Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
How to structure your equity portfolio post US election
Peter Garnry
Chief Investment Strategist
The second economic crisis in just 12 years, coming just as the wound from the first crisis has healed, has pushed policy to the event horizon of macro. Never in history have global interest rates been pushed so hard towards zero across so many countries, with massive increases in fiscal deficits on top of historically high debt levels.
What lies on the other side of all this? Nobody really knows. But the world is likely in for some exciting and unpredictable years, not least because of the US Presidential election on November 3.
Global equities need a significant jump in earnings
Aggressive policy action in the first half of the year by central banks and governments has engineered a strong rebound in equity markets and a general belief that the world will overcome the Covid crisis with less damage than from the 2008 financial crisis. Global equities have fully recovered their losses during the pandemic’s first wave, despite global corporate earnings collapsing by 56% – catapulting the P/E ratio to 27.7x at current price levels.
Expectations are high going into the third quarter earnings season, with estimates suggesting a 106% jump in quarterly earnings, which will then continue to climb until reaching a new all-time high in the fourth quarter of 2021. If the corporate sector delivers this rebound in earnings, the global equity market will be valued at 19.3x earnings in 2021. Not an unreasonable valuation given the alternatives in bonds.
What lies on the other side of all this? Nobody really knows. But the world is likely in for some exciting and unpredictable years, not least because of the US Presidential election on November 3.
Global equities need a significant jump in earnings
Aggressive policy action in the first half of the year by central banks and governments has engineered a strong rebound in equity markets and a general belief that the world will overcome the Covid crisis with less damage than from the 2008 financial crisis. Global equities have fully recovered their losses during the pandemic’s first wave, despite global corporate earnings collapsing by 56% – catapulting the P/E ratio to 27.7x at current price levels.
Expectations are high going into the third quarter earnings season, with estimates suggesting a 106% jump in quarterly earnings, which will then continue to climb until reaching a new all-time high in the fourth quarter of 2021. If the corporate sector delivers this rebound in earnings, the global equity market will be valued at 19.3x earnings in 2021. Not an unreasonable valuation given the alternatives in bonds.
So how likely is it that corporate earnings will rebound so strongly? The New York Fed Weekly Activity Index, a real-time tracker of US economic growth, has shown a strong V-shaped recovery since late April: although it is still at -5% as of mid-September. At the current trajectory, the world’s largest economy will be back into growth territory before year-end.
The number of permanent job losses has jumped from 1.2 million before Covid to 3.41 million in August 2020, which is high but still nothing compared to 2008, where the number jumped from 1.49 million to 6.82 million (and that was from a lower labour market size than today). According to CPB, world trade volume rebounded 7.6% m/m in June and is on track to continue rebounding. This indicates that things are normalising, even though global trade is in its worst period since the GFC.
The various data points that we have at this point skew the probability towards a rebound of corporate earnings to pre-Covid levels within the next 18 months, but the long-term growth rate from that point on is much more uncertain. The two most important factors for investors over the coming decade will be inflation and volatility in both financial markets and the economy. These subjects will be covered in detail in the coming quarterly outlooks.
US elections have little impact on equities but the VIX curve says this one is different
We have looked at all 31 US presidential elections in the period 1896-2016 to make sense of US equity market performance before and after an election. On average, the US equity market measured by the Dow Industrial Jones Index is flat ahead of US elections and then tends to rise around 3% after.
If we measure US equity market performance in all years during the period 1896-2016, including US presidential election years, then we observe the same average tendencies. A rising US equity market post elections is therefore most likely not a function of election outcomes or related sentiment thereof, but potentially a seasonal effect in the months November, December, and January. However, if one draws 29 out of the 31 elections at random, occasionally the ‘seasonality’ effect disappears. In other words, the statistical robustness of this effect is fragile to sampling.
The number of permanent job losses has jumped from 1.2 million before Covid to 3.41 million in August 2020, which is high but still nothing compared to 2008, where the number jumped from 1.49 million to 6.82 million (and that was from a lower labour market size than today). According to CPB, world trade volume rebounded 7.6% m/m in June and is on track to continue rebounding. This indicates that things are normalising, even though global trade is in its worst period since the GFC.
The various data points that we have at this point skew the probability towards a rebound of corporate earnings to pre-Covid levels within the next 18 months, but the long-term growth rate from that point on is much more uncertain. The two most important factors for investors over the coming decade will be inflation and volatility in both financial markets and the economy. These subjects will be covered in detail in the coming quarterly outlooks.
US elections have little impact on equities but the VIX curve says this one is different
We have looked at all 31 US presidential elections in the period 1896-2016 to make sense of US equity market performance before and after an election. On average, the US equity market measured by the Dow Industrial Jones Index is flat ahead of US elections and then tends to rise around 3% after.
If we measure US equity market performance in all years during the period 1896-2016, including US presidential election years, then we observe the same average tendencies. A rising US equity market post elections is therefore most likely not a function of election outcomes or related sentiment thereof, but potentially a seasonal effect in the months November, December, and January. However, if one draws 29 out of the 31 elections at random, occasionally the ‘seasonality’ effect disappears. In other words, the statistical robustness of this effect is fragile to sampling.
We also looked at daily volatility during the 63 trading days before and after each US election. In the 31 presidential elections from 1896-2016, we observed an average daily volatility of 0.98% before an election and an average daily volatility of 1.01% after. This difference is not statistically significant, however, and as thus we cannot say that elections add to volatility.
The daily volatility of 1.01% after US elections corresponds to around 16% annualised, and is therefore much lower than the current implied volatility measured by the VIX futures curve. Here, we observe implied 30-day forward volatility annualised above 30 for the months October, November, and December. Only the elections in 1916, 1932 and 2008 have seen higher realised volatility: implying that current VIX pricing discounts a true tail-risk scenario. In the event of a contested election, or if Biden wins, it could very well turn out that volatility was in fact cheap prior to the election.
US equity market during the Trump years and Biden’s potential tax drag on earnings
Wall Street analysts got it all wrong arguing in 2016 that a Trump victory would be bad for equities. The US equity market has done quite well during the four years with Trump, despite increasing tension between the US-China that has caused friction for US companies around their global supply chains.
US equity market during the Trump years and Biden’s potential tax drag on earnings
Wall Street analysts got it all wrong arguing in 2016 that a Trump victory would be bad for equities. The US equity market has done quite well during the four years with Trump, despite increasing tension between the US-China that has caused friction for US companies around their global supply chains.
Most of the gains have come from only three sectors: information technology, consumer discretionary and healthcare. These sectors, together with communication services (which were expanded to include social media companies in September 2018), benefitted the most from Trump’s corporate tax reform in 2017. Traditional sectors such as energy, financials, and real estate that one would have thought would have done great under Trump have been among the worst performers. Energy is in fact the only sector with negative returns during the Trump years.
Trump’s corporate tax reform is also key to understanding why a re-election is likely the best option for the equity market. Market participants are now used to Trump’s persona and the corporate sector has, in many ways, benefitted from Trump’s policies of lower taxes and less government oversight. Even the US-China relationship is to some extent predictable for companies and investors under a Trump administration.
A Biden win, on the other hand, could become a headwind for equities as Biden has proposed to hike the statutory tax rate from 21% to 28% on corporate income and increase the GILTI (Global Intangibles Low-Tax Income) tax from 10.5% to 21%. In addition, Biden has proposed to hike the minimum corporate tax rate to 15% and add a social security payroll tax on high earners. Combined, it is estimated that these tax changes would create a 9% drag on S&P 500 earnings – and that is before second-order effects, including change in investor sentiment, potentially hit valuations.
The two tax changes with the highest impact are the statutory and GILTI tax hikes. These would hit communication services, healthcare and information technology the hardest, as those companies have the lowest tax rates in general and are big users of intangible assets. As these sectors have fueled the equity market, there are reasons to suspect that momentum could reverse on Biden’s tax changes. The open question is whether Biden dares implement the tax changes during a weak economic backdrop.
US election baskets
The table shows our current best guesses on the market impact in the event of a Biden or Trump win on November 3. Overall, it probably does not make that big a difference whether Biden or Trump wins longer term. It matters more if the Democratic Party makes a clean sweep. Despite the overall picture, some industries are likely to thrive depending on which candidate wins. These are our best guesses at present and could change as the market reveals the true Trump/Biden trade post the presidential debates.
Trump’s corporate tax reform is also key to understanding why a re-election is likely the best option for the equity market. Market participants are now used to Trump’s persona and the corporate sector has, in many ways, benefitted from Trump’s policies of lower taxes and less government oversight. Even the US-China relationship is to some extent predictable for companies and investors under a Trump administration.
A Biden win, on the other hand, could become a headwind for equities as Biden has proposed to hike the statutory tax rate from 21% to 28% on corporate income and increase the GILTI (Global Intangibles Low-Tax Income) tax from 10.5% to 21%. In addition, Biden has proposed to hike the minimum corporate tax rate to 15% and add a social security payroll tax on high earners. Combined, it is estimated that these tax changes would create a 9% drag on S&P 500 earnings – and that is before second-order effects, including change in investor sentiment, potentially hit valuations.
The two tax changes with the highest impact are the statutory and GILTI tax hikes. These would hit communication services, healthcare and information technology the hardest, as those companies have the lowest tax rates in general and are big users of intangible assets. As these sectors have fueled the equity market, there are reasons to suspect that momentum could reverse on Biden’s tax changes. The open question is whether Biden dares implement the tax changes during a weak economic backdrop.
US election baskets
The table shows our current best guesses on the market impact in the event of a Biden or Trump win on November 3. Overall, it probably does not make that big a difference whether Biden or Trump wins longer term. It matters more if the Democratic Party makes a clean sweep. Despite the overall picture, some industries are likely to thrive depending on which candidate wins. These are our best guesses at present and could change as the market reveals the true Trump/Biden trade post the presidential debates.
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