Will a positive test burst the “bubble”?

When it became apparent that the virus was beginning to spread at a rapid rate across the globe, countries began to shut their borders, entire industries came to a standstill and global stock markets lost a third of their value in little over a month. Currently, travel between countries remains muted, economies have been left on their knees and many industries remain severely depressed. However, global equity markets have recovered strongly.

The third quarter saw the MSCI All Country World Index (“MSCI ACWI”) - a broad measure of global equity markets - complete its recovery from depths of March, following a return of 8% for the quarter as its performance year-to-date returned to positive territory. The performance of global stocks for the quarter was strong across most sectors of the MSCI ACWI – Consumer Discretionary (+18%), Information Technology (+13%), Materials (+12%), Industrials (+11%), Communications (+7%), Consumer Staples (+7%), Health Care (+5%), Utilities (+4%), Real Estate (+2%) and Financials (+2%). The exception was the Energy sector (-13%) which continues to suffer as low demand for oil saw the prices of Brent crude ($42 a barrel) and West Texas Intermediate ($40 a barrel) increase by barely 2% during the quarter. With the price of oil well below its pre-pandemic level of $60 a barrel, many companies linked to the industry, including the oil majors, have been forced to reduce their headcount by the thousands.

While the strong performance for the quarter was broad-based, for the first time since March, “Big Tech” stocks, which include the likes of Amazon, Apple, Facebook, Google and Microsoft, endured a sizable correction during September. The tech-heavy Nasdaq Index declined by as much as 12% during the month before recovering somewhat, bringing its total increase since its March low to 63%.

Much of the recovery in stock markets since March, specifically US markets, has been centred around these Big Tech stocks. Following its March low, the S&P500 Index has risen 50%. Big Tech has been a significant driver behind the performance of the S&P500 during the recovery and these stocks now account for more than a quarter of the entire market capitalisation of the S&P500. The performance in Big Tech stocks has seen their valuations elevated to lofty levels leading to comparisons being drawn to the Dotcom bubble of 2000. Whether this comparison is justified remains debatable, but it is worth noting a couple of points.

Firstly, it is worth considering how integrated many of these stocks are into our everyday lives. As we operate in an environment that continues to become more digitalised, the business models operated by Big Tech have grown in strength and power through incredible economies of scale which has enhanced their defensive features in the current environment. Through the pandemic structural trends such as e-commerce were pulled forward as big tech companies have continued to grow their revenue base and even expand their operating margins. These companies also possess solid balance sheets with ample cash reserves that they continue to build up as they are highly cash generative. The combination of continued cash flow generation and balance sheet strength has enabled these companies to continue with share buybacks even in the current environment. Big Tech accounted for nearly half the buybacks on the S&P500 Index during the second quarter.

The sell-off of Big tech towards the end of September was amplified by option sellers needing to hedge their exposures resulting from long call positions in these stocks. A surge in options trading on both the institutional and retail side has exacerbated the movements in Big Tech stocks. Stock options provide the participant with the right but not obligation to buy or sell a stock at a specific price. Many investors and traders are choosing the options route because it allows them to put down a smaller amount and earn a big return compared to buying the actual stock. The interest in options trading has grown dramatically. According to Goldman Sachs, the volume of options traded in August exceeded that of stocks by 20%.

Much of the recent exposure in options trading is attributable to retail investors. The US stock market in particular has seen an influx of retail investors who have turned their focus towards stocks and options while they are stuck at home without the usual sports betting activity to keep their gambling needs satisfied. With the introduction of zero commissions by retail brokerages towards the end of last year, retail investors are even more eager to pour their spare cash (including government stimulus checks) into the market. According to Citadel Securities, retail investors have become a material part of overall trading and can often account for nearly a quarter of US equity trades on peak trading days, more than double their activity from last year. Retail investors have mostly been piling into stocks that are in the news, such as Tesla, which has risen by nearly 500% since its March low.

Big Tech stocks have been the centre of focus as global markets recovered. However, the recovery has been broader than just Big Tech. In effect it is growth stocks that have outperformed during the recovery as the MSCI AC World IMI Growth Index has outperformed its value counterpart by 17%. Growth stocks which include Big Tech often have a digital element, are less cyclical in nature and are also beneficiaries from the stay-at-home trend. Despite their relative outperformance, towards the end of September, optimism over a potential vaccine added to the hope of faster recovery prompting investors to rotate out of growth stocks into value stocks. Whether this trend will be sustained remains to be seen, but for value to truly prosper over a longer period it would require an almost complete recovery in economies - a return to normality so to speak.

Heading into the final quarter of 2020, investors will be wondering whether stocks can continue their upward trend. Perhaps the biggest determining factor lies at the doorstep of governments and central banks. The recovery in stocks this year was largely driven my monetary and fiscal stimulus, the likes of which has never been seen. Markets continue to expect further support for weakened economies. In particular, markets are waiting in anticipation for an additional $2.2 trillion fiscal stimulus package from the US which has been delayed as Democrats and Republications squabble over its size and make-up. The accommodative policies of central banks continued this quarter, as the US Federal Reserve (“Fed”) announced a shift in its policy with regards to inflation. Over the past 25 years, the Fed has adopted a policy of inflation targeting which consisted of the central bank pre-emptively raising interest rates upon the signs of rising inflation. Going forward, the Fed will now tolerate inflation should it be expected to rise above the 2% level. What this implies is that should inflation begin to rise the Fed will not begin to hike interest rates. Considering that the US economy is not operating at full steam, which is expected to be the status quo for some time, and that the 2% rate of inflation has hardly been tested in recent years despite a period of expansion, interest rates are likely to remain low for a considerable period. In its recent guidance, the Fed noted that it will not begin to raise interest rates until inflation has been higher than 2% “for some time”, projecting that it would only begin to increase rates at the end of 2023. Further adding to the likelihood of no increases were the changes in wording that the Fed made regarding unemployment, noting that low unemployment alone would not lead them to hike rates.

Worldwide it can be expected that central banks will continue with their accommodative policies. In this regard, the European Central Bank (“ECB”) is currently reviewing its own framework. Christine Lagarde, the president of the ECB, recently indicated that it will look to allow inflation to exceed its target. By allowing inflation to overshoot, inflation expectations should rise which would in effect lower real interest rates. Elsewhere, the Bank of England, as well as the Reserve Bank of Australia, are considering pushing interest rates into negative territory.

A prolonged period of low rates would continue to reinforce the narrative of TINA (there is no alternative), especially when comparing equities to bonds and cash. The yields on 10-year and 30-year US government bonds are currently 0.7% and 1.5%, respectively, and in Europe many government bonds offer zero yield or in the case of Germany and Switzerland negative yields. Compare this with the current dividend yields of 1.7% for the S&P500 and 3.4% for the EURO STOXX 50. With interest rates expected to remain lower for longer, it will be even harder for investors to find yield and they may feel that they have no other alternative but to invest in the stock market, despite seemingly-elevated valuations.

A continued rise in equity markets may come under pressure over the next quarter as political uncertainty comes to the fore. The 3rd of November will see Americans return to the voting booths to elect the next US president. The divisiveness seen at the last presidential debate between Joe Biden and Donald Trump has only added to the political uncertainty which is bound to lead to volatile markets over the next few weeks. The fact that Donald Trump has now been infected with COVID-19 can only serve as a catalyst to more uncertainty.

Tensions between the US and China have been elevated recently, with the Trump administration imposing further restrictions on China with specific focus in the tech space. The US has imposed new sanctions on Huawei making it even harder for the Chinese telecoms giant to access critical parts and supplies. The additional restrictions are the latest in a string of actions taken against the company which the US has accused of espionage and technology theft. Restrictions have also been imposed on Semiconductor Manufacturing International Corporation (“SMIC”), China’s largest microchip maker, a move that will see Huawei cut off from its main supplier of chips. The Commerce Department in the US has told US semiconductor companies that they need to obtain a license before exporting certain technology to SMIC as it is concerned that such exports are being used for Chinese military services.

The Trump administration has also threatened to shut down the Chinese owned video-sharing platform TikTok, as it is concerned that the Chinese government is using the app to gain access to the personal data of American citizens. Adding fuel to the Sino-American cold war was an executive order issued by Trump that would halt transactions on WeChat, the social media platform owned by Chinese tech-conglomerate Tencent. The current US president is concerned that WeChat captures the personal and proprietary information of Chinese nationals visiting the United States thereby allowing the Chinese Communist Party to track Chinese citizens during their visit. Regardless of whether Trump or Biden occupies the oval office following the election result, tensions between the US and China are likely to remain elevated with both Democrats and Republicans wanting to be seen as tough on China. That said, Donald Trump has refused to accept an election result that does not go in his favour. A contested election result would only create further uncertainty and angst.

Adding further to the political uncertainty is the latest development in the Brexit process. In his latest negotiation tactic, UK Prime Minister Boris Johnson angered European Union (“EU”) officials by introducing an internal market bill. The bill seeks to introduce new legislation that would override certain parts of the Withdrawal Agreement signed by the UK and the EU during January of this year. Uncertainty over the Brexit process, which is likely to persist following this latest development, has contributed to the underperformance of the FTSE 100 Index, a broad measure of UK stocks. The index has underperformed relative to other stock markets indices since the March lows and is still down 22% year-to-date.

The rise in political uncertainty and the accommodative policies of governments and central banks, be it the enormous amounts of stimulus and liquidity injected into markets, the shift in inflation policy by central banks, or the lowering of interest rates to record low levels, has led investors to allocate an increased amount of their capital into the safe-haven asset of gold. Despite a pull-back in the price of gold in the third quarter which saw it fall below the $2,000/ozt level to end the quarter at $1,888/ozt, gold has been the best performing major asset class this year having increased by 24%.

The rise in the gold price to record levels led to strong performance by the South African gold miners with the JSE Gold Mining index up 80% year-to-date. Gold miners such as Gold Fields (+23%), Harmony (+24%) and Sibanye StillWater (+23%) as well as platinum counterparts Impala Platinum (+25%) and Northam Platinum (+47%) were significant contributors to performance of the JSE All Share Index. The index ended the quarter flat as the strong performance of the precious metal counters was offset by a decline in technology stocks Naspers (-6%) and Prosus (-4%) and rand-hedge British American Tobacco (-12%).