Markets spooked by uptick in uncertainty.
The S&P 1500® closed October down 2.3%, its second consecutive monthly loss, bringing its year-to-date return to 1.8% and about 8% off its September 2 all-time high. Rising COVID-19 case counts challenged the economic recovery and reopening, and stalled stimulus negotiations pushed much-needed fiscal support further out. Last but not least, the final days of the highly anticipated presidential election forced investors to recalibrate their near-term expectations (please see our fourth-quarter 2020 Strategy Insights, The 2020 Election: Investor Guide for more information).
Surprisingly, the fundamentally stronger growth and megacap stocks in the S&P 500® led markets lower in the month. The large-cap index was down 2.7%, while the more cyclically oriented and earnings-challenged mid- (S&P 400®) and small- (Russell 2000®) cap stocks outperformed, up 2.2% and 2.1%, respectively. While this is the second consecutive month of small- and mid-cap stocks outperforming large-cap stocks, we do not believe this is the beginning of a reversal of a longer-term trend. For context, the broader trend of large-cap equities outperforming small-cap equities has been over 500 trading days – and counting. Conversely, the S&P 500 has made multiple new all-time highs this year, most recently on September 2. In our view, for small-cap and value-oriented stocks to sustainably outperform their large-cap and growth-oriented peers, the macroeconomic backdrop needs to reaccelerate meaningfully beyond any near-term snapback to pre-COVID-19 levels, as earnings multiples remain well above long-term averages. That, in turn, would be driven by progress on COVID-19 containment and a recovery in earnings growth, all contributing to above-trend economic growth projections. We continue to believe we are not out of the woods yet, and the “stay-at-home” trade is likely to resume its leadership over the near term.
Domestic Valuations 10 Years Ended 10/31/20 (Chart 1)
Source: Bloomberg L.P., PNC
The CBOE Volatility Index (VIX) futures curve fell into full backwardation again in October following spiking COVID-19 case numbers and talks of economic shutdowns in Europe. The current (spot) VIX level closed the month at 38, its highest level since mid-June. It is rare to see all monthly futures contracts priced lower than the preceding month rather than the typical upward sloping curve; the last occurrence was in April amid the first wave of COVID-19 cases. The pronounced inversion over the month pointed to fragile market sentiment heading into the election.
Third-quarter earnings season is winding down, continuing the positive momentum that began last quarter. S&P 500 earnings season is on pace for its second largest upside surprise, coming in slightly below last quarter, with records going back to 2008.
The difference from last quarter has been the lackluster follow-through on performance, which we attribute to a slowdown in fourth-quarter earnings revisions. The next-12-month earnings-per-share (EPS) estimate is just 3%, and the growth rate for calendar year 2021 is 22.5%. In our view, this means analysts are expecting the latter half of next year to provide the majority of earnings growth, which is quite a leap of faith given the still highly uncertain macro backdrop.
Following the largest drop in economic activity on record, US GDP (quarter-over-quarter annualized) expanded 33.1% in the third quarter. This widely expected rebound was perhaps the most atypical on record, as self-imposed economic lockdowns to curtail the spread of COVID-19 were eased and massive fiscal stimulus helped bridge the income gap for much of the quarter. Data published on a shorter frequency, such as the weekly Johnson Redbook Index which measures the growth in US retail sales and Moovit Public Transit Index in the largest US metro areas, are showing approximately half the level of activity prior to COVID-19, but these data are now suggesting that the pace of the economic recovery is slowing as virus cases accelerate.
We continue to closely watch jobs data for guidance on the next leg of the recovery. While the overall unemployment rate has fallen to 7.9% from its April peak of 14.7%, improvements in the labor market are starting to weaken again. For example, continuing jobless claims remain well above the worst point of 2009, and the workforce participation rate of 61.4% remains well below its prepandemic high of 63.4%. In our view, what’s troubling from the most recent monthly labor report is that of the nearly 700,000 workers who dropped from the labor force, nearly 90% were women. We believe that as COVID-19 cases worsen, families with school-age children remain in a precarious situation dealing with child care, virtual schooling, and working remotely. While the labor market struggles to recover, the housing market continues to thrive with mortgage rates at all-time lows. The NAHB/Wells Fargo Housing Market Index reached a new all-time high in October.
Over the month, the United States experienced an unfortunate resurgence in COVID-19 case numbers. Overall, the seven-day moving average in new cases ended the month at over 78,000, well above levels early in the pandemic. Importantly, we continue to believe rising case levels alone are not likely the primary catalyst pulling markets lower.
In our view, investors are more focused on the probability of another round of forced economic shutdowns. We continue to monitor hospitalization rates, intensive care unit capacity, and mortality rates as gauges for capacity and potential stress in the US healthcare system.
Amid the pullback in US equities, Treasury yields actually increased to their highest level since June in anticipation of a new fiscal stimulus package. As such, the Bloomberg Barclays US Aggregate Index declined 0.45% for the month. Despite the uptick in equity market volatility, below-investment-grade (IG) credit spreads narrowed to near their lowest levels since the pandemic began, and the high yield (HY) index delivered positive performance for October. In our view, the performance in HY bonds highlights the challenge for traditional price discovery as the unprecedented monetary stimulus measures are potentially masking risks in lower quality fixed income, given the highly uncertain economic backdrop.
Developed International Markets
Markets alarmed by uptick in COVID-19 cases and partial lockdown measures.
Developed international equities declined for the second consecutive month as COVID-19 cases accelerated and governments implemented new restrictions to contain the virus. The MSCI World ex USA Index fell 4.1%, with every country in the index posting negative returns except for Australia and New Zealand.
Despite the performance challenges, earnings reports for the third quarter are on pace for another quarter of significant upside surprise (22%) over consensus estimates, continuing last quarter’s EPS rebound. However, revisions for the fourth quarter have slowed, and the 2020 EPS growth estimate remains at -29% where it has lingered since July. The longer-term earnings outlook for developed international markets has also slowed, as the current EPS growth estimate of 32% has fallen in recent months. As such, the forward price to earnings (P/E) of the index has compressed by almost two multiple points to 15.9 times (x). Compared to the S&P 500 forward P/E of 20.5x, that spread of 0.78 remains below the 10-year average of 0.87. The ongoing valuation discount is not a simple indication that developed international is “cheap” relative to US equities, but that the path forward remains highly dependent not only on containing Europe’s second wave of COVID-19, but also on an agreeable resolution to Brexit.
MSCI World ex-US vs S&P 500 Forward P/E on a Relative Spread Basis: As of 10/30/2020 (Chart 2)
Source: Bloomberg L.P., PNC
We continue to believe geopolitical uncertainty has been a significant drag on potential earnings growth throughout the region and, should Brexit become finalized, could unlock pent-up demand across the continent.
With Europe accounting for over 40% of new virus cases worldwide, various countries have reinstated restrictions. For example, UK Prime Minister Boris Johnson ordered a month-long lockdown and closure of nonessential businesses. Other countries such as Belgium, France, Germany, and Italy have all reinstated either curfews or partial shutdowns. As expected, higher frequency economic data show consumer activity is taking a hit against this adverse backdrop. For example, the TomTom Traffic Index, ShopperTrak retail shopping data, and FlightAware airline data across Europe have yet to reach prepandemic levels. Meanwhile OpenTable restaurant reservations in Germany already saw positive year-over-year growth in terms of usage; however, once lockdown measures went into effect in early November, those growth rates plummeted to less than 95%. Using the initial wave of COVID-19 as a guide, we remain confident European policy-makers can successfully contain the second wave combined with an appropriate level of fiscal support to bridge the gap until the economy reopens.
Despite stronger-than-expected third-quarter GDP reports from most Eurozone nations, recent macro data have pointed to an uneven recovery across most developed international economies. For example, the IHS Markit Eurozone Composite PMI® fell back into contraction territory after three months of expansion. That contrasts with the au Jibun Bank Flash Japan Composite PMI®, which has delivered six consecutive months of improving data, albeit still in contraction (less than 50). Eurozone consumer confidence also fell to a five-month low, and domestic demand for most developed countries remains subdued. We anticipate economic data to remain choppy through the winter as long as virus cases continue to surge.
In response to ongoing risks that remain tilted to the downside, the European Central Bank (ECB) Governing Council unanimously pledged to “recalibrate its instruments” to “ensure that financial conditions remain favorable.” ECB President Christine Lagarde even suggested the central bank might act sooner than the December meeting should economic conditions deteriorate further. In our view, the rhetoric regarding the pandemic stimulus program, increasing quantitative easing, or even providing new loans to the financial sector underscores the “whatever it takes” mentality among global central banks. We believe that while central banks can provide a nearly unlimited amount of liquidity to financial markets, only fiscal stimulus can fix the solvency issues that remain by providing a catalyst to jump-start economic growth that has been stifled by the unprecedented effects of COVID-19.
Central Banks Remain Committed to Accommodative Monetary Policy: As of 10/31/2020 (Chart 3)
Source: Bloomberg L.P., PNC
After nearly an eight-month stalemate, UK and European Union (EU) officials appear to be making progress toward a Brexit deal, in which the UK is expected to leave the EU on December 31.
As we have been in this situation before, the last time Brexit appeared to fall apart was over a disagreement regarding the Irish border. This time the primary sticking point deals with the policy of a “level playing field” so that workers’ rights are maintained throughout Europe, environmental protection remains enforced, and state aid that may be a competitive advantage for certain companies over others. This has been a long-standing policy within the EU framework, and thus we are skeptical a change in this policy for the UK can be readily agreed upon given the December 31 deadline. Repeated missteps toward a final resolution leave market participants hesitant to expect Brexit to occur as soon as politicians would like.
EM equities deliver a Halloween treat of positive performance as COVID-19 cases continue to decline.
The MSCI Emerging Markets (EM) Index outperformed domestic and developed international markets for the second consecutive month, delivering positive returns in October. We believe the outlook for EM remains compelling given the strong fundamental backdrop in the asset class.
The COVID-19 pandemic improved in most EM countries, led by India, where the number of new daily cases declined almost 50% throughout the month. In Latin America, Brazil was struggling to slow the virus case curve for months; however, by the end of October, cases were down to the lowest level since June. Other EM Asia countries such as South Korea continue to demonstrate successful policies in response to the virus and have already contained a third wave of new cases.
With the exception of China’s third-quarter GDP report coming in below estimates (4.9% vs. 5.5% on a year-over-year basis), the majority of data reports from the world’s second largest economy came in above expectations for the month. The Caixin China General Manufacturing PMI™ for September and the month’s industrial production report all beat estimates and expanded from the prior month. Retail sales also beat estimates (3.3% vs. 1.6%) for a second consecutive month of positive year-over-year growth. Contributing to this beat may be the fact that the Chinese consumer was affected more by COVID-19 than was the manufacturing sector.
Third-quarter earnings reports for the collective group of EM is approximately 50% complete and is actually delivering positive EPS growth, unlike virtually any other global index.
The Energy sector has the largest earnings upside surprise for EM (currently over 100%), which is in sharp contrast to the US Energy sector earnings backdrop, where shale oil production remains at unprofitable levels with West Texas Intermediate crude at $40 per barrel. We remain positive on the longer-term outlook for EM earnings, with consensus EPS growth estimates expecting a relatively small decline of 13% in 2020 and an outsized recovery of 32% EPS growth in 2021.
In an initial sign that EM capital markets remain robust, the Ant Group Co. Ltd. initial public offering (IPO) (33% owned by Alibaba Group Holding Ltd.) raised approximately $34.5 billion, the largest for any IPO. Trading was expected to begin during the first week of November; however, on the morning of the US election, news broke that Chinese regulators were suspending the IPO. Given the size of the IPO, it remains to be seen if the regulatory issues get resolved quickly and without causing material concern from foreign investors.
COVID-19 Daily New Cases (7-Day Moving Average) As of 10/31/2020 (Chart 4)
Source: World Health Organization, PNC
The rise in interest rates across the globe was fairly modest for the Bloomberg Barclays EM Aggregate Index, which outperformed relative to its US IG counterpart. Rates did rise materially in Argentina (the 10-year sovereign bond rose 200 basis points in the month), which is back in the headlines again as investors are questioning the long-term viability of the country’s latest attempt to restructure its bloated debt problems. The country only has three stocks in the EM equity index yet comprises 2% of the EM Debt Index. In our view, country-specific issues are a reminder that we recommend deploying actively managed strategies in both equity and fixed income EM exposures due to the inherent and wide-ranging idiosyncratic risks.
TEXT VERSION OF CHARTS
Chart 1: Domestic Valuations 10 Years Ended 10/31/20 (view image of chart 1)
Chart 2: MSCI World ex-US vs S&P 500 Forward P/E on a Relative Spread Basis: As of 10/31/2020 (view image of chart 2)
Chart 3: Central Banks Remain Committed to Accommodative Monetary Policy: As of 10/31/2020 (view image of chart 3)
Chart 4: COVID-19 Daily New Cases (7-Day Moving Average): As of 10/31/2020 (view image of chart 4)
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