulus, which will absorb a significant proportion of the euro investment grade market, whilst lower rates boost equity valuations. Can we have it all at the same time though? Is it reasonable to think that we can have an acceleration in the recovery next year and a recovery of value stocks without a harmful steepening of the yield curve?
This Santa Claus narrative relies on a narrow path that is probably only sustainable temporarily: a global growth recovery without a recovery of inflation. Central banks have already warned that short-term overshooting of inflation will not derail their dovish stance. But controlling the entire curve is another story. In the end, it is a credibility call: as long as the market is persuaded that the vaccine will not shorten the forward guidance, we should not worry too much on steepening. The second risk lies in Forex markets. The now very consensual weakening call on the dollar should not be too rapid, otherwise it may jeopardise the long expected recovery of European equities. Meanwhile, optimism seems to bring investors their Christmas presents before Thanksgiving, which has already been a technical turnaround point for markets in the past. As usual, the long- term is more certain than the day to come...
(1) Goldilocks : an economy that performs well without creating inflation and which enables central banks to remain accommodative: “not too hot or too cold but just right”... as the popular children’s story says!
Monthly House View, 19/11/2020 release - Excerpt of the Editorial
November 26, 2020