By Charlie Ripley
With the U.S. election risks mostly behind us, a sigh of relief is let out as a major hurdle of uncertainty for market participants has been removed.
While the dynamic nature between the cross-sections of policy politics, the public health crisis, and the economy will persist well into 2021, we find comfort in the fact that the economy won’t have to absorb extensive policy changes on top of the ongoing battle with the public health crisis.
For the most part, the economy has been recovering faster than many expected, as consumer spending has held up quite well throughout the crisis. Much of this can be seen through consumer spending habits, where the pandemic has caused consumers to shift spending away from service-oriented products and into to more goods-related products.
While this has been beneficial to the economy overall, it has created a bifurcated recovery, as some sectors of the economy continue to be extremely depressed. Arguably, the battle against the virus is expected to get worse as we approach the winter months, but a viable vaccine with a high degree of effectiveness appears to be on its way.
As we think about economic growth and the path for the economy, we expect a continued recovery into 2021 that hinges on the introduction of a vaccine to combat COVID-19. It’s becoming clear the uncertainties that were previous headwinds to the economic recovery are beginning to fade. Thus, we think a recovering economy supported by both fiscal and monetary stimulus while a vaccine is also deployed could bring growth north of 4% in 2021.
For income-seeking investors, the rate environment has been quite difficult throughout the year, as Fed action along with uncertainties surrounding the economy have kept risk-free rates anchored within a tight trading range.
As we think about the rate outlook, we look at different points of the curve separately, as the current backdrop creates a different path for short-term rates versus long-term rates. For the font-end of the curve, we expect rates will remain anchored to the zero-bound throughout next year, as the Fed has signaled policy rates will remain unchanged through 2023.
Despite a recovering economy, they have committed to keeping policy rates low until average inflation moves back above their 2% target. However, the long-end of the curve will likely experience higher interest rates, as the path of least resistance is upward.
With a viable vaccine set in motion, a steeper yield curve is no longer dependent on increasing fiscal spending. The combination of a stronger economic recovery with increasing inflation expectations will put upward pressure on the 10-year yield throughout 2021.
Breaking Down The Election Results
The 2020 election was a historic one in many ways, not only because voter turnout was the highest in nearly 50 years with over 148 million votes cast, but also because over 65 million votes were cast with mail-in ballots, and the numbers could grow as final results are certified.
Joe Biden, the Democratic nominee, looks to have secured over 270 electoral votes, barring any legal challenges, to become the 46th President of the United State. In other elections, it appears the most likely scenario is that the Republicans will maintain a slim majority in the Senate, but those results won’t be final until a runoff election is completed in January for the state of Georgia.
Following election day, a divided government as a plausible result was immediately priced into the markets. For the economy, gridlock on Capitol Hill largely means that sweeping policy changes by either party are highly unlikely.
The lease on the Oval Office is already a short four years, and the agendas on the ballot for Joe Biden are unlikely to come to fruition with no single party controlling the policymaking process. Things like rolling back corporate tax cuts and substantial fiscal spending packages are off the table.
On trade, Biden is expected to take a less protectionist approach, but most market participants expect Biden to maintain a hardline approach to U.S.-China relations. Biden is also expected to place emphasis on more regulation through executive orders, but most of his proposals are likely to have minimal effect in the short run.
From an economic perspective, a divided government is likely the best possible outcome for a recovering economy that is still trying to overcome the public health crisis it’s currently facing. Overall, the results of the election will allow the economy to continue along the path of recovery as the Biden administration places immediate focus on resolving the health crisis and less focus on extensive policy changes.
The Federal Reserve Notes Risks
As expected, Fed officials left the official policy rate unchanged at 0.00% to 0.25% and opted to not make any changes to the asset purchase program at its most recent meeting in November. The Fed continues to reiterate the downside risks and economic implications of the pandemic.
There were some thoughts that the Fed could increase the pace of asset purchases in the event of a significant deterioration of financial conditions resulting from the election, but markets have responded very favorably to the election results so far. The Fed made the right decision by skating though the last meeting without making any significant policy changes or signals.
However, given that the impetus for additional fiscal spending from lawmakers has likely declined with a divided election outcome, the burden of keeping the economic recovery going might fall more on the Fed now.
Should conditions worsen for the economy, we suspect the Fed will rely on the expansion of the asset purchase programs or other measures such as yield curve control to sustain the economic recovery and achieve the targets set forth in their dual mandate of maximum employment and price stability.
Overall, the major area of concern for the Fed going forward will continue to be the public health crisis and the ramifications to the economy over the medium term.
Equities started the month of October with strength on hopes of additional stimulus but slowly sold off during the second half of the month as the likeliness of the Democratic and Republican parties agreeing on a stimulus package diminished. Additionally, increasing COVID-19 virus cases within the U.S. and around the world also put downward pressure on risk assets like equities. Ultimately, all three major U.S. indexes ended the month lower, as the gains from the beginning of the month were erased entirely.
Volatility, as measured by the VIX Index, edged higher throughout October. There were a number of factors that drove the uptick with some of the most notable being President Trump testing positive for COVID-19 at the beginning of October followed by election uncertainties and rising virus cases both domestically and abroad. Since the end of the month, we’ve seen volatility retreat substantially due to Pfizer announcing that its COVID-19 vaccine is 90% effective and the fear of a drawn out, contentious election being mostly avoided.
The Treasury yield curve bear steepened throughout the month of October with the longer end of the curve increasing the most while the short-end remained nearly unchanged. Interestingly, the rise in rates came at a time when volatility was moving higher and equities were selling off. Typically, during an event like the one described previously, you’d see investors flock to safe-haven assets like Treasurys, which ultimately would push yields lower. However, that wasn’t the case at the end of October. Furthermore, rates have since steepened further following the positive vaccine announcement from Pfizer. Going forward, we expect more modest upward pressure on rates.
Hurricane Zeta pushed oil prices higher during October, as nearly 50% of oil production off the U.S. Gulf was halted. However, the gains in oil dissipated toward the end of the month as a crude inventory buildup in the U.S. more than offset the supply constraints from Hurricane Zeta. Rising COVID-19 virus cases are the likely the reason for the drop in demand and corresponding buildup in inventories. Overall, we expect oil to be range bound as demand ebbs and flows as a result of the virus.
Consumer confidence, as measured by the Conference Board, unexpectedly declined in October to 100.9 from September’s downwardly revised figure of 101.3. Within the data, consumer’s sentiment toward current conditions increased to 104.6. However, consumers felt less optimistic toward short-term expectations for employment and business conditions. Overall, the COVID-19 virus continues to weigh on consumers, as sentiment levels still remain far below the pre-pandemic highs.
Real gross domestic product (GDP) increased at an annual rate of 33.1% in the third quarter after a drop of 31.4% in the second quarter of 2020. The recovery was driven by a 40.7% rebound in consumption, which itself was based to a large degree on an increase in durable goods consumption and to lesser degree on nondurable and services spending. Other contributors to the rebound were business equipment and residential investment, while government expenditures and net exports were detractors.
The core Consumer Price Index for September was in line with expectations, rising 0.2% over August and 1.7% year-over-year. Support for the CPI continues to come from core goods’ prices, which rose 0.8% in September after a more than 1% increase in August. However, strength in core goods was almost exclusively centered in used autos, in which prices jumped 6.7% in August and marked the largest one-month jump since 1969. Core services, on the other hand, remained soft, especially in sectors disrupted by COVID-19, like airline fares, motor vehicle insurance, and shelter. At this point, we see little danger of core inflation sustainably exceeding the Fed’s 2% target over the near term.
The labor market showed further signs of recovery in October, as 638k jobs were added to the economy. However, while the job additions came in above expectations, the pace of jobs added each month continues to decline. Since the economic recovery has started, just over half of the jobs lost have since been brought back. In addition, the unemployment rate dropped by a full percentage point to 6.9% with the participation rate increasing slightly to 61.7%. October’s report highlights the challenge for lawmakers, as the impulse for additional fiscal stimulus hangs in the balance between the pace of the economic recovery and the downside risks of the public health crisis.
In summary, the economy continues to face major uncertainties along the path of recovery. However, some of the headwinds challenging the economic recovery are beginning to diminish as election risks are largely in the rearview mirror and the potential for a viable vaccine has increased significantly.
We cannot say the road ahead won’t be bumpy as the economy faces the ongoing challenges of the pandemic, but execution of the distribution of a successful vaccine is a major fulcrum to the next leg of the recovery.
Charlie Ripley is senior investment strategist for Allianz Investment Management