As The Tri Polar World Turns - Self Inflicted Wounds

MACRO THEMES

A much needed & healthy risk asset correction centered around US, Tech led equity, is in train, deepened by some self-inflicted wounds. Fed Chair Powell begging Congress for more fiscal stimulus at the same time the president himself questions the peaceful transition of power is, shall we say, not a good look. The question today is whether it will stay healthy? The trifecta of focal points: Stimulus, election and vaccine have grown to four with the addition of a Supreme Court fight after the passing of Justice Ginsburg, an American hero & true New Yorker.

It seems the Republican Party and President Trump have determined that a Supreme Court seat is more valuable than another stimulus package. This conclusion threatens to turn a healthy correction into something worse as a pre-election stimulus package gets priced out. However, as I write Treasury Sec Mnuchin is on the tape saying he is open to talks with Speaker Pelosi – goodbye Fed put, hello Mnuchin plunge protection team? Down 10% and the call goes out.

Arguably we are already IN the election process with early voting underway in roughly 20 states. Pres. Trump’s provocative statement that “we will have to see” about a peaceful transfer of power, quite possibly the first time such a phrase has fallen from a US President’s lips, escalates concerns around a contested election and reinforces the importance of a Supreme Court pick that could cement a 6-3 conservative majority in any election conflict.

We have long wondered if Covid 19 could upend US financial asset dominance as it has everything else. Perhaps it will be a combo of self-evident US dysfunction followed by a Covid vaccine that does the trick. The risk reward for holding US stocks into a contested election that could make 2000 look like play stuff is becoming a dicey proposition while a vaccine will be “kryptonite” for tech stocks.

The tension between further economic recovery/Rotation Trade and recovery concerns/support for Tech shares suggests the prospects for an uneasy equilibrium in US equity as investors await both the election outcome & vaccine news. Q3 earnings & growth data are up next which should support equities though follow through may be muted. The non-US equity markets continue to outperform as our Covid investing formula would suggest (LINK). ACWX faces neither the electoral risk nor the ham-handed nature of US fiscal policy making.

Given this set up, we continue to expect the next three to six months to be tougher to navigate than the last. Yet, a synchronized global economic recovery, abundant liquidity, much improved positioning (sorry Robinhood bros) and sentiment indicators support our decision to remain constructive on risk assets with a Cyclical/Value tilt & a non-US focus. Having earlier taken profits on the Tech side of our barbell we have been selectively adding to Cyclical/Value & non-US equity during the pullback. It's unlikely the same portfolio that won the day thru August will be the one to lead in the coming six months.

Our Covid investing formula remain intact: control the virus > successful reopening > domestic demand recovery (key given global trade decline) > stock market outperformance. China/Asia and Europe are the poster boys for this approach. The counter to the Covid formula is also important: failure to control the virus > sluggish reopenings > slow domestic demand recovery > need for more stimulus > rising political risk > weaker FX. Tech led equity outperformance has masked this US reality until very recently.

As we noted in a recent Musings, regime change is upon us in almost every sphere of life: equality, climate, policy, politics and markets. Our Global Risk Nexus (GRN) process remains a useful way to consider this emerging world.

HEALTH

As in many areas today there is both good news and bad news in the Health area. The good news is that rapid testing is being deployed and the various vaccine trial updates remain positive. The bad news is that the US has for all intents and purposes given up on controlling the virus at the national level while in some European countries, (Spain, France, the UK), cases levels are rising to worrisome levels, leading to small scale lockdowns and a general reduction in consumer confidence. Hospitalizations and deaths remain significantly below Spring levels though, reducing the risk of health system overload and supporting a more targeted response to clusters/outbreak. Asia, first in and first out of Covid, continues to be the most successful region in combatting the virus perhaps leveraging its more recent history of viruses to inculcate a more uniform response across its populations. See Chart 1.

Chart 1: Better Mortality Allows for Limited Lockdowns

Source: BofA

Speed remains Covid 19’s signature: speed of spread, policy response, market reaction and now speed of science. Rapid testing is up and running with airlines, sports teams and others pressing for more usage to in order to stimulate consumer activity. As noted, vaccine news remains constructive and we expect a vaccine in the coming months. The speed of science may then run into a slower implementation process however given that several vaccine prospects are pathbreakers and could require special handling (refrigeration etc.). Risk assets are likely to react first and ask implementation questions later. 

The key investment point remains better Covid control through science is both likely and coming fast. The shrinking numbers of those who feel comfortable taking a vaccine are worrisome, but they are very fluid and could change once a concentrated effort to assure people of its safety is mounted as it surely will be. A vaccine is likely to upend many portfolios: that which has lagged will likely lead & that which has led is likely to lag.

ECONOMICS

The good news is we are early in a global synchronized economic upturn; the bad news is that it is starting to ebb and requires further support – a vaccine or continued Govt assistance. September Service PMIs, especially in Europe, reinforce this worry. The primacy of production over distribution, seen first in China, is now visible in Europe while US hi frequency data suggests that the loss of pandemic financial support is becoming evident on the consumer demand side.

The US now seems to be in a race between the risk of ebbing consumption and the news of a vaccine. Asian demand is picking up on a slow but steady basis. Retail sales in China are now up y/y while early indicators around National Day travel plans are well ahead of year ago levels. European demand has taken a step back in several countries but with recent additional fiscal packages in Germany, France and others the risk of a material pullback seems low. It is the US that has failed to control the virus, has thus failed to reopen completely and as a result is most in need of additional fiscal support, though even here lack of stimulus is likely to slow the recovery rather than reverse it. See Chart 2.

Chart 2: Switch From Fed to Fiscal is Challenging

Source: BofA

Near term, investors need to face two realities: a Fed that essentially said it’s are done (Peak Fed) and a White House that said stimulus shimmulus… I’d rather have a 6-3 advantage on the Supreme Court. That’s quite a bit to absorb in a two-week span. The shift from a Fed led monetary policy response to a Congressional led fiscal policy response was bound to be problematic given the shift from a technocratic Fed to a politicized DC. Investors may need to get used to more volatility around fiscal policy decisions.

As we have noted the policy shifts from wealth concentration to wealth distribution, from fighting inflation to seeking inflation, from capital to labor and from monetary to fiscal are all global in nature. The focus is increasingly around boosting growth and stimulating consumption via fiscal stimulus at a time of record low interest rates and a troubled global trade backdrop. Thus, the European policy of keeping people employed, the US policy of paying those who the virus made unemployable & China’s dual circulation strategy (DCS) with its focus on internal demand are, in essence, all the same approach.

The backdrop is that of the first global, synchronized economic recovery in over a decade, coupled with a liquidity waterfall far exceeding that of 2009 and that may not be done growing just yet as JPM predicts it could expand from $9T to $15T over the coming year. Domestic demand is priceless in a weak trade world and so those countries able to stimulate it should recover faster & their risk assets do better than those that cannot.

The fuel is there: US household net worth hit a record in Q2 while European savings rates are likewise in record territory. Young Americans are making a major Real Estate bet buying houses like hotcakes in an attempt to lever up and recapture  wealth lost in 2008-9 and during Covid.That’s what makes the next few quarters so tricky – a vaccine could bring all that spending capacity out into the open while failure to produce a vaccine would require much more Govt support.

We had both expected US fiscal stimulus (even though Trump, highlighting the illusion of a great economy, is loath to ask for it) and foresaw the possibility of a stock market pullback being required to force DC’s hand. So far, we got the pullback without the stimulus; weak stocks = weak economy and vice versa so maybe a deal is doable; after all its really Trump negotiating with Senate Republicans.

Notwithstanding strong US data around housing & auto production there is the growing risk that a pullback in Govt support will lead to a pullback in spending and hence economic activity. While Q3 US GDP will be record setting, growth in Q4 and Q1 2021 is more important to risk asset outlooks. GS cutting its Q4 US GDP forecast in half on fears of no stimulus is illustrative.

Inflation concerns which were bubbling a bit in the US over the summer have pulled back as the reopening process slows. Euro strength has caused European inflation expectations to fall considerably resulting in some serious ECB jawboning of the Euro back under 1.20. China’s RMB strength provides some reflation space for Asia. We continue to think there is the possibility of some near-term inflation concern once a vaccine is introduced as supply demand imbalances percolate.

POLITICS

The US remains the center of the global political universe. PM Abe of Japan stepped down and was replaced by his right-hand man Yoshihide Suga causing barely an asset price ripple. A messy Brexit looms but that’s an old story & hence unlikely to have big market impact. We remain of the view that US – China risk is overstated, offering the RMB strength as an example. No, political risk is US centric.

The President has put contested election risk front and center. Early voting is underway and there are unprecedented efforts (Mike Bloomberg anyone) to get out the vote on the Democrat’s side. What’s perhaps most worrying is the President’s deliberate attempt to create the dynamic that anything less than a Trump victory is fraudulent. Thus, the need to go to the courts which helps explain why the Supreme Court pick trumps the stimulus bill.

In my copious reading on the election a few points stuck out: polls have not meaningfully changed in over a year between Trump and Biden. The likelihood that the polls will be off as in 2016 has been reduced by improvements in capturing the education levels of folks being polled while perhaps most importantly, there is no real 3rd party candidate (sorry Kanye) to draw votes away from former VP Biden as occurred in the 2016 race. So, notwithstanding stimulus (uncertain), vaccine (unlikely before 11/3) and now the Supreme Court fight, polls are unlikely to meaningfully change.

One interesting note is that there have been concerns on the Democratic side that VP Biden had an enthusiasm gap with younger voters. With cultural icon RBG’s passing the youth vote seems mighty energized and while the religious right is likewise activated the money flows in the immediate days of her passing were very much in favor of the Democrats.

So, at this point the polls suggest its Biden's race to lose with good odds of a Democratic sweep of the White House, Senate and House. Given the likelihood of heavy mail in voting & Trump’s comments it’s likely the election will stretch well beyond Nov 4th, though the surprise could be a smashing Biden win which would obviate the angst around the prospects for a contested outcome. See Chart 3.

Chart 3: Big Win for Biden or Trump Will Be A Surprise

Source: BofA

Thus, anything other than a big win, for either Biden or Trump, suggests a disputed election & weaker US risk asset prices, especially as the President continues to rail that the only way he can lose is if the vote is rigged. 

POLICY

Peak Fed and a politicized fiscal policy process give a glimpse of the future in the US and perhaps Europe. Peak Fed is likely to be followed by peak Central Banks globally, requiring more fiscal support on a global basis. See Chart 4.

Chart 4: Peak Global Central Bank, Over to You Fiscal

Source: BofA

China’s dual circulation strategy is likely to accelerate Asian integration; it implies a significant transfer of wealth and power to ordinary people. As Chinese import demand grows it will become a more and more important market for its neighbors as well as Europe and others. A stronger RMB keeps the cost of imports down and drives the strategy while providing cover for the rest of Asia to compete. We continue to wonder why the US is so adamant at forcing China to become self-reliant - American companies are likely to be disadvantaged in one of the world’s largest and fastest growing consumer markets. 

Splinternet is already leading China to develop a separate full tech stack. The financial sanctions push costs New York big business as stakeholders flip their China tech holdings from NYC to Shanghai while a potential record setting IPO (Ant Financial) lists in HK and Shanghai. China’s UN announcement that it will be carbon neutral by 2060 shows it aligning with Europe on climate – the complete absence of the US is telling.

Europe continues to drive its integration via the dovetailing of the Joint Recovery Fund (JRF), Green Deal & seven-year EU budget. The decision to issues $200B+ in green bonds sets the tone for a Europe that will be both climate leader as well as climate regulator. The JRF money flows for countries like Italy and Spain represent major opportunities for them to rethink their economies.

The potential for joint debt issuance leading to joint taxation across the digital and climate spaces allows one to imagine a powerful European renaissance in the years ahead. The multi-year nature of all three of these programs suggest (pending ratification) that Europe’s medium-term policy path is set - a stark contrast with Europe’s crisis filled prior decade: Greece, bank crisis, migrant crisis, Brexit, Covid etc.

Much as China drives Asia, Germany drives Europe. Germany seems much more on board with a banking union as well as steps towards a fiscal union. It’s shift to embrace more fiscal spending and a more integrated Europe has its antecedents in the recognition that China is taking market share even in advanced manufacturing. Thus, Germany needs to get bigger and the EU is the vehicle to do so. Importantly, Germany likes a weak Fx suggesting that the ECB will have a free hand in the years ahead. We see growing potential for the 2020s to be the Decade of Europe.

The US stands in sharp contrast. A bare bones Republican Party convention platform suggests a Trump 2nd term will likely be more of the same. The Biden policy mix is much more fleshed out and will likely focus on putting people back to work, shoring up the safety net, infrastructure and climate though much depends on the vaccine trajectory.

More interesting is the possibility that a Biden Admin could be a throwback to the very active administration of Lyndon Johnson. Like Johnson, Biden is a man of the Senate who knows how to get things done; the prospects for a pragmatic and active Biden Admin are well worth contemplating.

From a Tri Polar World perspective, an active Biden Admin would be quite bullish for integration in the Americas. Much as China and Germany lead Asia and Europe, the US can lead the Americas. There is a real opportunity to leverage the push for supply chain reshoring to stimulate the integration process of N and S America. Instead of pushing re-shoring which will likely mean production returning but not jobs (due to automation) the US can encourage factories to set up in South and Central America and thus help deepen Hemispheric integration, employ people in their native countries and foster a more integrated regional approach, something Joe Biden is known to favor. 

Covid 19, climate change and the US - China rivalry are all accelerating the Tri Polar World. The shift in trade from global to regional and the need for smaller countries to move closer to the center in each region further reinforces the Tri Polar World.  A failure to act by the US in the coming years would lead to the Americas falling further and further behind Europe and Asia.

MARKETS

Investors looking at near total US governmental dysfunction – from the failure to pass a much needed stimulus bill to abject defeat against Covid 19 to the daily presidential brief that any outcome other than a Trump victory is the result of a rigged election… can be excused for taking some money off the table. ROW is doing much better reinforcing the geographic as well as sectoral & style nature of the rotation trade.

What was at first a much-needed pullback from an overextended Tech sector has been joined by an interruption of the nascent Cyclical/Value move as the failure to pass another stimulus bill staggers the Rotation Trade, taking the whole market down. With the biggest outflows from QQQs since 2000 and short positions in the Nasdaq 100 at 12-year highs, it seems natural that a tech led short covering rally will help signal a near term bottom. A synchronized global economic economic recovery together with a vaccine in the wings underpins our decision to use the pullback to selectively add to both parts of the rotation trade, US Cyclical/Value & non-US equity (Japan at 1.2xBV) coupled with thematic plays in both ESG clean energy and Innovation. Looking forward we expect continued US political & policy dysfunction to compare poorly with robust policy support in Europe & Asia. See Chart 5.

Chart 5: Healthy Correction, Rotation Interrupted, Not Reversed

Source: BofA

We believe that more than Tech alone is needed to take the S&P significantly higher. Our view is that the Rotation trade is needed to broaden out the advance and sustain it. The essence of the Growth/Value trade is Tech/Financials and we view rising rates as the fulcrum for the Rotation Trade, spurring on Cyclicals/Value while simultaneously harming Tech’s cash flow led valuation support. A vaccine & rising rates are kryptonite for tech; we expect the rapid testing /vaccine to stimulate economic activity & lead to rising rates, especially at the long end which now has to bear all the inflation and supply related risk given a pegged short end. The failure of US rates to rally during the equity sell off is worth noting.

With that backdrop we think the Rotation Trade which is both sectoral/style driven as well as geographic is only interrupted not reversed. Additional US fiscal support is likely post-election regardless of who wins while a vaccine comes closer to reality as every day passes. That coupled with the liquidity backdrop and synchronized nature of the global recovery supports risk assets on a 12-month outlook.

An environment where US equity does ok on an absolute basis is the best for ROW outperformance. Beyond a vaccine, the case is building for Tech underperformance on a relative basis if not an absolute basis as work from home sells off, the tech IPO calendar gets heavy, policy risk grows in both the US and Europe, rates rise, and Tech cash flows become less highly valued. 

We remain overweight equity in a multi asset portfolio, overweight non US DM vs US and EM, prefer China and N Asia tech chains within EM and Cyclical and Value together with small caps in terms of styles/factors. Financials are especially favored (watch for Fed news on buybacks & dividends in coming weeks). Non-US DM provides inexpensive and underowned Cyclical/Value exposure; the combination of a Trump 2nd term and a vaccine is likely to be quite bearish for US assets as the lack of a 2nd term program contrasts poorly with active European and Asian integration efforts while a vaccine reduces the appeal of US tech heavyweights.

Fixed Income is at an inflection point; one that might herald the beginning of a long duration Sov bond bear market. If the world’s full throated fiscal and monetary support isn't enough to do it what is? Perhaps a vaccine? A taper tantrum in long dated Sovereigns seems quite feasible, especially given all the supply that is coming. Banks have been huge buyers of UST; should the economy recover and banks open the lending window who will replace them as giant UST buyers? A 10 yr UST at 1.25 - 1.5% in the coming six months doesn't seem like a stretch, likewise a 10-year BUND yield above zero. 

The Fed suggesting ST rates could remain near zero for five years, echoing the post GFC seven year stretch, while saying it could tolerate inflation above its 2% target suggests it will tolerate higher long rates. Thus we remain quite underweight Sovereigns with exception of EM $ debt, prefer Credit and within credit HY, continue to hold TIPs & Preferreds and are looking at RE vehicles. The shift in inflation regimes is likely to have real ramifications for pension funds, risk parity strategies and 60-40 portfolios.

Within FX the question is whether the recent big moves in the USD and Euro are signaling a shift in relative fortunes and a precursor to how equity leadership might play out. We are sympathetic to this view and would be even more so in the event of a Trump 2nd term. US financial assets are the most over owned in the globe and have been huge beneficiaries of capital inflows from abroad. The recent USD bounce is likely to be short lived. As the lines of distinction are drawn between US governance and that of Asia and Europe those flows could be at risk, leading to greater FX volatility. With the Euro arguably close to FV, China’s yuan could be the one to watch.  Our Tri Polar construct suggests the outlines of regional currency blocs: the euro, yuan and dollar.

The sharp sell off in precious metals would seem to suggest a decent entry point for a world where policy makers of all stripes are working towards inflation. We continue to see upside for Commodities which remain significant relative underperformers. Higher rates could dampen near term ardor for gold/silver while inspiring it for industrial metals. The move to clean energy and ESG driven investing strongly suggests clean energy needs to be a part of one’s commodity picture, especially with a Biden presidency. We have added to clean energy. Old energy is tricky and seems less appealing.

I hope you find this monthly piece of value and look forward to engaging with you on a monthly basis as we move through 2020.

Jay Pelosky, CIO & Co-Founder
TPW Investment Management

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