- Many major economies, including the US, are in the early-cycle phase of recovery, but COVID-19 and further policy support will likely affect their progress.
- Uncertainty surrounding the US election and other policy questions implies the potential for higher market volatility.
- Longer term, we believe the long-standing global regime of relatively stable and investment-friendly policies, politics, and regulation is nearing an end.
- Almost all asset categories posted positive returns for Q3 as the global recovery boosted emerging-market, small-cap non-US, materials, and industrials stocks.
Global stocks rebounded for the second quarter in a row, extending a broad-based recovery from steep Q1 declines. Commodities and riskier fixed income categories, including high-yield bonds, posted solid returns amid extraordinary monetary support and continued economic progress. US large-cap stocks moved into positive territory for 2020, but gold and higher-quality bonds remain the year-to-date leaders.
Abundant central bank liquidity and sustained progress on economic reopening underpinned the continuing rally in riskier asset prices. Many major economies, including the US, entered the early-cycle phase of recovery, but uneven progress suggests momentum may remain dependent on the path of COVID-19 and further policy support. Elevated uncertainty implies the potential for higher market volatility.
Economy/macro backdrop: Global business cycle in recovery phase
After a historically sharp but short recession during the spring, most major economies are now in early-cycle recovery. China remains somewhat ahead of the rest of the world due largely to its faster reopening. In the United States and Europe, both consumer and business confidence continued to improve, despite uneven progress, below-normal activity levels, and elevated COVID-19 caseloads.
Employment conditions continued to improve as temporary job losses were regained, but permanent layoffs are on the rise and unemployment remains high overall. So long as the pandemic limits reopening, there may be a ceiling to job and activity gains for industries hit hardest by virus-related restrictions. The recovery in the number of small businesses and their employees has lost momentum and remains 20% below January levels.
US manufacturing activity dropped less and recovered more compared with service industries, boosted by a sharp rebound in durable goods consumption. COVID-19 has driven a shift from consumer spending on travel and other services toward the purchase of goods, and the housing market has benefited from low interest rates and increased demand. Service-industry activity has improved but still faces reopening challenges.
Following a steep decline in earnings, investors expect profits in some of the hardest-hit sectors to rebound sharply over the next year and for the overall market to reclaim its pre-pandemic earnings levels by the end of 2021. If earnings meet expectations, it would result in a significantly faster recovery versus past recessions. The technology sector has provided ballast to market profitability, maintaining positive earnings expectations for 2020.
After falling sharply during the first half of 2020, consumer inflation bounced back in Q3. We expect inflation to remain range-bound amid an uneven recovery and significant labor-market slack. Over the long term, inflation risks may be higher than anticipated. The expected 30-year annualized consumer price index (CPI) is less than 2%, a stark contrast from a decade ago when the market expected monetary accommodation to eventually lead to higher inflation.
Since March of this year, global central banks have injected more than $6 trillion of liquidity into world financial markets. Most of the easing came in the form of quantitative easing (QE), which helped support asset prices. In the United States, the Federal Reserve’s creation of extraordinary facilities such as the Main Street Lending Program and the Corporate Credit Facility restored calm in the financial markets, but total use of these facilities has so far been less than $100 billion. Bank lending standards tightened during Q3 despite the Federal Reserve’s extremely accommodative policies, highlighting the limits of monetary stimulus on the real economy. Also during the quarter, the Fed amended its framework toward an average inflation targeting (AIT) approach, wherein higher inflation is tolerated to make up for past misses. AIT reinforces the notion that extraordinary accommodation will continue well into the recovery.
The $3 trillion of fiscal stimulus in the first half of 2020 provided crucial support to the US economy. Amid severe budget shortfalls among state and local governments, ongoing federal support may be needed to avoid a significant fiscal drag on the economy similar to the post-global financial crisis expansion.
A divided-government election outcome could cloud the outlook for fiscal policy. However, if the Democrats sweep the White House and both houses of Congress, presumably they would be more inclined to raise government spending in 2021. Fiscal multipliers, which estimate how much economic activity is generated by fiscal easing, tend to be stronger when associated with spending, a weak economy, and easy monetary policy. Such policies may also include higher corporate taxes and prove more inflationary.
Longer term, we believe the long-standing global regime of relatively stable and investment-friendly policies, politics, and regulation is nearing an end. We expect greater government intervention may inhibit corporate profitability, distort market signals, and lead to higher political risk in investment decisions throughout the world.
For instance, the dramatic worldwide rise in public and private debt reflects monetary and fiscal policymakers’ proclivity to use low interest rates and government support to try to boost growth. At the same time, deteriorating demographics among most advanced economies have been heightening fiscal pressure to raise pension and health care spending, and already elevated government debt/GDP levels are likely to rise further. We believe greater policy experimentation and “peak globalization” trends will eventually cause long-term inflation to rise faster than expected.
Asset markets: Continued broad-based recovery across asset categories
Almost all asset categories posted positive returns for Q3. The global recovery boosted emerging- market and small-cap non-US equities, in addition to materials and industrials stocks. US growth stocks, including the technology and consumer discretionary sectors, registered another strong quarter and led in year-to-date gains. Riskier credit segments such as high-yield and leveraged loans gained back most of their 2020 losses.
The rally in stock prices and decline in earnings drove global equity valuations to decade highs. The rise in P/E ratios was broad-based across regions, with all categories finishing the quarter above their long-term historical averages. US forward P/E ratios remain elevated, but developed- and emerging-market equity forward valuations have fallen below their long-term averages, providing a relatively favorable long-term backdrop for non-US stocks. Despite depreciating for the second quarter in a row, the US dollar remained relatively expensive against most major currencies.
Shorter term, stock market volatility historically has risen ahead of a US presidential election and declined thereafter. Futures markets are pricing in higher volatility for the rest of 2020, as uncertainty could be prolonged by slower vote counting and potential legal disputes. Fidelity’s fundamental company analysts, however, believe the trajectory of COVID-19 over the next 6 months will have a greater impact on their companies than will the November elections.
US 10-year Treasury yields kept near record lows, held stable by weak economic activity, quantitative easing, and a global low-yield environment. The real cost of borrowing fell deeper into the negative due to a rise in inflation expectations from depressed levels. Credit spreads tightened during the quarter, but remained elevated relative to their long-term averages. Massive central bank accommodation in both the Treasury and credit markets put downward pressure on both rates and spreads, helping keep bond yields in high-quality debt categories near their lowest levels on record.
The business cycle can be a critical determinant of asset performance over the intermediate term. Stocks have consistently performed better earlier in the cycle, whereas bonds, historically, have tended to outperform during recession.