- The US election unsurprisingly raised anxieties that manifested themselves in selling pressure across markets. This occurred with a mixed backdrop of rising COVID-19 cases and improving financial conditions.
- Federal Reserve support has returned many key measures of financial stability to pre-pandemic levels; however, cash holdings remain near historic highs. We believe the redeployment of cash will be the next dynamic to shift as election anxiety fades and COVID-19 vaccine timelines become clear, and investors will adapt to new conditions for growth and potential inflationary outcomes.
- We expect the oncoming reallocation of capital to create an excellent opportunity set for excess returns. We are uniquely positioned by seeking to monetize these opportunities systematically over the coming months.
In what has been an unpredictable year on many fronts, markets proceeded through the US election cycle on a remarkably conventional path. Rising levels of anxiety led to a de-risking and higher implied volatility heading into November, and this was followed by greater risk appetite among investors as election results came in. Despite Wall Street’s preoccupation with politics, there remains little evidence that any particular president has a statistically significant impact on market performance. What matters most around elections is that uncertainty is reduced, after which money can return to markets in pursuit of opportunities driven by a clearer policy outlook.
Recent market results have proved to be no different, with both stocks and bonds rallying the week of the election as cash moved broadly into financial assets. This logical response offers insight into what we see on the horizon for markets as levels of uncertainty are further reduced – not just in politics, but more importantly in public health and the economy.
Improving Financial Conditions Amidst Resurgence of COVID-19.
Key Takeaways
- The rise of COVID-19 cases has had a devastating toll on public health, and further attempts to slow the spread are limiting the economic recovery
- At the same time, financial conditions in the US continue to improve, and vaccine-related developments are providing a clearer path to address the pandemic
The ongoing resurgence of COVID-19 continues to break records for daily new cases in the US and elsewhere across the globe. Attempts to halt the spread have been wide-ranging, with states and countries implementing new lockdown measures to varying effect. While similar efforts managed to flatten virus transmission curves in the spring, it is unclear how effective they will be as we enter a challenging period of winter months.
What is clear is that the new set of lockdown measures will put further downward pressure on the economy and impact recently damaged components – particularly those in the service sector – most acutely. As a result, the recovery is likely to progress unevenly, and without fiscal support, many businesses will struggle to survive while waiting for the distribution of vaccines.
Figure 1: Recovery of US Financial Conditions
Source: Bloomberg
At the onset of the pandemic, the sharp drop in financial conditions roughly matched the extent of falling economic output. The subsequent recovery in financial conditions, however, has risen ahead of the broad economy’s incomplete rebound. Extraordinary policies from the Federal Reserve have already returned key measures of financial health, such as credit spreads and money market liquidity, to pre-crisis levels, supporting the full function of financial markets while the economy takes time to recover.
A stable foundation of healthy financial conditions is critical for economic recovery and fosters confidence for investors to allocate capital where they see opportunities. Under these conditions and as vaccine timelines become clear, we expect investors will actively put money to work and adjust to a new economic landscape.
Cash Levels are a Growing Risk
Key Takeaways
- When money markets and cash-like instruments offer negative real returns, they introduce new risks to portfolios that may not be fully appreciated
- We expect this risk to be recognized as uncertainties around elections and the pandemic are reduced and cash is redeployed into assets with the potential for positive real returns
In thinking about how markets work, it’s important to consider that there is technically no such thing as cash on the sidelines, as for every seller of an asset raising cash levels there must also be a buyer reducing them. With that being said, supply and demand for different types of financial assets, including cash-like instruments, is always changing as investors seek to maximize risk-adjusted returns. Demand for cash-like instruments, such as money-market funds, can increase from time-to-time, and this represents a natural friction in markets as people buy and sell financial assets. Periods of rising demand for these instruments, however, have been temporary throughout history due to the relatively low levels of return they offer investors who generally seek to outperform riskier benchmarks
Demand for cash-like instruments, such as money-market funds, can increase from time-to-time, and this represents a natural friction in markets as people buy and sell financial assets. Periods of rising demand for these instruments, however, have been temporary throughout history due to the relatively low levels of return they offer investors who generally seek to outperform riskier benchmarks.
Figure 2: Money Market Assets Remain Elevated Versus Pre-Pandemic Levels
Source: Bloomberg
Over the past twelve months, money market assets have grown to historic highs while their yields have fallen to historic lows. Based on the Fed’s target for inflation, these yields are now all but assuring negative real returns which introduce new and unfamiliar risks for portfolios. Real losses are rarely a good thing for clients and sustaining these in historically “safe” portfolio allocations creates a critical new challenge that investors must address.
Reallocation of Portfolios
In a year when a global pandemic was punctuated by a presidential election, it is understandable that uncertainty drove investors out of markets into extraordinarily high levels of cash. The prospects of negative real returns on this cash and related risks in portfolios, however, are set to change this dynamic as we head into the new year.
With the recovery of financial conditions and vaccine developments providing a clearer outlook for both the economy and public health, we expect investors to redeploy cash from portfolios at scale in pursuit of real returns. Imbalances from market activity over such a turbulent period have widely expanded the opportunity set in fixed income, and we seek to monetize this systematically as capital comes back into markets and portfolios recalibrate to the new economic environment.
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