After such an extraordinary bounce-back in markets over the last six months, September has been much more balanced and the last few days in particular, with equities dropping and credit spreads widening, may have investors wondering what to do next.
Over the course of the post-March rally the dips have generally been bought, but given the more mixed tone this month investors will be asking themselves if that trend will persist this time and whether they should be booking some profits too.
The first question to ask is whether the sharp rally was justified in the first place. We think so. The enormous technical drivers won the day while the fundamentals have begun to catch up, albeit from a very low base, but the direction of travel is important.
Secondly, has the rebound been normal or does it have strange characteristics? Nothing has felt totally normal in 2020, but the recovery in credit has been led by quality and as you would expect, credit has generally outstripped equity as investors tend to become more quickly confident around solvency than they do about earnings outlook. The anomaly here has been the equity tech sector, though this too has played an important part in the recovery as it has contributed in a significant way to investor confidence. The speed of the recovery was also remarkable and obviously eventually unsustainable.
As we entered September we knew markets would face a confluence of headwinds, perhaps none large enough to steer markets off track on their own, but collectively they could be quite a force.
- The onset of a second wave of the COVID-19 pandemic
- Stuttering (but still improving) economic data
- A US presidential election in six weeks’ time (markets typically struggle to rally in the run-up to these)
- An escalation in negative trade rhetoric between the US and China as the election approaches
- The increased likelihood of a negative outcome in Brexit discussions
- Inevitable profit-taking, particularly in tech, which would dampen sentiment
All of these negative headwinds are now in play, and in the last few sessions they have evidently had the upper hand. However, when we analyse each of them and set them against more positive forces – the extraordinary technical imbalance, the gradual economic improvement, and a medium term view that we are still very, very early cycle and markets will become more expensive as the cycle progresses – we would conclude that over a slightly longer term view (maybe to year-end rather than month-end) markets will continue to progress.
For fixed income that should mean tighter spreads by year-end than where we are today, which is something that all the authorities want as it means the cost and availability of credit will be supporting the recovery.
Overall, in our view there may be some temporary volatility ahead which investors can try to sidestep or even take advantage of, but it’s probably not worth trying to be too cute as our medium term outlook is still constructive.