The reflation trade appears to be still alive and well as the US goes to the polls. Global equities are up, bond prices are down, and the dollar is weaker. What are markets telling us? It appears that markets are pricing in solid odds of a Blue Wave today, implying significant fiscal stimulus and debt issuance in 2021. Because of the perceived risks of another surprise victory by President Trump, we do not think the Blue Wave is fully priced in and so there is room for further movement if Biden does indeed win. That said, “there’s many a slip twixt the cup and the lip” and so these directional bets can quickly reverse. Markets should not be lulled into a sense of complacency and should instead be prepared for greater volatility across all markets over the coming days.
With so much at stake heading into the elections, we thought it would be useful to recap where we are year to date for the main asset classes. Starting with implied volatility, we are now just about at the averages for year in equity, FX, and US fixed income (taking into account the March spikes, of course). Of note, US equity and fixed income implied vol markets seem to be sending different signals. Fixed income market vol (MOVE index) is at the highest since April and suggests rising concerns about a spike in yields, which some foresee under Blue Wave scenario. Equity markets (VIX) implied vol has moderated, however, in line with the risk-on performance in the last few days and likely suggesting easing concerns of a large stock selloff after the elections.
Under a potential Blue Wave scenario, equity markets are right to expect massive US fiscal stimulus in the coming months. Working against this will be the as-yet unknown impact of the rising infection rates in the US and across Europe. These crosscurrents will remain in play, but the deciding factor may be continued liquidity support from the major central banks. The RBA just announced another slug of QE to complement its Yield Curve Control, the BOE is expected to add another GBP100 bln to its asset purchases this week, and the ECB is expected to add EUR500-750 bln to its asset purchases next month. The Fed is expected to remain on hold this week, but we believe it will be forced to boost its QE next year. These measures are all supportive of equities and risk assets.
In the equity space, China has been the clear outperformer over the last few months, with the Shanghai Composite up 7.2% year to date. This compares to a 2.5% YTD gain for the S&P 500. It’s worth noting that countries in the greater China supply chain have also outperformed, particularly Taiwan (+6% YTD) and Korea (+6.5% YTD). European markets have lagged substantially (-15%) while UK has been by one of the worse performing markets this year (-24%) in part due to lingering Brexit uncertainties.
In the FX space, the dollar index (DXY) is going into the elections down nearly 3% on the year. However, the performance has been far more mixed when looking under the hood. Recall that the DXY places near 60% weighting to the euro. So far this year, the dollar has been especially weak against the euro (-4.4%) but also against JPY (-3.8%), SEK (-5.7%), and CHF (-5.7%). On the other hand, the dollar appreciated substantial against the Norwegian Krone (+6%) EM currencies (11.5%) when measured against the MSCI index and is up 2% on the year against the pound.
We believe the dollar’s recent bounce is due largely to positioning, safe haven demand, and the worsening virus situation in Europe. Fundamentally speaking, the US outlook has gotten worse with the continued rise in viral infections. At this point, the US seems more likely than Europe to fall behind the curve in containing the second wave, and this is yet to be priced in. The inability of Congress to pass another round of stimulus only complicates matters, possibly shifting the burden of adjustment to the Fed. We expect the Fed to deliver a dovish hold this week that underscores why investors should not be counting on a stronger dollar in Q4.
Fixed income markets have been remarkably stable given the unprecedented cross currents of fiscal expansion and QE. Looking at selected 10-year sovereign bonds, most markets have been range bound since the volatile March period. While US long yields have started edging higher as markets price in greater convictions about a Biden victory, the move has been modest up until now. Note that the 10-year yield traded at 0.88% today, the highest since June 8 and on its way to test the June 5 high near 0.96%. We also believe that the upside in US yields will most likely be capped near-term due to lack of inflation pressures as well as official resistance. Why?
We posit that the Fed’s QE will have to increase if there is a Blue Wave that leads to aggressive fiscal stimulus. Debt issuance would most likely spike and we think the natural tendency would be for long rates to rise. It would fall on the Fed to prevent such a rise by boosting QE. Purchases are currently spread out evenly across the maturity spectrum and so another possibility for the Fed would be to shift its purchase more towards the long end. However, this would likely fall short of explicit YCC. We do not think the Fed will be happy with the steepening yield curve and may offer some verbal pushback this week. The Fed simply does not want tighter financial conditions over the next several years. Period.
Lastly, it has been year of mixed performance in the commodity space. Precious metals were the clear outperformers, driven by a combination of systemic and inflationary risks along with a dose of currency debasement fears. Energy markets have collapsed, now down 45% according to the Bloomberg index, and still facing a lot of supply and demand challenges this year. Next year, however, we wouldn’t be surprised to see pick up in energy pieces as the industry continues to suffer from underinvestment and fails to respond fast enough to rising demand.
Markets appear to have greater conviction now of a Biden win and Blue Wave. Stocks are recovering, the US 10-year yield is at the highest since June, and the dollar appears to have topped out as market sentiment improves. Market are often wrong, while the election results will simply remove one major uncertainty for the markets. What’s left uncertain is the impact of the rising virus numbers and the impact on global economic activity. As such, we would caution investors to beware of “irrational exuberance” as long as the pandemic remains a major headwind.