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The Big Conversation

Each week we examine major themes driving the markets and use Refinitiv’s best-in-class data to assess the risks and opportunities for investors. Powered by Real Vision.

The Big Conversation

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Episode 51

US election: the markets pray for clarity

Published on: October 29, 2020 • Duration: 17 minutes

This week we talk about the potential outcomes of the US election and how they might affect the markets. For economies that have been reeling from the COVID crisis, either continuity or a clarity of outcome is more important than who actually wins. Regardless of the victor, fiscal policy will have a big part to play in this economic future.

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  • In just under a week’s time, its US election day. For economies that have been reeling from the COVID crisis, either continuity or a clarity of outcome is more important than who actually wins. Regardless of the victor, fiscal policy will have a big part to play in this economic future. That’s the Big Conversation.

    Firstly, I’m not going to make any predictions about the election itself or the suitability of each candidate. I’m more interested in what happens to the markets. What I am going to look at is the potential outcomes under various scenarios, without saying which of them would be the most likely. As I mentioned at the start, this election takes place under extremely unusual circumstances, with the COVID crisis still ravaging the world’s economies, forcing policy makers to turn to fiscal support on a scale that many western economies have not seen in years. That’s not to say, however, that we haven’t had unusual backdrops in other elections over the last 20 years.  In 2000, the dot com crisis was starting to unfold, with the Nasdaq having peaked earlier that year on its way to a decline of over 80% that would last for nearly three years.

    The 2008 election took place during the depths of the great financial crisis which had been rumbling on for a couple of years by that stage and then SPX accelerated in September of 2008 with the Lehman bankruptcy and equity markets reaching their lowest levels for the year in late November. The equity market did bounce into and then decline after the election, but the tone was set by other factors. But the key difference today is that the policy response to most of the crises  over the last twenty years was generally a monetary response –initially with interest rates being cut and then after the GFC, policy makers also turned to extensive bouts of Quantitative Easing or QE, in which assets were also purchased as well as interest rates being cut. Whilst this QE may have helped stabilize asset prices, with equities in the US and long bonds in Germany performing particularly well, it has done little to deliver long term economic growth and many consider that these policies have widened the income and wealth gaps, particularly in places such as the US and UK. In fact, many would also argue that the last two decades of monetary policy have weakened economies to the point where they were unable to survive the COVID shock without the direct intervention of fiscal expenditure. In many cases, these fiscal expenditures will be widening out the budget deficits and pushing up the debt to GDP ratios.

    The US is going into this election as one of the countries which has turned to significant fiscal support. Both Trump and Biden are expected to increase that support if they win the election, but the speed and size of that support could be crucial and that will depend on the result. For this election I am using three basic outcomes (although there are obviously far many more permutations. The first is where we get a relatively known quantity of government, so for instance Trump wins the race for the White House and the Republicans hold the Senate, maintaining the current status quo OR where Biden becomes president and the Democrats win the Senate. A true clean sweep is possible, where one party takes the White House, Senate and the House and therefore controls Congress. The Democrat’s hold on the House suggest that they are unlikely to be dislodged at this election – though as we’ve seen the world over in recent years “never say never” at a major election. The second outcome is where we get a split result. Trump, for instance, retains the presidency but the Democrats take the Senate, OR Biden becomes President and the Republicans hold the Senate. The third outcome should be a temporary one – or at least most investors will hope it is – where the election is contested, with no clear immediate winner. In 2000, the last time there was a contested election, it took over a month for the final result to be declared. When thinking about these outcomes, people will primarily be concerned with the equity market, the dollar, bonds and gold, but in most cases, the post-election trends may have already been set by the macro-economic forces that were in play over the preceding months. In fact, something this year may have to give. Only once in the last 100 years has an incumbent President experienced a recession in the two years prior to an election and been re-elected, according to Strategas Research Partners. If, however, the equity market has been up in the 3 months prior to the election, they note that the incumbent was returned to office on 87% of those occasions (and 100% since 1984). As of Wednesday morning, the S&P500 is just up over the last three months, so it’s getting close, but as it currently stands, one of these two indicators might have to fail this time around.

    Despite the trend for the US equity market to perform well during election years (there’s only been four down years since 1928), the period immediately into and out of an election is affected by the level of uncertainty. When the outcome is uncertain, the S&P usually moves sideways before the big day, but once the election result is known, the equity market usually rallies as investors again start to allocate capital. Three of the last four cycles saw the equity market rally in the following three months after the election. Only in the case of the 2008 election did the market decline and that was in the midst of the GFC. In 2000, during the last contested election,  which is considered a possibility again today, the S&P did lose ground whilst Florida re-counted and then Gore challenged the result – but was the equity weakness to do with the election or to do with the unraveling of the dot-com bubble? As we can see in this chart, the equity market actually rallied in the final few days of this period of uncertainty. This year of course, we have had the exogenous shock of the COVID crisis and the swift and emphatic response from both the fiscal and monetary authorities, which have distorted price action through most of this year. Fiscal policy will continue to play a lead role regardless of who wins. But if this election is contested for a prolonged period of time and given that the S&P is still fairly close to its all-time high, despite this week’s weakness, it would come as no surprise if the S&P declined, probably more than the 4% decline in 2000. This is a market that currently relies on fiscal and monetary support, although the central banks will no doubt be on standby if market weakness became too excessive. A contested election should hopefully be resolved and that would take us into the other two broad scenarios.

    Now I am bunching together what initially appear to be two wildly different scenarios, such as a clean sweep for Biden and the Democrats……… OR…….. Trump and the Republicans holding both the presidency and the senate. And that’s because both these outcomes would reduce the level of uncertainty – one is an emphatic win with clear implications and the other maintains the status quo. The lower the level of uncertainty, the greater is the likelihood that investors will quickly return to the market. Overall equities should move higher, though the focus would be on how well the US performs versus other regions. Under both scenarios, we should expect extensive fiscal packages supported by monetary policy. If the Democrats were to win the Presidency plus the Senate, whilst holding onto the House, then expectations would be for a larger and swifter support package than if the Republicans simply maintain the status quo. Ironically, a true clean sweep by either party would actually have the most similar initial outcomes because both would have equal power to grapple with the exogenous impact of COVID. Obviously there are concerns that Biden would implement higher taxes – but again here the impact of the COVID crisis today should delay the implementation of those policies.

    What about bond yields? Could they rise if we get a clean sweep by one party or the other that leads to a swift fiscal response? There has already been a squeeze higher in longer dated yields, but central banks will be very wary about letting these get out of hand. Yield curve control has been discussed by the Fed. If yields started to move dramatically higher, it would destabilize risk assets - and central bankers have been trying to damp down the worst excesses of volatility. Therefore, yields could rise, but it would likely be met by a central bank policy response. Yields would underperform inflation in this environment, because actual yields would be suppressed even if inflation picked up. This would push real yields lower. Lower real yields have generally been great for precious metals such as gold. If this also came with a reflationary impulse, then industrial metals would perform well, making silver look very attractive. For the US dollar, the expectation of more fiscal and monetary support, including higher budget deficits, are expected to weaken the currency but will the US be operating in isolation? Currencies are a relative game, so whilst the policy response under both regimes could be extreme by historical standards, they may not be extreme when compared to other countries.

    The dollar should be weaker if there is a clean sweep, because a unified government would be able to act decisively. The underlying weakness of the economy and ongoing issues around the COVID pandemic mean that both parties would be following a similar route. If the USD drops, then we could expect to see foreign equities outperform the US. A weaker USD has generally been good for the relative performance of emerging market equities as we can see on this chart of the DXY next the ratio of the S&P versus MSCI Emerging Markets . The ratio of the SPYDER ETF versus EEM looks like it may be forming a head and shoulders top and the recent outperformance of EEM could accelerate if the dollar drops. It is less clear cut, however, for European equities. If US policies are truly reflationary, then European equities such as the Eurostoxx50 index will perform well because they are a play on global growth. If however, the policies are reflationary primarily for the US, then Europe could struggle, as we have seen over the last few months, where the Eurostoxx50 has underperformed the S&P500 with the recent bout of euro strength. Therefore, I would prefer to play EM equities over European equities if the dollar starts to weaken. The third scenario outlined was the one in which either Trump wins the presidency and the Democrats win the senate OR Biden wins the presidency and the Republicans win the senate. In both these cases, it would be a far more attritional and divided outcome. This outcome would increase uncertainty and therefore the potential upside in the equity market would be muted for an extended period of time. Long end bond yields should fall. Net non-commercial – also known as speculative positions – have become increasingly short in the 30-year space in an anticipation of a large fiscal impulse. If there is political disunity, bonds could rally and yields could fall. Although inflation expectations may be reduced, the decline in bond yields should keep long end real yields close to their lows. That would be another scenario in which precious metals would thrive, although the emphasis would be more on gold than silver, because the reflationary impulse which helps industrial metals would be lost – one of the reasons that silver underperformed during March’s deflationary hit. If there was a gridlock on the policy response, then it would eventually have a negative impact on the economy. This would lead to a backloaded fiscal stimulus, again because of the underlying fragility of the economy. Therefore, whilst a unified government would see a swift stimulus, a gridlock could eventually lead to a bigger stimulus because of inaction.  A gridlock would be less emphatic for the US dollar. Uncertainty may weigh on the currency, but equally the lack of immediate fiscal fire power may allow other regions such as Japan and Europe to steal a march on the US in implementing additional support measures. So in summary, if either there’s a clean sweep, we should expect a bigger fiscal response. If the White House and Senate spoils are shared, the fiscal response could be delayed, and this should see long end yields fall.

    Maintaining the current status quo, whilst still divided, would maintain continuity and familiarity.

    If it’s a contested election with no clear winner for the foreseeable future, then US assets could come under pressure as they did during some of the debt ceiling impasses of the last decade, where the US equity market actually underperformed other global benchmarks. But if things do start to get hairy the US Federal Reserve will still be there to try and calm markets by capping volatility in all the asset classes. In the medium term however, the Covid crisis will drive even a divided government to converge on similar fiscal policies. The 2020 election will still be overshadowed the impact of COVID. As discussed in the first section, it has already seen a generational shift toward fiscal policy in which the central banks will play more of a supporting role. In fact, many think this will lead to more extreme measures of fiscal stimulus such as Modern Monetary Theory and the introduction of a Universal Basic Income if the initial rounds of government expenditure fail to ignite real economic growth. Even in the short term we can see how the ongoing impact of the COVID crisis continues to weigh upon the market.

    This week in Europe, the German DAX had lost 7% by Wednesday morning, led by a near 24% fall in the in the tech company SAP after it cut its sales forecast due to the effects of the pandemic, again highlighting the gulf between European and US tech names. SAP is one of the largest components of the DAX and by far the largest component of the Pan European tech sector.The European Service sector PMIs have been dipping back into contraction territory over the last couple of months, with the eurozone October reading coming below expectations at 46.2, having been as high as 55 in July. The US equivalent, on the other hand, beat expectations at 56. Whilst one of the focuses for this election is whether Trump and the Republicans or Biden and the Democrats will be the most active on the fiscal front, it may well be Europe that needs to return with another round of monetary and fiscal support. The next ECB meeting is Thursday 29th October, though most observers expect that the they will be on hold until after the US election to gauge the nature of the US administration. The last ECB meeting of 2020 will be on December 10th.

    So far, monetary policy has had very little effect on the real economy – the main impact has been on asset prices. Eurozone inflation remains very weak, with the German HICP numbers again falling into negative territory. Economies have not recovered. So far, fiscal policy has provided support, not stimulus. It has helped economies rebound, but not recover to their former levels.

    Until fiscal and monetary stimulus create more growth and more demand than has been lost through the pandemic period, then the short-term outlook remains disinflationary. Whilst economies maybe on an upward trajectory, they are starting off a very low base with multiple headwinds still in place. Manufacturing economies which appear to have returned to full growth may find there’s not the end demand for their goods. This is why we should expect policy makers around the world to continue with their efforts to SUPPORT A SHORT TERM REBOUND at the expense of efficiency. Long term growth prospects will therefore remain subdued so that, even once the economy has seemingly fully recovered, it will be left structurally weaker again, just like it was after the dot com bubble and then the GFC.

    Turning back to the election, what would constitute a shock for the market? I don’t think anything will surprise this market as readily as the election of Trump in 2016. The price action that year was far more dramatic than could be attributable to other exogenous forces. On the day after the election itself, the first move in many asset prices was a knee jerk move lower. But, once the realization kicked in that Trump and the Republicans had won a clean sweep, the markets quickly reversed. But what was even more emphatic was the outperformance of specific sectors. The mid cap Russell 2000 index outperformed the S&P500, whilst US equities in general outperformed emerging markets, on the expectation that Trump would now have the clout to push through policies that favoured US industry, especially domestic manufacturers. Tax cuts were also being priced in.  The US dollar also rallied, with the DXY reaching its highest level of this cycle so far. This reflected the positive side of the US dollar smile, where the dollar is strong during times of strong US outperformance relative to the rest of the world. The other side of the smile is where the dollar is strong during periods of economic stress, like at the end of 2015 when the global manufacturing recession was taking place. The dollar is at its weakest when there is coordinated global growth (or reflation) and the higher beta currencies of EM or commodity countries tend to outperform. But what should be noted is that the Trump bump of the time only lasted a couple of months before the underlying global trends reasserted themselves. In 2017, we saw a continuation of the coordinated growth that kicked off in early 2016 when China again injected vast amounts of credit into the system. The dollar started to sag as global growth picked up. US equities performed well, but underperformed the broad EM equity space.

    So can this election create as much as a shock as 2016?  It might be a surprise if one Party achieves the clean sweep of the Presidency and Congress……but that still wouldn’t constitute a shock. The real shock, the pandemic, is still working its way through the global economy and until this has been resolved, the policies of both sides are likely to be more convergent than the personalities who are vying for power.

    And you can now get The Big Conversation from Refinitiv as a flash update on your Alexa device or Google assistant. If you want to know more about how to download it to your smart speaker, please go to Refinitiv dot com forward slash flash briefing.

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The Big Explainer

Understanding fund flows and asset price performance

Published on: September 1, 2020 • Duration: 10 minutes

This week Roger Hirst is joined by Bob Jenkins, Refinitiv Lipper’s Global Head of Research, to talk about fund flows. Understanding fund flows can help us understand asset price performance, but first we need to know and understand how these fund flows are calculated.

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  • [00:00:00] Fund flows tell the story of how investors and advisers are behaving, reacting to what's going on in the markets and the world around them.

    [00:00:09] Welcome to the Big Explainer. A wide variety of businesses use fund flows to make investment decisions to help create investment products or simply to try and decipher what are the key drivers of the market. Fund flows have always been one of the key drivers of asset price performance, but over the last few years, flows have arguably become more relevant than fundamentals, especially in the US, where the S&P 500 index continued to rise despite profits having flatlined for five years. Understanding fund flows can help us understand asset price performance, but first we need to know and understand how these fund flows are calculated.

    [00:01:00] We know fund flows are calculated on pretty much any open-ended investment vehicle that provides timely and accurate data as to the total net assets under management and performance that they've had over a given period. That's essentially the calculation, we just look at what are the assets under management at the beginning of the period, say it's a month, and what are the assets under management at the end of the period? Then we just kind of adjust or net out, if you will, the actual performance of the underlying securities, and whatever the differences, those are your flows. So I mean the flows are always an estimate, no matter who does them, whether it's us or some of our competitors out there, they're always an estimate and they're more accurate based on the accuracy of the information that we get. And so you'll see that more often than not, flows that are designed to tell a story, if you will, which is what they really do, they do a wonderful job of.

    [00:01:49] The fund categories that are being analyzed comprise a lot more than just well known mutual funds. There are many sources that can be used to help build the big picture.

    [00:01:56] Well they are what you just said, the conventional funds, their ETF and theyr’re money market funds, those are the primary ones and really across most of the major asset classes that have tradable fund products built underneath them, so that would be you know, stocks, bonds, money markets, even commodities have a lot of funds that are built around them nowadays.

    [00:02:19] The analysis of fund flows has many uses helping to define product strategy for asset managers, as well as helping investors spot how the key investment themes are evolving.

    [00:02:30] You know, probably the most common users of fund flows, ones who are really scrutinizing these are your product strategy managers for buyside shops in particular. So this tells them what products in their palette are doing well, where the trends are going, what investors are interested in, how they're doing against their competitors and such, and it really gives them kind of that roadmap for what did we do right back here and what should we be doing going forward.

    [00:02:57] When looking at fund flows, we're not just looking at absolute size, but also relative changes in flows which are calculated on a net basis.

    [00:03:05] They're inherently a net calculation at the end of the day right. You're netting out performance against total net assets. So essentially it's a net calculate on in all instances. In terms of which ones get the most, I mean that really varies quite substantially and therein lies kind of the intrigue and the descriptiveness that flows can provide if you're trying to tell a story about what's going on macroeconomically, you know, how does it, how is the world adjusting and dealing with the pandemic? We saw it very much in flows, and so for instance, in your other question about size, where we're looking at percentages or the absolute number, quite frankly everything when you're doing data analytics ends up being relative at the end of the day, in my view. But there are instances when that certain that size number it can just hit you like a block. And for instance I'll say that during the last month of March and going into April of this year when the pandemic was really hitting and the market was really cratering, we saw one trillion dollars moving to US money markets in a period of about three and a half weeks. It was an immense record amount of money. You don't need to know that that's less than 10 percent of total money market assets under management because that may diminish it, but that type of a move is very emblematic of what's going on and how investors are feeling at the time and how they reacted. And by the way, that's an active product. So typically people think of the market downturn. People are selling out of active products are going to pass the products. Actually no, during our little downturn that we had this past Q1, people sold out of passive and they bought into active in a large way. And they bought into again, larger money market funds. So we saw that it was at that sheer number. Now that's come down quite a bit since. And then we had a resurgence in bonds. Bonds sold off during that kind of a pandemic trough and then they bought back in again. So we saw that nice surge back up and bonds had very strong flows. So really moves on a month to month basis, which as the class has the most. These are the three major asset classes of course, they're always going to be, if you will, jockeying for the top spot in terms of flows, and it's really dependent upon what's going on in the world, in the markets. I told you I mentioned before about secular trends we're seeing of investors generally selling out of large cap, active equity products in large developed markets and buying into bond products. That is a secular trend, and we saw it actually continue mostly unabated during even the sell off we had recently. So you can see both short term trends and long term trends playing out in flows. And it really helps you understand what's going on in the industry.

    [00:5:31] Central banks have been playing an increasingly decisive role in financial markets. Is there evidence that the expansion and contraction of balance sheets such as the U.S. Federal Reserves are having an impact on the speed and size of flows?

    [00:5:44] There's kind of two things working here. I think with the central bank intervention, it definitely showed itself again in this past Q1, a very interesting quarter of course. We didn't see a lot of selling in equities in Q1. The markets collectively in terms of pricing went down, but that was more of an institutional story than a retail story. Retail fund investors weren't selling out of equities strangely. They may have just been shell shocked by what was going on. However bond funds started to sell. And this is the area where I told you there's been a long term secular trend of inflows into bond funds for many years now, largely, again, because of an aging demographic, etc. But they sold off. And the problem with bond funds is once you start selling, particularly ETF bond products, you kind of break through that very high level of liquidity in an ETF and you quickly get into a kind of illiquid nature of a lot of the bond sectors out there, except for, of course, the US governments. The rest of the bond sectors, particularly in anything that's mid to lower quality, very little liquidity, and they sold out instantly. I mean we saw them kind of come right running right back in as soon as the Fed put up that immense backstop and essentially put up a put, if you will, in particularly the credit markets, if not the overall economy. And that re-inspired investing back into bond products almost overnight, literally overnight. And you could see that happening with large inflows in bonds in April, May and into June. So you do see it both in a long term basis, and a short term basis. But long term also kind of offsetting the immense amount of liquidity that's been going on literally for the last 10 plus years now is these trends that I mentioned before. Aging demographics tend to buy income oriented products, whether it be annuities, whether they're putting keeping the money in their pensions, what have you, all that seems to keep a floor under bond prices in general. And as soon as the rates go up a little bit, people buy back into those, you have pension funds which are looking to lock in their liabilities and such. And it creates that kind of floor, so despite all the central bank intervention, we still haven't seen like runaway inflation.

    [00:07:41] So how do people analyze fund flows and what sort of tools can be deployed?

    [00:07:45] Well we provide flows in a number of different formats. We can provide feeds of flows to people. We can provide flows via our desktop tools. And we also provide flows via a brand new fund flow tool that we have now on EIKON, and we really have an incredible amount of optionality in terms of how you slice and dice it. And that's also part of it, too as you combine the flows that we have and we generate from the vast amount of funds that we cover, some 300,000 plus across 60 some odd countries in the world, and we segregate those into our classification scheme. Which is also the most granular that is out there. So you can really get a very meaningful like for like pure comparison with your flows and really understand how a given product's doing relative to its primary competition. And so that slicing and dicing is very important and really expands the use case. So again Refinitiv has a variety of different ways you can access this through our Lipper for investment management products, through our EIKON products, through our feeds products and gives you again that insight into the flows, and you can then kind of manipulate us as per your needs.

    [00:08:51] In many ways, fund flows are themselves the story of the market. We can see how demand for specific themes may be rising or falling, and when combined with price action fund flows can help inform investors and product designers about the potential longevity of a trend. Over the last few years, the steady flow out of active mandates into passive mandates has been one of the biggest market stories in which the fundamental investment framework has been reshaped. Many anticipate this trend will continue, especially in a world of explicit central bank intervention. For investors and asset managers, there are many micro trends that are taking place within this framework. Some such as ESG investing continue to build momentum despite the skepticism. Some of the best investors of the last few decades have built successful careers by incorporating fund flow models into their frameworks. And regardless of the underlying drivers, fund flow analysis will always be a valuable tool that helps us to understand how financial markets are evolving. 

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