With markets cooling off, US politics and COVID‑19 developments come into spotlight

• Strong reversal in prices of certain financial assets in early September indicate that equities might have entered consolidation period
• Potential passing of new fiscal stimulus bill in October and presidential elections in early November in USA could have material short‑term impact on prices of global financial assets in both directions
• Coronavirus cases continue to rise, and if trend is not reversed, new lockdown measures could be reintroduced globally
• Upcoming “event risks” suggest that high volatility is likely to persist

In September equity markets finally took a pause to ongoing rally, with majority of global equity indices falling in price during first month of autumn. Last time we mentioned that certain equities were rising inadequately high and fast in August, reminding us of patterns observed during speculative mania. Therefore, it was not really a surprise when these stocks experienced strong reversal in the matter of days with declines from peak to trough reaching 20% to 35% depending on the particular stock selected. As already discussed, such sharp moves in largest and well established companies cannot be considered reasonable and actually serve as a reminder that despite recent strength financial markets still remain relatively fragile.

FANMAG performance in September​

Source: Bloomberg

Such fragility can be explained by the fact that without support of governments and central banks, large number of companies would experience massive financial difficulties and risks of becoming insolvent. Even with financial aid in place, companies still experienced significant decline in their financial results this year. According to Refinitiv data, during second quarter 2020 earnings and revenues of US S&P‑500 companies dropped by 31% and 9% respectively, while drop for European Stoxx600 companies constituted - 51% for earnings and -20% for revenues. Until the end of the year such figures are expected to improve somewhat though still remain negative. Expectation is that only next year companies would be able to recover fully and show decent growth in financial performance. 

S&P and Euro stocks revenue and earnings growth and growth estimates

Source: Refinitiv

In our view, there are considerable risks that even such positive expectation may not materialize, if support is being removed. Usually, when there is economic recession, like this year, most indebted and uncompetitive companies go bankrupt, removing economic excesses and making financial system healthier. However, this time around, such inefficient companies still remain afloat as they have access to cheap and highly available financing through financial markets or through funds granted to them directly by governments. Therefore, supply of goods and services is not being considerably reduced right now, as it has always happened in recessions before.  

At the same time demand during recessions usually is being reduced through higher unemployment and adverse consequences that it has on personal income and spending capabilities. Indeed, right now we actually see excessively high unemployment rate across the globe with permanent job losses in USA continuing to surge on pace with previous 2008 recession. However, due to increased unemployment benefits and direct payments to population by the governments no significant decline in income and therefore demand is experienced yet.   

S&P‑500 performance vs US permanent job losses

Source: Bloomberg

From all this follows interesting observation – while governments keep supporting producers and consumers, demand and supply remain relatively elevated for the time being, providing impression that economy is going back to normal. Post‑COVID improvements in macroeconomic data to large extent support such feeling, and therefore market participants are largely optimistic about future economic growth. Big question, however, remains – what would really happen, when financial aid is finally gone? In that case consumption is likely to drop, leading to lower demand, followed by excess supply, lower revenues and profits for corporations, and if financial markets are rational also decline in asset prices. Partially market decline in September supports such logic, with no new stimulus measures announced and already allotted funds coming to an end, “fuel” for further macro improvements and rally in asset prices is also coming to an end.

Understanding these threats, democrats and republicans by the end of September decided to resume negotiations to pass new stimulus bill. Parties cannot yet reach agreement on the amount of funds, but, anyway, if passed, total size of stimulus would be almost certainly more than USD 1 trillion. This is extremely large amount of money, and most likely short term consequences of such bill being passed would be positive for the markets and the economy, so we may see yet another rally in risky assets for at least another 3‑6 months. It is also expected that bill may include another round of USD 1,200 checks to population, and if just like in spring, part of this money is spent on trading in financial instruments, it may also prolong speculative excitement that has been witnessed in certain stocks recently and lead to new price records.

Meanwhile coronavirus developments are again taking central stage. Number of new cases continues rising steadily all across Europe, raising concern that new widespread lockdown measures could be introduced similar to how it happened in spring. Cities, such as Madrid, for example, where situation is especially challenging, have already reintroduced lockdown measures, and other hotspots across Europe may follow soon thereafter. In USA also after gradual decline in August, COVID‑19 new cases started to rise gradually in mid‑September, and on 1st October major headline was announced that Donald Trump has contracted coronavirus.

COVID‑19 USA and Europe cases

Source: Bloomberg

With less than one month left until US presidential elections, Trump testing positive for COVID‑19 adds another layer of unpredictability to market behavior both before and after the elections. Seasonally, it is usually the case that stock market tends to experience worst declines during the election year just 1 month prior to new president being selected, so precisely in October. Overall, such market behavior is rather reasonable, as investors do not want to risk their profits and participate in potential volatility, if not their “favorable” president is being selected. This time around it is really hard to say, victory of which presidential candidate would be more beneficial for financial assets, and what can be initial market reaction to victory of one or other nominee. Last time many thought that stock market would tank, if Donald Trump would be elected, but in reality markets barely noticed and actually made new all‑time high just around one week after he had won. This time polls so far indicate that Joe Biden has better odds of becoming a president, and given his stance on increasing taxes for corporations and high net worth individuals, initial market reaction to his potential presidency might not be taken positively.

US presidential elections 2020 average poll results

Source: Bloomberg

However, most likely irrespective of who wins US presidential elections, more important factors determining future market direction at least this year would be linked to situation with COVID‑19, direction of macroeconomic trends, central bank actions and availability of new government stimuli. In that sense, both candidates likely wouldn’t have much power and influence to impact how these things are progressing.

Given that market reaction to certain upcoming events, like passing or not passing of fiscal stimulus bill in USA; coronavirus progression and how well Trump overcomes the disease, what would be election results and how these results would be perceived by investors – persistence of high volatility in financial markets is highly probable. Navigating such markets requires prudent long‑term planning and keeping the portfolio consistent with one’s risk tolerance.