As the global COVID-19 caseload nears 30 million and the number of fatalities has now surpassed 930 000, the resurgence of the virus is gaining the markets’ attention again. The focus is now on western Europe where new case numbers have continued to rise across several countries, even if for the time being hospitalisations and fatalities remain relatively low.
While government-imposed restrictions do not currently appear overly strict in the eurozone, voluntary self-distancing and waning fiscal support are expected to hurt sentiment on consumer spending and capital expenditure. Encouraging updates from some candidate providers on the timeline of a vaccine are grounds for hope in the markets, even if the results are still months away.
In the eurozone, infections have been rising persistently – this is the case not only for major European economies such as Spain and France, but also for the broader EU-19. Currently, the rise in case numbers is mostly driven by the younger demographic, but the number of new cases among the older population have been increasing too.
If a reversal in these trends does not come soon, we cannot exclude the possibility of a lockdown in one or more of the major economies with the obvious negative implications for the economic recovery.
For the markets generally, central bank support, via the ongoing wall of liquidity, remains the mainstay of market stability and continues to ensure that the current liquidity stresses are alleviated. This has left financial conditions supportive.
However, while central banks can provide liquidity, renewed fiscal policy will be the key to stave off insolvencies and further job losses. Without more fiscal support, a rise in bankruptcies looks likely in the months to come.
On Tuesday, the US Federal Reserve’s Federal Open Market Committee (FOMC) began its first meeting since the recent monetary strategy review. It is also the last meeting before the US presidential elections on 3 November.
Chair Powell and his colleagues will be updating their economic forecasts and ‘dot plot’ of policymaker expectations on the course of interest rates and deciding what, if any, changes they want to make to their forward guidance around rates and quantitative easing (QE).
We expect the FOMC’s forecasts will show stronger economic growth and lower unemployment, but little change to the core inflation profile. The ‘dot plot’ is unlikely to show any interest rate hikes in the forecast, which will run to the end of 2023.
We see a reasonable chance the FOMC changes its forward guidance on interest rates and QE. It could adopt explicit criteria linking the earliest possible increase in interest rates to specific conditions on inflation (that, for example, core inflation should be above 2%) and the unemployment rate (lower than 4.5% perhaps?).
We also expect the FOMC to make it clear that QE will continue at some steady rate for years rather than months.
If these changes are not announced this month, the November and/or December meetings will likely be used to flag these changes. Such an announcement would mark a significant and proactive shift in the Fed’s transition from monetary stabilisation to accommodation.
After the sell-off earlier this month, the NASDAQ tech market has started to rebound (see graph below), overall market volatility has settled and the S&P 500 VIX futures term structure has normalised.
The VIX future for October (pricing in US presidential election risk) had reached 40 and is now back at 30.6. The market continues to price in uncertainty around the outcome of the election, with October VIX futures continuing to trade at a premium.
If the election is closely fought, there is a risk that the contest becomes litigious, hence delaying the result and the removal of uncertainty for the markets. This could not only drive October VIX futures levels back up, but also November levels with an ensuing risk of a S&P 500 index correction.
Despite the recent correction in equity valuations, risky assets continue to benefit from US 10-year real interest rates trading near record lows and financial conditions remaining supportive.
In such an environment of accommodative central bank policy, a major sell-off in equity markets appears unlikely.
Moreover, in a low interest rate world, the equity risk premium (ERP) continues to make equities look attractive in spite of the V-shaped recovery we have seen in global equity indices in recent months. Europe remains a laggard, but we expect European equities to play catch-up into the year-end.
In bond markets, corporate issuers (especially the higher rated ones) are continuing to issue new debt at a robust pace. While defaults may continue if fiscal support slackens, the default cycle may be peaking. In this environment, dispersion will remain high as some of the weaker credits struggle to survive.
With the acceleration of M2 money supply and still accommodative central bank policies, continued USD weakness is likely. This backdrop is expected to continue to support commodities. Over the long term, in a world of debt monetisation, support for gold will persist.
Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice.
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