Treading cautiously, but increasingly optimistic
September was almost set up to fail. The US markets had seen a strident August rally of over 7% in dollar-terms — the strongest monthly gain since 1984 — leaving valuations looking strained. Japan had seen a similar surge, the 4%+ rally in Europe was impressive, and even Brexit-plagued Britain managed a 2% advance. Then the tone darkened: news commentaries read, “September is never a good month in election years”, “September’s often the worst month of the year”, or even just “we need a correction to get these markets looking reasonably valued.”
Seemingly on cue, US equities posted four weeks of declines in a row: Between the 2nd and 23rd, the US market slipped about 10% – a correction in market parlance. Yet it’s worth bearing in mind that equity markets weren't so problematic internationally. Admittedly, over the same period Europe also stumbled, slipping 5%, but Japanese equities were almost flat and the UK even eked out a gain. The market volatility was, ironically, triggered by the technology sector, which has been a driver of outsized returns. Over the summer, many tech stocks – especially those fostering an improved work-from-home capability – surged in value, leaving prices hard to justify. As a result, investors fled technology names and the US tech sector slipped by nearly 17% up to the 23rd. Then, for little reason other than that the sell-off had run its course, September caught a bounce to end the month, which has carried forward into October, and global equities – led by the US – are within shooting distance of all-time highs again.
With this oscillating backdrop and a US election looming, some may rightly ask if risk assets may be challenged again. While we accept that there are several salient risks ahead – we are far from out of the COVID-19 woods – the US election is one which has little impact on our investment decision making. Long-term investors should be more focused on where risk-assets are likely to be on 4th November 2025, rather than 4th November 2020.
Firstly, no one knows who will win the election, if it will be controversial, or how markets will react in the short-term to what no one can predict in the first place. Four years ago, there were widespread fears of what would happen if Donald Trump were to win; few expected such an outlandish thing could occur. He did win, and markets generally rallied. Indeed, conventional wisdom from experts on election outcomes or the likely market reaction is a poor guide for investment decision making.
Secondly, history tells us there is little to choose from between the two main US parties in terms of equity market performance over the long-term. From 1877 to now, the average, real (i.e. net of inflation) annual equity market return under Democratic regimes is +7.3%; under Republican administrations, it is +7.4%. In plain words, there is no difference between the two at the headline level for investors over time. There are huge differences within the data set and each administration has its idiosyncrasies. Nonetheless, the reason returns tend to average out over time, regardless of the party in power, is most likely because the US enjoys rule of law and established institutions that handle the basics of governance (e.g. enforcing contracts, ensuring peaceful transfers) relatively well.
As we have noted in the run-up to myriad geopolitical risk events, our investment process seeks to evaluate the long-term fundamentals rather than focus on short-term movements. It is deliberately long-term to eschew the “noise” which inevitably surrounds such events, and look to what we consider indelible, longstanding drivers of asset returns: economic climate, valuation, momentum and sentiment. To the degree that geopolitical events impact these pillars of our process, we pay attention. To the degree they do not, they are more-often-than-not red herrings best ignored.
Over the third quarter, we have begun modestly adding to risk assets following our reduction during the seismic ructions in markets early in the year. As always, we are guided by our investment process:
Economic regime: Our Leading Economic Macro Indicator (LEMI) suggests the global economy has moved from a regime of "contraction” into one of “recovery”, albeit one that is slow, deeply uneven and largely dependent on the course of the Coronavirus. Nonetheless, our base case is that there will be no more full lockdowns in major economies and that there is now sufficient strength in the recovery, lowering the chances of falling into another recession.
Valuations: Valuations for equities – the largest source of risk and return in most strategies – remain challenging in absolute terms. However, with global interest rates near zero, there is a case for a higher than usual tolerance to valuations. Moreover, when compared to government bonds, equities still have a clear advantage in terms of long-term expected returns.
Momentum: As of the end of June, the global equity market tipped into positive territory on the ten-month moving average metric that we favour. The trend has persisted for several months – despite September’s sell-off – which supports risk-taking in equities.
Sentiment: Of the indicators we follow, some imply bullishness and some imply bearishness. Overall, sentiment is neutral.
While the above changes resulted in a recent increase in risk in most strategies, it is modest, and we remain underweight risk assets compared to our benchmarks. We recognise that the current market backdrop is more uncertain than usual and volatility is elevated – therefore we are treading cautiously, even as we are increasingly optimistic.