- COVID-19 infections peaked among U.S. residents in late July and continued to fall through mid-September, before rising once again by quarter’s end.
- We sense that the next few months of what has already been an eventful year could prove critical to the future course of the global economy and financial markets.
Global equity markets delivered another quarter of outsized gains, moving further from the March 2020 lows as the economic recovery that took hold in the second quarter continued throughout the summer.
U.S. stocks climbed steadily for the first two months of the quarter until peaking at the start of September and mostly declining for the remainder of the period. European equities moved higher over the full quarter with relative consistency, while U.K. stocks were flat in July, higher in August and flat again in September (finishing lower in sterling but higher in U.S. dollars). Japanese stocks advanced for the majority of the third quarter, while Chinese equities jumped in early July and finished the quarter with strong performance. Hong Kong stocks also started July in a rally, but finished the third quarter on a downbeat after selling off in September.
Short-to-intermediate-term U.S. Treasury rates declined and long-term rates increased, resulting in a steeper yield curve. U.K. government-bond rates increased across most maturities during the third quarter. Eurozone government-bond rates generally decreased, although shorter-term rates were mixed in both markets. The U.S. dollar continued to decline versus a broad trade-weighted basket of foreign currencies throughout most of the third quarter before beginning to recover in a mid-September reversal.
The number of people infected with COVID-19 in European countries continued to rise throughout the third quarter after having reached low points in June and July. Spain saw the earliest resurgence and ended the period with a greater percentage of its population infected than that of any other country in the region, followed first by France and then the U.K. Upticks in Italy and Germany have been much more subdued. Meanwhile, the percent of infected U.S. residents peaked in late July—nearly matching the high point Spain would reach two months later—and continued to fall through mid-September before rising once again by quarter’s end.
U.S. companies announced a large wave of layoffs for workers that had been furloughed earlier in the year as the quarter concluded. Employers in the worst-affected industries—airlines, travel accommodation, sports, entertainment, retail and education—have generally run short of resources after depleting the Paycheck Protection Program loans that were helping to support workforce retention. Prospects for additional fiscal stimulus dimmed amid election-season politics, with Democrats and Republicans holding firm on their respective funding demands. However, the Congress did pass a resolution on the last day of the third quarter to continue funding the federal government through mid-December, avoiding a government shutdown.
U.K. Prime Minister Boris Johnson announced in late September new restrictions in England on pubs and restaurants, transportation, and group gatherings as COVID-19 cases in the U.K. climbed to their highest levels since the spring. At the end of the same month, the U.K. House of Commons voted for passage of an internal market bill that contradicts the Brexit divorce agreement. Johnson argued that the powers granted by the bill would allow the U.K. to override EU attempts to shut down trade between Northern Ireland and other parts of the U.K. An amendment to the bill would require the government to gain parliamentary approval for any changes to commitments in the divorce agreement, representing a concession on the government’s behalf. Nevertheless, the EU announced it would pursue legal remedy given the bill’s contradictions with the Brexit agreement, even as trade negotiations continued.
Japan’s ruling Liberal Democratic Party selected Yoshihide Suga to succeed Prime Minister Shinzo Abe, who resigned during the quarter due to health issues. Elsewhere in Asia, China-Taiwan tensions flared around a high-level U.S. government official’s visit to Taiwan; China was angered by what it saw as one of its territories assuming sovereignty by inappropriately conducting international diplomacy. Chinese planes made a show of force to coincide with the visit, prompting Taiwan to quickly mobilize its military jets. The island’s government had previously condemned nearby Chinese military drills as provocations. In Beijing, a military spokesman accused Taiwan’s ruling Democratic Progressive Party of “collusion” with the U.S., and said the U.S. is trying to “use Taiwan to control China.”
The foreign ministries of China and India issued a joint statement in September declaring their intent to deescalate a territorial conflict that began in the spring along their Himalayan border.
U.S. technology company Oracle and retailer Walmart won a joint bid in September to serve as trusted technology partners of TikTok’s U.S. operations and, in order to appease U.S. national security concerns, gain full access to TikTok’s source code. However, under the current proposal, Chinese parent company ByteDance will retain an 80% stake despite the Trump administration having sought majority ownership for the U.S. companies. A U.S. judge temporarily blocked an executive order signed by Trump to ban downloads and updates for TikTok and other popular Chinese apps beginning in September.
The Trump administration announced in September that it would not pursue a 10% tariff on U.S. imports of Canadian aluminum previously announced in August, as trade is now expected to normalize in the coming months following high import levels earlier in 2020.
Israel normalized relations with the United Arab Emirates and Bahrain in early September in a US-brokered agreement that is expected to result in the mutual establishment of embassies and increased regional trade between the U.S. allies.
The EU imposed sanctions on a “substantial number” of Belarusian officials in response to fraud and violence associated with the August 9 election victory that awarded President Alexander Lukashenko his sixth term after 26 years in power. EU leaders declared that the election—which Lukashenko was said to have won with 80% of the vote despite large, ongoing protests—would need to be rerun as it was “neither free nor fair.”
Armenia and Azerbaijan renewed a long-simmering conflict centered on control of the Nagorno-Karabakh region. Beginning in July, Armenia announced joint defense programs with Russia—which Azerbaijan countered via military exercises with Turkey. Both sides accused the other of employing fighters from other regional conflict zones. By the end of September, skirmishes yielded to outright battles during which Armenia claimed Turkey shot down an Armenian fighter jet in Armenian airspace.
- The recovery in U.S. manufacturing steadily progressed during the third quarter, ending in a solid overall expansion punctuated by strong new orders and steady employment. Services sector activity climbed out of contraction in July and returned to a healthy expansion by August, where it levelled off through September. New weekly claims for unemployment benefits declined modestly throughout the quarter, but remained above levels that were unprecedented before COVID-19-induced lockdowns. The overall U.S. economy contracted at a 31.4% annualized rate during the second quarter, improving a bit on preliminary readings.
- U.K. manufacturing activity cooled a bit in September after returning firmly to growth territory in July and peaking in August. The U.K. services sector started the third quarter with solid growth, which heated up in August before settling back to a slower, but still-healthy expansion in September. The number of people claiming U.K. unemployment benefits drifted higher by 2.8% between July and August, reaching 2.7 million. The overall U.K. economy contracted by 19.8% during the second quarter and 21.5% year over year, slightly less than recorded by earlier estimates.
- A sluggish recovery in eurozone manufacturing activity through July and August warmed to healthier levels in September. Activity in the services sector plunged from a solid expansion at the start of the quarter to an outright contraction by September. Loans to non-financial European corporations grew steadily through July and August, at 7.0% and 7.1%, respectively, continuing a trend that began in April. The eurozone unemployment rate increased through August, jumping to 8.1% from 7.9% in July.
- The Federal Open Market Committee (FOMC) kept the federal-funds rate near zero during the third quarter. During July, the Federal Reserve (Fed) Board of Governors announced extensions of temporary U.S. dollar-liquidity-swap and repurchase-agreement facilities with other central banks through March 2021. In August, the FOMC introduced a new average inflation target that would allow above-target inflation following periods of below-target inflation. This change indicates that the FOMC will likely let the U.S. economy run hotter than in the past before taking policy action to temper growth. At the end of September, the Fed announced it would extend an order through the fourth quarter of 2020 for large banks to cut dividends and halt stock buybacks given expectations for a higher rate of loan defaults.
- The Bank of England’s (BoE) Monetary Policy Committee held the Bank Rate at 0.1% throughout the third quarter after announcing at the end of the second quarter that it would expand its stock of asset purchases to £745 billion. Committee members have debated the implications of employing a negative interest rate at recent meetings.
- The European Central Bank (ECB) held its benchmark rates unchanged during the third quarter. ECB President Christine Lagarde expressed an expectation that the central bank’s Pandemic Emergency Purchase Programme (PEPP)—which was granted a higher ceiling for asset purchases in June that totaled €1.35 trillion—would need to be fully employed given the current outlook.
- The Bank of Japan (BOJ) held course throughout the third quarter. Notably, newly elected Prime Minister Suga has expressed a desire to see more Japanese bank mergers on the belief that it is a crowded marketplace.
U.S. equities climbed significantly during the third quarter, led by growth stocks for most of the period. The large full-quarter return masked September’s decline, during which value stocks held up better. Our U.S. large-cap strategies1 produced substantial absolute returns during the third quarter, but lagged their benchmarks. Overweighting the financial sector and underweighting the information technology sector detracted. A value tilt contributed during September, but detracted for the full quarter. U.S. small-cap stocks lagged large caps, but still generated elevated returns for the three-month period. Our small-cap strategies outperformed their benchmarks during the third quarter primarily due to stock selection in financials, an overweight to consumer discretionary and an underweight to real estate; value and low-volatility orientations detracted. Overseas, our international developed-market equity strategy outperformed its benchmark. Stability and momentum exposures were the greatest contributors for the full quarter, while selection within value exposures was also generally beneficial. Emerging-market equities outpaced their developed-market counterparts during the third quarter. Our emerging-market equity strategy lagged its benchmark for the period due to unfavorable selection as well as value and dividend-yield exposures that did not keep up with faster-growing stocks in online retail and information technology.
1Individual holdings will differ between strategies. Not representative of our passive strategies.
Our cored fixed-income strategy outperformed its benchmark during the third quarter as most non-government fixed-income sectors led comparable U.S. Treasurys. The Treasury yield curve steepened, putting pressure on our overweight to the long end of the curve as long-term yields increased. An overweight to corporate bonds contributed as longer-term maturities outperformed short-term maturities. Mortgages modestly underperformed the benchmark during the third quarter, dragging down an overweight to agency mortgage-backed securities (MBS); however, selection was generally positive as more generic MBS types underperformed. An overweight to asset-backed securities (ABS) was beneficial, particularly as our largest ABS allocation was to strongly performing student loans. A higher-quality bias within commercial MBS (CMBS) detracted as lower-quality tranches outperformed for most of the third quarter. An overweight to U.S. dollar-denominated foreign agencies and sovereign bonds contributed, while an underweight to taxable municipals detracted. Our high-yield bond strategy outperformed its benchmark during the third quarter primarily on the strength of its allocation to collateralized loan obligations (CLOs). An overweight to and selection within retail contributed, as did an underweight to and selection in telecommunications. Selection in leisure was the top detractor, followed by an underweight to and selection in capital goods as well as selection in transportation. Our emerging-market debt strategy outperformed its blended benchmark during the third quarter, driven by an underweight to foreign-currency debt and an allocation to foreign-currency emerging-market corporate bonds; the strategy was partially held back by an overweight to local-currency debt. Key developments in Latin America (that is, Mexico’s continued recovery, in addition to Argentina and Ecuador reaching restructuring deals with bondholders) helped propel the strategy during the quarter, as did an underweight to Turkey.
Manager Positioning and Opportunities
Equity volatility remained elevated and valuations appeared stretched as the recovery continued through the third quarter. Within our U.S. large-cap strategies, we continued to underweight some of the largest-capitalization stocks in favor of more attractively valued opportunities further down the capitalization spectrum. Within our small-cap strategies, we maintained exposure to value- and stability-oriented stocks to provide insulation from further volatility. We expect a rotation in value as the market normalizes, but this may depend on getting through a second wave of COVID-19 cases. Within our international developed-market equity strategy, we tilted away from momentum and toward value, resulting in a mostly neutral orientation compared to the strategy’s benchmark. We remained overweight strong growth opportunities in the information technology and industrials sectors, and underweight defensive sectors like utilities, consumer staples and real estate with low growth prospects. Our emerging-market equity strategy’s momentum and stability tilts were slightly reduced in favor of value. We decreased overweights to information technology and industrials in favor of materials and consumer discretionary, while financials remained underweight.
With long-term yields remaining near historically low levels, our core fixed-income strategy continued to reduce its overweight to the 25-to-30-year segment of the yield curve and increase its position in the 7-to-10-year segment. An overweight to the corporate sector was modestly decreased as valuations grew rich after a springtime rush of discounted new issuance. We maintained overweights to ABS and CMBS with a higher-quality bias due to their attractive risk-adjusted yields. We also retained an allocation to non-agency MBS and an overweight to agency MBS. Our high-yield strategy’s largest position remained an allocation CLOs, which was increased gradually throughout the quarter. An underweight to the energy sector—the strategy’s second-largest active position after its CLO allocation—was reduced during the period. Our emerging-market debt strategy increased an underweight to foreign-currency debt and an overweight to local-currency debt over the course of the three-month period. In terms of country exposure, an overweight to Mexico was the largest position, followed by an underweight to Philippines and an overweight to Egypt. Exposure to Egypt was increased during the period, while overweights to Chile and Ukraine were decreased.
It has already been an eventful and exhausting year, but we have a sense that the next few months could prove critical to the future course of the global economy and financial markets. Most countries were in V-shaped recovery mode during the third quarter, moving sharply off their low points in May and June. We assume that future lockdowns to contain COVID-19 outbreaks will be far more limited in scope. For developed countries, treatments have improved, vulnerable populations appear to be better-protected, and younger, generally healthier people are accounting for a much larger share of confirmed new cases.
But we doubt there will be a full return to normal economic behavior until safe and effective vaccines are introduced and distributed globally. The news on this score has been positive, and probably is a key reason for the continued buoyancy of equities and other risk assets. According to the World Health Organization, researchers were testing 38 vaccines in clinical trials at the end of September, while 93 more were in pre-clinical testing. Ten vaccines have been approved for large-scale efficacy and safety trials. We think it is realistic to assume that a few different vaccines will be generally available by this time next year, which means that social-distancing measures must still be followed well into 2021 and, most likely, into 2022.
There’s no disputing that U.S. economic activity remains far below normal. Although incomes are now recovering as more people get back to work, the lack of additional income support may drag down consumer spending as we head into the end of the year. Business sentiment appears to have bottomed, but the outlook remains sufficiently uncertain to keep us in a watch-and-wait mode. We would not be surprised to see the official U.S. unemployment rate move up in the months ahead as hard-hit industries eliminate jobs now that government support has run out.
In August, Fed Chairman Jerome Powell officially unveiled a new framework for conducting the central bank’s monetary policy. The Fed has decided to see how low the U.S. unemployment rate can get before it causes the inflation rate to exceed the 2% mark by a meaningful extent. The FOMC’s own inflation projection does not envision a return to 2% inflation until the end of its forecast window in 2023, so it may be a long time before the federal-funds rate rises.
In our view, all that’s really left in the Fed’s monetary toolbox is quantitative easing, along with the provision of lifeline support to corporations as well as state and local governments through its various credit facilities. Monetization of debt will likely continue until the pandemic crisis is well past and the U.S. unemployment rate approaches its previous lows.
The U.S. presidential election will have a major impact on the economy and financial markets in the months and years ahead. Still, we firmly believe that it would be a mistake to pursue even a short-term investment strategy that necessitates accurately predicting: (1) the election winner; (2) the policies proposed by the newly inaugurated president; (3) the ways in which Congress will modify those proposals throughout the legislative process; or (4) the impact those new laws would have on the economy and financial markets.
Regardless of the election’s outcome, we assume that both candidates would see their platforms tempered before they’re put into practice. There is a high degree of institutional inertia, which is partly deliberate (constitutional checks and balances) and partly happenstance (increasing polarization of opinion in the country tends to favor a draw). While there could be some market volatility plausibly attributed to the election, it is usually best to pay strict attention to the fundamentals and to ignore the politics.
The U.K. is undergoing its own unique political melodrama, with Prime Minister Boris Johnson facing a rebellion among his own backbenchers and intense criticism from senior Conservatives over his proposal to renege on the withdrawal treaty that would allow Northern Ireland to trade without border restrictions with Ireland and the rest of the EU. The move to abrogate the treaty, if successful, would almost certainly lead to a hard Brexit—a reversion to the World Trade Organization’s most-favored-nation trading rules with the EU. It also could breathe new life into the separatist movement in Northern Ireland itself, not to mention Scotland.
Prime Minister Johnson’s decision reflects his government’s frustration with EU negotiators. There are two main sticking points, one small (EU fishing industry demanding full access to U.K. waters) and one large (EU demanding the UK’s continued adherence to EU strictures on government financial assistance to private-sector businesses).
Obviously, a hard Brexit will not help matters. But the worst impact potentially will be sustained by financial companies and other service-producing entities, since World Trade Organization rules deal mostly with tradable goods. The increase in tariffs, for the most part, will be bearable once border-related issues are worked out. In the meantime, the U.K. and the rest of Europe are facing a second wave of COVID-19 that could turn what’s been a V-shaped recovery into something looking more like a W.
This year’s pandemic and postponement of the summer Olympics proved to be a bitter ending to Japanese Prime Minister Shinzo Abe’s record-breaking term in office. His push to lift Japan out of its deflationary spiral was somewhat successful. Prices mostly stopped declining in the aggregate, but there were few occasions when overall consumer-price inflation rose above 1%. Pandemic pressures have caused a return to outright deflation in recent months.
In our view, it is unlikely that radical changes will be made to the direction of policy under Japan’s new Prime Minister Yoshihide Suga. In the near-term, the priority will be on the response to the coronavirus; fiscal policy will remain quite expansionary. The Bank of Japan will continue to buy most of the government-issued bonds, along with other types of corporate debt and equity, as it has been doing as part of its Quantitative and Qualitative Easing program over the past four years.
The contrast of the big Asian stock markets versus other large emerging-market equities is dramatic. China’s strong gains can be chalked up to its rebound in economic activity. Although travel and other services are still constrained due to lingering concerns about the virus, infrastructure-related spending and manufacturing have experienced an almost-complete recovery to pre-pandemic levels. Investors seem to be unfazed by the deterioration in the US-China economic relationship or by the increasingly fraught diplomatic relations between China and other countries.
Emerging markets are already showing some good news. The price of raw industrials bottomed in early May, and have since enjoyed a sharp move higher. If industrial commodity prices advance in a sustained, multi-year fashion as they have in previous cycles, it’s a good bet that emerging-market corporate profits will also rise sharply.
Our optimism is somewhat tempered by the rising debt burden facing many emerging countries. Much of the increase in emerging-market debt has been tied to the corporate sector—especially in China, where private domestic, non-financial debt has reached an eye-watering 216% of GDP. Of more concern are the mostly small-to-medium-sized countries that are running current-account deficits and are too dependent on external hard-currency debt, or do not have the reserves to easily cover their debt service.
The actions of the world’s major central banks back in March, especially the Fed’s provision of U.S. dollar liquidity, have helped to ease the strain on the market for emerging-country debt. Governments and other official lenders, meanwhile, have granted loan forbearance to nearly 80 countries; it’s a tougher job to get private creditors to agree to do the same. Nonetheless, emerging-market sovereign yields on dollar-denominated debt have fallen back toward their previous record lows, more than reversing the spike endured in March, prior to the Fed’s rescue operations.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding SEI’s portfolios or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts.
There are risks involved with investing, including loss of principal. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment grade securities, due to the speculative nature of their investments.
Diversification may not protect against market risk. Past performance does not guarantee future results. Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index.
Information provided by SEI Investments Management Corporation, a wholly owned subsidiary of SEI Investments Company (SEI).