The first week in November had a very different feel this year for most Victorians. In the past, the excitement of the Melbourne Cup long weekend meant a big weekend of plans and socialising with family and friends. The first week in November 2020 was less about the social happenings and more about what was happening in politics and financial markets.

So why is the first week in November so important?
The November Reserve Bank Board (RBA) meeting provides our central bank with the last genuine opportunity to influence the broader economy with interest rate changes before the Christmas break. The big show in town is the fact that once every four years it also the week of the US Presidential election. In 2020, the week was particularly noteworthy, with the following outcomes:

• The RBA announced a lowering in the cash interest rate target to a new record low of 0.10%. The target yield for the 3-year government bond was also lowered to 0.10%. In addition, a “quantitative easing” program was introduced, that will result in the RBA purchasing $100 billion of government bonds of maturities of around 5 to 10 years over the next six months, in an attempt to further lower interest rates across the yield curve.
• A Democrat victory in the US election, paired with Republican control of the Senate. This provided financial markets with their “preferred” scenario of political stability without the prospect of the new President having unencumbered power to alter policy settings dramatically.
• The second wave of COVID-19 infections in the Northern Hemisphere has seen the United Kingdom, France and other European countries introduce another round of lockdowns, expected to be in place until at least the end of November. An experience that us Melburnians know all too well!

What is the impact this time around?
Following a period of weakening in equity markets and rising global bond yields over October, the above events appeared to have reset markets with equities rallying again and bond yields shifting lower. Expectations are that interest rates will have to remain low for an extended period due to the continuation of the COVID crisis, combined with the new US administration more limited in its ability to add substantial fiscal stimulus. Central banks now appear primarily focused on restoring employment and economic growth. Domestically, this sentiment was highlighted by the RBA’s latest policy announcement.

In equity markets, the extension of the period of low interest rates and COVID related restrictions has a somewhat disparate effect. Companies with above average earnings growth prospects tend to benefit the most from low interest rates as there is less “penalty” for the time delay applied in the valuation of future earnings that skewed to future years. In addition, although some businesses are clearly negatively impacted by lockdowns and broader implications of COVID, others have thrived and using the events of 2020 to change business models or accelerate changes that were already in train.

Information technology (IT) is a high growth sector and sits at the intersection of the positive influence from low interest rates as well as the business model changes caused by COVID. IT has led most major markets higher over recent years, particularly in the US where it is the largest sector and has appreciated by 23% per annum over the past three years – dwarfing the overall US share market increase of 10% per annum.

Potential risks to the groundhog day scenario
The current scenario reads as constrained economic growth, low interest rates, and disparate sharemarket growth where specific sectors such as IT and healthcare are the big winners. Sound familiar? I could forgive you for thinking you are reading news from 2018-2019, as the events of the past week are delivering a groundhog day vibe from the past few years. Having said that, there some risks to the continuation of this scenario:

• Valuations – given the dominance of the same prevailing trend over recent years, bond yields and share prices in high growth sectors like IT appear priced for perfection. In the case of the Australian and US central banks, there seems little appetite to take interest rates below zero, creating a lower bound, which should ultimately cap bond prices and interest rate sensitive equities.
• Inflation – the ongoing maintenance of low bond yields is dependent upon the continuation of low inflation. Financial markets and central banks do appear confident that inflation will remain low. This expectation is built upon the spare capacity in the labour market (eg. unemployment) keeping wages growth subdued. However, whilst spare capacity is a key influence on inflation, it is by no means the only influence. The experience of the 1970s and 1980s demonstrated that high inflation could coexist with higher unemployment. Not just that, the unprecedented nature of the recent government spending combined with heavy purchasing of government bonds by central banks has rapidly pushed up money supply growth and household savings. This ultimately could create demand conditions that are inflation inducing at a time when supply in certain industries is being artificially constrained by COVID related measures.
• Vaccine development timeline – an earlier than expected COVID vaccine release should be unambiguously positive for equity markets. However, the associated stimulatory impact on spending could rapidly build on the inflationary pressures discussed above. The resulting upward shift in bond yields may then trigger a significant change in the pattern of price movement on equity markets, with those higher growth sectors that have dominated price growth in recent years being the least supported.
• An unexpected US Senate result – financial markets appear to be operating on the assumption that the new US administration will be constrained somewhat by a Republican controlled Senate. However, there is an outside possibility that Senate control will be determined by a run-off election in the State of Georgia in early January. Given that Georgia appears to have favoured Joe Biden in the Presidential election, a Democrat victory in the Senate can’t be ruled out at this stage. Such an outcome would be likely to change inflation and interest rate expectations, with policies such as a doubling of the minimum wage and a larger government spending program more likely to be introduced.
• The COVID crisis worsening – after the initial sell-down in March, share markets have been prepared to “look through” the downturn in company earnings associated with COVID and push prices to record high levels in some markets. Implicit in the market’s response is the expectation that COVID will have only a temporary impact on the earnings. However, should a vaccine take longer than expected to be developed and distributed, and infection rates continue to require lockdowns, then the impact on company earnings may have to have a more significant effect on share prices. The subsequent pullback in valuations would likely impact companies that have experienced the biggest recent price appreciation the most – with these companies ultimately requiring a healthy economy to meet the earnings growth rate assumed in current valuations.

Where to from here?
So while financial markets have in the short term had a positive reaction to the events of the past week, the base case assumed by markets is far from guaranteed. With local cash rates now virtually zero, investors will be seduced into following the momentum of markets and shift portfolios to those investment categories and styles that have performed better in the past. <<insert rant that last years winners are often not this years winners, and following the herd is a recipe for frustration>>. However, given the heightened valuations of some of these investments and the potential for the broader economic scenario to shift rapidly, investors should consider diversifying well beyond “yesterday’s winners” to build a robust strategy for the years ahead.

In short, the fundamentals of good investing remain in play. If you are unsure how your portfolio might be impacted, or if a change needs to be made then get in touch via pete@pekada.com.au