Market Update November 2020 – Volatility v. Volatility

CAPITAL MARKETS

Here we are.  The convergence of three significant topics reaching a crucial point together.  It started with a pandemic, which quickly roiled markets with fears of a major economic slowdown.  The US political climate was already fractured and only became more divisive as the year moved on.  Now we are here.  The election itself has arrived and, as with prior elections, most voters are more than ready for its conclusion.  But, for investors it is not an election “day”, but rather an election season.

As we reach the election day, markets have backed-off the mid-year advance.  Who would have thought on January 1, 2020 that the S&P 500 Index would be down over 30% by late-March on the back of concerns regarding the toll that the global pandemic might take on the global economy.  Just then, global leadership stepped in with unprecedented fiscal and monetary stimulus efforts, providing support to both the global economy and the orderly functioning of global capital markets.  As businesses worked to adjust to the new environment, investors sought out opportunity and moved asset prices higher, culminating with new highs in the S&P 500 Index by mid-August.  

But as September progressed, market action shifted again as the uncertainty of the post-election era had become all too real.  And now, with the election just days away, market activity has made it clear that the election and pandemic carry further uncertainty unique to 2020.

First, the election.  As of this writing, polling suggests that Biden has a significant advantage over Trump, while public perception cannot quite be convinced that the outcome is certain.  In 2016, polling and prediction markets also gave Clinton a strong advantage leading up to election day – and we know how that turned out.  Although Biden‘s probability of winning this year is similar to 2016, the details are different.  Namely, there are far fewer states with close races for the electoral votes.  2016 showed that it’s never over until is over, but Trump will need to overcome even greater odds to be re-elected in 2020. 

Second, and maybe more significant, is the near-term resurgence of COVID-19.  While the virus is of great concern, the issue for investors has been the impact the pandemic is and can have on global economic stability.  New cases have again begun to rise (although fatalities have remained subdued) causing concern of re-emerging risks to global businesses.  Particularly at risk are those businesses and industries that have only modestly recovered from the first slowdown.  Can they weather another wave?  For example, the travel industry (airlines, lodging, etc.) has seen only modest improvement since March.  Could a second slowdown trigger defaults and/or bankruptcies, impacting the credit markets and raising the risk of additional problems? 

A prolonged resurgence of the virus will be consequential on its own, even more so if it pushes corporate conditions too far.  And this brings investors back full circle to the election and what may be most significant to look for once a winner is declared.   First and foremost will be the ability to quickly provide another stimulus package to cushion the blow of a pandemic that is seemingly trying to reassert itself.  Regardless of who wins the election, this is likely to be “job one”.  Investors should acknowledge that each party has been supportive of providing more support to the economy, despite the inability for a stimulus agreement to have been reached before the election. The debate was not about “if”, but about the size and focus of additional stimulus.  Post-election, each party will have enough incentive for a solution that a package should be agreed upon.

Following stimulus plans, the next item to consider will be tax policy, where a more marked difference exists between each candidate’s philosophy.  A Trump win and investors will likely see a continuation of the policies put in place during his first term, possibly even expanded.  However, Biden’s tax policy related discussions during the campaign have consistently leaned toward higher taxes in part for (1) high income earners, (2) corporations and (3) capital gains.  Each of these have historically been problematic for capital markets as risk taking is re-thought given expected reduced returns net of taxes.  If Biden were to win, the combination of stimulus and tax policy will certainly be at the top of investors’ minds.  And the outcome of the races in the Senate will play a large role in his ability to move policy forward.  If his platform is to be advanced, the best-case scenario would see additional stimulus put promptly in place while changes in tax-policy are formed, but implementation is deferred until there’s better visibility of stabilizing economic conditions.

While it is difficult to have confidence in exactly how the next president will address these issues, the markets are sending a message as we approach the election.  Recent equity market declines have been more about uncertainty, with short-term market participants minimizing their “bets”, than indicative of investors “getting out”.  But the primary questions have emerged: Will the resurgence of the pandemic cause additional meaningful stress for the global economy?  Will global leadership respond timely with additional monetary and fiscal support to cushion further economic disruption?  Will US leadership consider all policy decisions in light of current conditions?

As the election approaches, investors are casting their market vote for “uncertainty” and waiting for post-election clarity before determining where future risk-taking may be best rewarded.

CHART OF INTEREST – Volatility v. Volatility

Since early September, the S&P 500 Index has bounced sideways while trying to discern what the post-election environment may look like.  As it has moved back and forth within a ten percent range, the increased volatility has caused concern for some investors.  What does this indecisiveness tell us about the future opportunity? Are these declines signaling economic trouble ahead?  Or are they a result of investors pausing to better understand what the future may look like before redeploying capital.

To help understand what the recent volatility is telling us we can examine if the more fundamentally based fixed income markets are also behaving this way.  If so, then both markets may be signaling a warning sign of trouble ahead with heightened concerns about the future state of the economy and the impact it would have on the capital markets.  But if the fixed income markets are not confirming these concerns, it is likely that the equity market’s increased volatility is the result of investors taking a wait-and-see approach for more information before reaffirming their equity positioning. 

To analyze this, the chart below compares the VIX Index (an index tracking the volatility of the S&P 500 Index) to an index of credit default swaps for a basket of corporate bonds (the MARKIT 10yr investment grade credit default swaps index).  When the cost of the credit default swaps is rising, investors are concerned that economic conditions may not be sufficient for certain issuers to be able to repay their bondholders. 

But the chart shows that, for now, the credit default swaps index has been stable, suggesting that the equity market volatility is more about the uncertainty of both the election and rising COVID cases, rather than fears of a sustained, imminent economic downturn.

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Markit’s North American Investment Grade CDX Index is composed of one hundred twenty-five (125) of the most liquid North American entities with investment grade credit ratings that trade in the credit default swaps market.

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