The last week’s market highlights:
Each week, we present our featured topics in the context of the major themes listed below from Nuveen’s Fourth-Quarter 2020 Outlook:
- U.S. economy: After the third-quarter bounce, a wobblier and flatter trajectory for U.S. growth.
- Global economy: Considerable fiscal stimulus should keep economies afloat.
- Policy watch: No Federal Reserve interest-rate hikes until at least 2023.
- Fixed income: Lean into higher-risk assets to generate income.
- Equities: Focus on quality across the board (and dividend payers, too).
- Asset allocation: Consider benefits of active management amid idiosyncratic opportunities.
Quote of the week:
“There is hope in dreams, imagination, and in the courage of those who wish to make those dreams a reality.” – Jonas Salk
The light at the end of the tunnel shines a little brighter
It’s been our view since the start of 2020 — even before the pandemic hit — that the U.S. elections wouldn’t be the most important market driver this year. It turns out they weren’t even the most important market driver this month. So far, such an award goes to Pfizer’s announcement last Monday that its COVID-19 vaccine had proven to be 90% effective in large-scale trials. A vaccine brings the promise of economic normalization, replenished revenues for companies crippled by the pandemic and more jobs for workers in service industries. Moreover, Pfizer’s unambiguously positive achievement spurred hopes of even more vaccines and treatments arriving soon.
The vaccine news kicked off a “Manic Monday” on November 9:
- The S&P 500 Index gained 1.2% amid volatile trading, led by economically sensitive sectors such as energy and financials.2
- Gold, a traditional safe-haven asset, tumbled 4.5%.3
- Yields on longer-dated U.S. Treasuries spiked, as they often do when a “risk-on” mood prevails. For example, the yield on the bellwether 10-year note jumped from 0.83% to 0.96%.4 (Bond yields and prices move in opposite directions.)
But since markets were already pricing in the availability of an effective vaccine by the second half of 2021, why did they react so sharply? Because of reduced uncertainty.
In our view, the most significant “tail” risk for next year would be an across-the-board failure of vaccines and treatments to meaningfully curtail the pandemic. (A tail risk is the risk of an event that has only a small probability of happening but would have an outsized impact on markets if it did.) This year’s plunging stock prices for retailers, airlines and other service industries reflected at least some of that negative potential outcome.
Now, thanks to last week’s announcement, doubts about the timing and effectiveness of a vaccine are greatly reduced, and much of that tail risk can be priced out. Indeed, our base case of widespread availability of a vaccine by the second half of 2021 looks more likely if not overly cautious, while the worst-case scenario now looks far less probable. That helps explain last Monday’s rally in cyclical stocks and selloff in Treasuries and gold.
The Pfizer effect was short-lived, however. From Wednesday through Friday, investors began to refocus their attention on the dramatic rise in COVID-19 cases worldwide and the increasing likelihood of renewed economic shutdowns. The S&P 500 wavered between gains and losses, finishing the week with a 2.2% gain.5 Meanwhile, the 10-year Treasury yield moved sharply lower from its Tuesday close of 0.98%, ending at 0.89% on Friday.6
Meanwhile, President Trump’s failure to concede appeared to be of little concern to markets last week, as the bottom line of the November election results remained intact: Democrats lost at least 5 seats yet retained control of the House, and Republicans appear poised to maintain a majority in the Senate. With a divided government, we see little scope for sweeping policy changes—a marginally friendly backdrop for markets. Why? Under that “split” scenario, any attempt by the incoming Biden administration to enact personal and corporate tax hikes will be far more difficult than it would have been under a “Blue Wave.”
Growth to value and large to small: how durable is the recent rotation?
Let’s dig just a little deeper into last week’s market action. It’s clear that the vaccine news provided an immediate boost to cyclical (economically sensitive) assets such as U.S. value and small cap stocks, which have long been underperforming their growth and large cap counterparts. Last Monday and Tuesday, value stocks (+5.6%) beat growth shares (-2.9%) by a whopping 8½ percentage points, and small caps (+5.7%) handily outperformed large caps (+0.8%) as well.7 Those two days of gains erased outperformance by large caps and growth since March and August, respectively.8
But it remains to be seen how durable that rotation to value and small caps will prove to be. Indeed, both growth and large caps reasserted themselves from Wednesday through Friday.9
The degree of conviction (or lack thereof) in the recent rotation reflects in part how far we still need to go in overcoming the pandemic, notwithstanding last week’s positive vaccine news. Anyone saying there’s a light at the end of the tunnel is conceding that we’re still in a dark tunnel. We know from experience that the current spike in COVID-19 cases will translate into a spike in fatalities. Experience also tells us that as the number of deaths rises, consumers will begin to “close” the economy even in the absence of a governmental mandate. Lastly, we know from experience that local U.S. officials will be loath to order businesses to close, especially in the absence of federal support for those businesses. While some components of the CARES Act that are due to expire at the end of the year — including extended unemployment benefits — may be renewed as part of the omnibus spending package Congress will debate and vote on next month, the Paycheck Protection Program (PPP) is unlikely to be among them.
This is crucial for understanding what the U.S. economy, as opposed to the eurozone economy, will look like in the first half of next year. By locking down, at least in part, Europe is accepting a higher immediate economic cost as it tries to preserve as much of its private sector as possible — consumer spending power and business solvency alike — until mass vaccinations arrive. In the U.S., the virus is spreading uncontrollably across large swaths of the country, but without an economic relief package it will be difficult for elected officials to order businesses to close. Of course, that hardly matters if customers are already making the decision not to show up. The U.S. faces a greater risk of sustaining significant further economic damage, including business failures, layoffs and permanent reductions in consumption, because of the policy choices currently being made.
If we were all to wake up tomorrow miraculously vaccinated, the global economy would take off like a rocket, given the health of private-sector balance sheets and the related durability in consumer confidence. And the market trends favoring value and small caps that we saw forming early last week could take deeper root. But by next June or July, when the developed world could potentially reach herd immunity with the help of one or more vaccines, economic fundamentals might not look as good as they do today. That’s one reason for investors to avoid latching onto strong cyclical rallies that are likely to be short-lived.