It is virtually impossible to author an October monthly commentary prior to the November 2020 US election. The election is a macro risk event akin to a pool game break shot: The path dependences are far too difficult to predict with any absolute certainty. I find it more prudent to discuss economic and societal trends which are impacting portfolios today but are obscured by the election. These topics are likely more impactful over the longer term. Key non-election trends that investors should be aware of include:
1. No one likes beats - The proportions of companies beating earnings-per-share (EPS) and revenue estimates are at record highs so far this earnings season. For S&P 500® Index firms, the figures stand at 86% and 81%, respectively.1 No one, however, seems to care: Firms that have beat on EPS have seen an average price decrease of 1.7% during the period spanning two days before the earnings release through two days after. This is well below the five-year average 0.9% gain for firms with positive earnings surprises.2
A low bar—EPS was expected to decline by 21%3—alongside a cloudy outlook and elevated valuations4 have led investors to reconsider the organic nature of these positive surprises, and contemplate whether they can continue amid a resurgence in COVID-19.
2. Cases are rising - Germany, France, and the UK recently announced renewed lockdowns. When the first lockdowns were announced, major equity benchmarks precipitously declined and economic growth forecasts were slashed. Not surprisingly, as these countries ushered in new lockdown measures, the MSCI ACWI IMI Index had its worst week of performance since March.5
Rising case rates will increase volatility. Fiscal stimulus is a tourniquet; it helps but will not solve the problem. Right now, Q2 2021 is the earliest time frame for a broadly available vaccine.6 As a result, expect more case-related headline-induced volatility, requiring portfolios to have a modicum of defense built into their foundations—especially if the US follows the rest of the word with lockdowns.
3. When, not if, on stimulus - 12 million Americans remain unemployed and economic sentiment has stalled out after an initial rebound—similar to the trend witnessed on a global scale.7 While US lawmakers could not agree on a stimulus package prior to the election, a deal after the election is more likely. As a result, stocks could witness an initial bump when those plans are released. But, as stated above, this is just a tourniquet. Perhaps the next round of stimulus will be a bridge loan to get us to Q2 2021, but if lockdowns persist, it may not be enough to dampen the new episodic risk regime in which we find ourselves.
4. Asset class distortion - Just as the pandemic has impacted certain societal behaviors, it has also distorted asset class risk/return profiles—especially in fixed income, given the renewed low interest rate environment. In addition, policy responses to the pandemic have been inflationary to asset prices, causing stock market earnings multiples to increase significantly.
Returns, therefore, may be lower in the future but without any commensurate reduction in the risk needed to obtain those returns. As a result, structuring portfolios in and out of the core now requires a more tailored approach in order to meet specific return objectives and ensure portfolios remain properly diversified—no matter who wins the election or what party is in control.
Asset class ETF flows: Bonds continue to lead
Equity ETFs posted inflows of $11.3 billion in October, 37% below the five-year average monthly flow figure of $17.9 billion. Equity flows reflect modest positioning ahead of a systemic risk event. Beneath the headline number, however, distinct positioning is apparent with more tactical instruments. As it has been all year long, given the volatility and dispersion witnessed across the market, investors have preferred searching for alpha through rotations as opposed to strictly obtaining broad-market beta.
Bond ETFs continued to take in assets at an elevated pace, as shown below. The $19.9 billion October figure is 84% above the category’s historical five-year average monthly flow figure of $10.7 billion. The strong flows in October pushed 2020 year-to-date flows to a new annual record, besting the 2019 record of $155 billion. With two months left, the 2020 figure could break the $200 billion mark. In fact, if flows were to match just the five-year average monthly flow figure—less than the $17.4 billion average from 2020—flows for the full year would total $196 billion. A more bullish case—using the 2020 average—would have flows hitting $209 billion.
Bond ETFs continue to be used to position portfolios for an uncertain and low-yielding world. Since the onset of the pandemic, investors have gravitated toward the ETF structure for bond exposure, thanks to the low cost, transparency, market coverage, and liquidity afforded by the vehicle. The flows are partly secular, as more investors gravitate towards the vehicle, but also partly tactical as investors search for ways to buffer equity risk or obtain yield in a precise and efficient manner.