“Noise causes markets to be somewhat inefficient, but often prevents us from taking advantage of inefficiencies. Noise in the form of uncertainty about future tastes and technology by sector, causes business cycles and makes them highly resistant to improvement through government intervention.”

Excerpt from Fischer Black’s timeless paper titled “Noise” first published in the July 1986 Journal of Finance:-

LAST QUARTER REVIEW

The strong resurgence in equity markets during the second quarter carried on through into the third quarter and was especially powerful on Wall Street during August led by technology stocks before September saw a large chunk of those gains given back. During the summer, equity markets, and most notably Wall Street, have been seemingly oscillating between extremes of fear and greed with the aptly named FOMO (fear of missing out) along with a new generation of retail day trader (on some days representing as much as 20% of volume on the New York Stock Exchange) accounting for the schizophrenic actions.

At the Federal Open Markets Committee (FOMC) meeting in mid-September, the Federal Reserve (Fed) left the target range for its federal funds rate unchanged at 0-0.25%, in line with market expectations, and signaling that it may hold them there until 2023. Fed officials now see the US economy shrinking 3.7% in 2020 (which is much less than previously feared), followed by 4% growth in 2021.

Retail sales in the US increased 0.6% month-over-month in August, following a downwardly revised 0.9% gain in July, as unemployment benefits were reduced and support for small businesses dried up. Preliminary readings showed the University of Michigan’s consumer sentiment for the US had jumped to 78.9 in September from 74.1 in August, the highest reading since March, with the data suggesting that the election has begun to have an impact on expectations about future economic prospects.

Meanwhile, the US National Association of Home Builders (NAHB) housing market index jumped 5 points to 83 in September of 2020, beating market forecasts of 78. It is the highest reading on record as record-low mortgage rates continue to boost demand for new homes and many people move away from the big cities due to the coronavirus pandemic, and a growing recognition that most people can do their jobs remotely from home.

In the UK, The Bank of England (BOE) voted unanimously to maintain the Bank Rate at a record low of 0.1%, and to maintain its bond-buying program at £745 billion during its September meeting. Policymakers noted that domestic economic data have been a little stronger than expected in August, while the outlook for the economy remains unusually uncertain due to the coronavirus pandemic as well as recent Brexit developments, potentially leaving the door open to negative interest rates and more quantitative easing (QE).

The BOE stated that Consumer Prices Inflation (CPI) is expected to remain below 1% until early 2021 and that unemployment will probably remain elevated for some time. Accordingly, the central bank said it will not tighten monetary policy until there is clear evidence that significant progress is being made in eliminating spare capacity and achieving its 2% inflation target sustainably. Meanwhile, British house prices rose 5.2% in August, the largest gain since 2016, amid a surge in market activity following the easing of lockdown measures, and a nine month window of lower stamp duty tax on property purchases to help the market recover.

In late September, UK Chancellor Rishi Sunak unveiled additional plans to support the economy and protect jobs over the next six months, including a new wage subsidy scheme to encourage firms keeping people on short-term contracts; a “Pay as you grow scheme” that will allow small firms to extend their bounce back loans for a decade (previously 6 years); and an extension to the VAT cut for the hospitality sector until March 31st 2021. However, credit rating agency S&P cut its GDP forecasts for Britain, saying it now expects the economy to contract by 9.7% in 2020 before rebounding by 7.9% in 2021.

In early September, the European Central Bank (ECB) decided to keep its interest rates and coronavirus-stimulus program unchanged while stating it believed its strategy efficient and effective. During the press conference, ECB President Christine Lagarde said policymakers had discussed the appreciation of the Euro (mainly against the US$) but that the central bank does not target the exchange rate.

The ECB expects the Euro Area economy to contract 8% in 2020, while the inflation outlook remains at 0.3% for this year. PMI figures showed the construction sector in the Eurozone contracted for the sixth month in August, while new passenger car registrations fell 18.9% from a year earlier to 769,525 units in August, and during the first eight months of 2020 demand for passenger cars contracted by 32%.

Meanwhile, exports from China soared 9.5% year-on-year to $235.3 billion in August of 2020, above market forecasts of a 7.1% growth and following a 7.2% rise a month earlier. This marked the third straight month of increase in overseas sales and the fastest rate since March of 2019, amid further improvement in global demand as more countries lifted coronavirus-led restrictions, and boosted by record shipments of Chinese medical supplies and robust demand for electronic products.

The US dollar continued to decline during the quarter before rallying in late September to around 94 on the widely followed DXY index ($ measured against a broad basket of currencies). The September rally was attributed to investors turning to safety amid concerns about the pace of the global economic recovery and rising COVID-19 infections worldwide.

The greenback was also bolstered by the Congress approved bill to keep the US government funded through December and avoid a shutdown before the election, as well as comments from Charles Evans (President, Federal Reserve Bank of Chicago) suggesting that the central bank could raise interest rates before inflation averages 2%. Meanwhile, oil was considerably less volatile than in the previous quarter with the price of a barrel of West Texan Intermediate (WTI) barely changed over the three months to end September.

GDP Data shown are to the 30th June 2020; Interest Rate, Equity & Bond Index Data are to the 30^th September 2020; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50, China – Shanghai Shenzen CSI 300, Japan – Nikkei 225, Germany – Xetra Dax; Sovereign Bond Indices used: S&P US T-Bond, S&P UK Gilt Bond, S&P Eurozone Sovereign Bond (Eur), S&P China Bond, S&P Japan Government Bond, S&P Germany Sovereign Bond.

CURRENT CONSIDERATIONS

As we suggested might happen in the last market view, the US dollar which not only underpins the largest economy in the world but also serves as the exchange medium for global trade, continued declining steadily throughout the summer until last month, when, for a number of reasons including investor appetite for risk reversing, the dollar began to appreciate once more.

The action of global stocks led by Wall Street was almost a mirror action of the dollar as July and most especially August saw investor confidence soar and investors pile into almost every market and sector, thereby adding fuel to the hope that the March April bear market would prove to be a short sharp setback before the equity bulls continued on their way. September provided a sharp reality check however as equity markets corrected strongly on fears of further restrictions enforced upon the global economy due to authorities battling an increase in the number of Covid cases.

The biggest conundrum this summer has been the disappointing performance of UK equity indices led by the FTSE 100, which have lagged almost every other global equity market in 2020, with the benchmark index down more than 20% since the beginning of the year. Several commentators have suggested the weakness of the dollar as the primary reason for this, citing the fact that almost two thirds of the earnings of the FTSE 100 constituents are achieved overseas and that therefore these dollar trades have impacted on profitability when translated back into sterling.

While this may in part account for the poor relative performance, it seems implausible it could be the main reason. A more likely explanation is that the continuing uncertainty surrounding the terms upon which the UK finally exits the European Union (EU) continues to weigh on investors’ minds.

It is extraordinary to think that the British electorate actually voted to leave the EU in June 2016, and yet here we are more than four years and three Prime Ministers later and the terms of Britain’s exit still cannot be finally agreed. Little wonder the equity market appears to value British stocks at a seemingly permanent discount to their American, European and Japanese listed contemporaries!

There has also been a lot of negative reaction and concern expressed by some market participants concerning the BOE’s reference to the possibility of moving to negative interest rates in the future as a means of combating the economic slowdown. However, investors will have been reassured by comments made by both BOE governor Andrew Bailey and deputy governor Dave Ramsden that the central bank was “not about to use negative rates imminently”.

It is also disappointing that traditionally higher yielding (or value) stocks in the UK have spent much of the year trading at an even bigger discount relative to growth (non or lower yielding) companies after the dramatic impact of the pandemic on these sectors of the economy caused many to cut or suspend dividends. Investors should eventually see this margin narrow as the economy gradually returns to a more normal environment.

We also live in hope that, in the not too distant future, an agreement mutually acceptable to both the EU and UK will be reached, at which point the “Brexit discount” should finally disappear, and those investors holding UK stocks will be richly rewarded. Until then, there are numerous arguments in favour of continuing to be overweight including the benefits of the FTSE 100 being heavily exposed to global oil and commodity focused sectors where the rewards must eventually come through with a post COVID-19 recovery.

Meanwhile this quarter, investors will be predominantly focused upon the US November presidential elections, notwithstanding that whomever wins should prove positive for the stock market over the medium term. President Trump has promised that re-election will result in tax cuts that will even outshine those from his first period in office, which is always music to the market’s ears, although one suspects some of that may already be factored into current valuations.

Admittedly, on the face of it, Joe Biden in the White House looks less attractive for markets, although if as likely the Democrats continued to control the House and possibly snatched the Senate too, the probable subsequent enactment of modern monetary theory (MMT) legislation would definitely excite Wall Street participants, despite the dangers many commentators suggest this would introduce. For many market commentators, MMT is the key to ensuring the recent economic crisis can eventually be overcome.

According to Investopedia, MMT is a macroeconomic theory that, for countries with complete control over their own fiat currency, government spending cannot be thought of as a household budget. Instead of thinking of taxes as income and government spending as expenses, MMT proponents argue that fiscal policy is merely a representation of how much money the government is putting into the economy or taking out, and therefore, if enacted, can be utilised in a similar manner as central banks currently operate monetary policy.

Professor Steve Keen, a renowned “post-Keynesian” economist believes MMT would work for the US and enable it to create money to spend on much needed infrastructure projects as well as offer subsidised (or even free) university and other educational facilities, that would ultimately benefit the economy. He argues that the funding issues for the US government are much, much simpler than the funding issues for a private entity, and accordingly the level of government debt is irrelevant, because it can never run out of US dollars and go bankrupt as in the case of a corporation or private individual.

However, for every economist, who is in favour of using MMT for resolving current US and global economic woes, there at least ten whom warn that uncontrolled inflation will be the eventual outcome of such actions since history shows politicians cannot be trusted to practice the financial disciplines we normally associate with central bank monetary policy. Interestingly, Dr Lacy Hunt, a respected fixed income analyst and strategist (who has consistently over several decades correctly called the continuation of the Treasury bull market) went on record last year to explain the Fed cannot monetise the government’s debt (which is effectively how MMT would have to work) without Congress legislating to change the Federal Reserve Act of 1937. 

Dr Hunt provided persuasive reasons as to why granting the Fed the ability to monetise US government debt would open a Pandora’s box that could potentially wreak havoc on not just US citizens through eventual hyperinflation, but also the world since the dollar is the global reserve currency. Accordingly, depending upon whether Professor Keen’s optimism for MMT, or Dr Hunt’s warning on its potential dire consequences for the global system is the correct one, the forthcoming American presidential election is from an economic perspective the most important in maybe a century, and therefore we shall be watching developments with the potential introduction of MMT very closely.

FORWARD OUTLOOK

The last quarter of the year is often the most unpredictable and volatile; this is most especially so every fourth year during a presidential election cycle. The outcome of the November presidential election appears factored into markets with a Trump second term the favoured option, but a Biden upset is also comfortably within the margin of market expectation.

From a monetary perspective, the Fed and other central banks remain totally supportive of doing whatever is necessary to facilitate a gradual controlled global economic recovery following the COVID-19 shock. In his testimony during the last week of September before the House Financial Services Committee regarding the Coronavirus Aid, Relief, and Economic Security (CARES) Act, Fed Chair Jerome Powell said that while, “the US economy has picked up from its depressed second-quarter level and many economic indicators show marked improvement, it still has a long way to go before fully recovering from the coronavirus pandemic.”

The Fed Chair added that “a full recovery is likely to come only when people are confident that it is safe to re-engage in a broad range of activities. The path forward will depend on keeping the virus under control, and on policy actions taken at all levels of government.”

Equity markets look well positioned to continue feeding positively on these sentiments, while bond markets remain becalmed and seemingly resigned to a continuing gradual deflationary environment during the long economic recovery ahead, barring any legislative introduction of MMT of course! Several renowned market commentators believe the actions and comments of the Fed and some of its senior personnel during the summer suggest that it is now impotent and finished as a monetary force, citing the unresponsiveness of interest rates at the long end of the Treasury yield curve to Chair Powell’s observation that interest rates were likely to remain at 0% until at least 2023 as evidence.

History has shown, however, that investors ignore the Fed at their peril, and we would be surprised if the American central bank did not have a few monetary surprises that could be deployed if and when necessary in the future. Here in the UK, and, as mentioned earlier, equity income and value stocks currently trade at an unrealistic discount to larger growth stocks and we are confident that investors will be rewarded over time for holding these as increasingly both institutional and foreign investors recognise the opportunity, with a final resolution of the long running Brexit saga quite possibly providing the catalyst.

With regard to investment funds:-  Whilst the recent popularity of “environmental, social and governance” (ESG) funds may have resulted in valuations becoming highly rated in the short term, we do recognise that this is undoubtedly an investment theme that is here to stay. We also believe that recent developments will result in attractive opportunities in government supported infrastructure projects, providing a useful means of additional diversification along with the prospect for a real return. It is also pleasing to note that commercial property funds are now increasingly reopening for trading and can once again be included within an actively managed balanced portfolio.

Additionally, while concerns remain about the trade war tensions that have existed for some time between the US and China, investment opportunities in the Asian equity market generally look more attractive than they have for some time, potentially enhanced by the declining dollar narrative.

As always, investment risk is at the forefront of our advice and, whilst it is often necessary to undertake adjustments in portfolio allocation in order to meet objectives and to maintain individual preferences, we are confident that our advised portfolios remain well placed to meet our clients’ needs.

On behalf of all of us here at Ash-Ridge Asset Management, we hope that you and your loved ones remain healthy and upbeat until we have finally seen the last of this dreadful pandemic!

Copyright © Ash-Ridge Asset Management 1st October 2020.

Data Sources: Bloomberg; Brookings Institute; Economic Cycle Research Institute: Financial Sense; Financial Times; German Federal Statistical Office; Hoisington Investment Management; Macro Voices; National Bureau of Statistics China; Office for National Statistics; Real Vision; S&P Indices; The Cabinet Office Japan; The Economist; The Federal Reserve; The National Bureau of Economic Research; Trading Economics; UK Debt Management Office; US Debt Clock.org; Wall Street Journal; Zero Hedge.

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