Below we’re sharing an insightful article for our investors from Global X ETFs, the innovative firm behind two of our thematic portfolios. This piece was authored by Jon Maier and Michelle Cluver, CFA, and the original posting is available here.
Global X ETFs Q3 2020 Review and Outlook
COVID-19 has been center stage for most of 2020, but we expect that election buzz will steal some of the limelight during the fourth quarter. The main items on our radar for the remainder of 2020 are the election, rising wave of northern hemisphere COVID-19 cases going into fall, encouraging progress on the vaccine front and the growing chatter about rotation into cyclical and value focused sectors.
Overall, equity markets had a strong third quarter with the S&P 500 Index rising +8.9% during Q3 bringing its YTD return into the green with a +5.6% return. In mid-August, the S&P 500 Index set its first all-time high since February. The market continued to power higher until early September when valuation concerns drove a shift in performance between growth and value and market volatility increased.
The strong quarterly performance wasn’t isolated to U.S. markets. Emerging market equities outperformed the S&P 500 Index with a quarterly return of +9.6%, bringing their YTD total return to -1.2%. International developed markets also had a good quarter returning 4.9% and -7.1% in Q3 and YTD, respectively. During the September selloff, international markets generally held up better than U.S. equity markets and long-duration Treasuries provided some shelter. Overall, risk on sentiment remained the dominant force during the quarter and this dampened the performance of the Bloomberg Barclays Aggregate Bond Index, which returned +0.6% for the quarter.
Volatility is likely to remain elevated during the remainder of the year. Rising COVID-cases combined with a very different election cycle are likely to increase volatility during the fourth quarter.
Presidential Election Likely to Steal the Limelight
Last quarter we ended our outlook with the belief that there was momentum in favor of the Democrats potentially taking leadership in the House, Senate, and Presidency. Currently, the Democrats only hold the House, and are likely to maintain this majority. With 4 weeks until the election, how can we avoid the topic of the election of 2020. We still believe that the likely outcome is that there will be a Biden Presidency with the possibility of the Democrats taking control of the Senate. The Democrats need to gain a net 4 senate seats. With the Republicans defending 23 and Democrats defending 12, there is a reasonable chance that the Democrats may be able to gain a majority in the Senate.
It is a common belief is that if the Democrats take control of government, it would be a negative for economic growth. Our view is counter to this. We believe that a Democratic sweep can be a positive for markets for following reasons:
- A large increase in fiscal spending, including an infrastructure plan, would boost economic growth and help offset the pressure on earnings as a result of both COVID-related weakness and higher corporate tax rates used to fund the fiscal spending.
- A more cohesive federally based approach to the containment of COVID-19.
- Improved consistency in approach to both domestic and international policy.
We know this isn’t your typical election cycle – with COVID-19 still being a tail risk in the U.S. and concerns about the type of recovery we can expect across the global economy. Things to consider include the shape of the U.S. economic recovery, the policy by the Federal Reserve, fiscal stimulus and the current valuations of markets. I continue to believe the current investment landscape is unusual and while we wait for the outcome of the election, both parties have and will continue to embrace deficit spending – it is the only way through. But nothing comes without consequences.
Fiscal Spending Remains on the Horizon
Although both sides remain in discussions regarding a possible fiscal stimulus package, and there have been hints of optimism over the past few days, our base case is no fiscal stimulus prior to the election. The pre-election posturing and a partisan Supreme Court battle now upon us has lowered the probability of reaching an agreement on fiscal stimulus prior to the election. However, the uneven performance in the first presidential debate may have changed the calculus.
Our base case scenario is short-term gridlock. While we remain of the view that more fiscal stimulus is likely after the election, there is the risk that the outcome of the election may affect the likelihood of further fiscal stimulus. If there is not a Democratic sweep, gridlock could move into 2021. Should this occur, it will be a big negative for the markets. Conversely a stimulus package will be a net positive.
Data Improving, but Is it Enough
Initially there was a strong recovery in the data as the market began to open. That was because there was an “easy recovery” rebound. Going from near zero to something greater than zero was easy and the market reacted positively. Transitioning from the 90% economy to a full recovery is something quite different. There is reasonable concern that a more sustained recovery is challenging. Please don’t forget why we are where we are – the virus. COVID-19 constrains re-engagement, especially with the increase in cases around the country and globe. Without new fiscal stimulus, the economic implications of COVID-19 will drag on the recovery.
This has already started to be seen with retail sales growth slowing. Although consumer spending increased 1% in August, lower unemployment assistance resulted in personal income declining 2.7% relative to July. Without the assistance of fiscal stimulus, this has the potential to lower consumer spending during the second half of the year which will drag on the economic recovery.1 While we have seen significant improvement in the employment data, both initial and continuing jobless claims remain stubbornly high. While the Federal Reserve has revised down their expectations for unemployment, the unemployment rate is still expected to remain above 5% until 2022.2 Without further fiscal stimulus or a significant improvement in the labor situation, the consumer story could face serious headwinds.
This situation is likely to become more challenging as the weather becomes cooler. Outdoor dining is a lot more challenging in the cold and if cases continue to rise, there may be less willingness to eat indoors (if that is even available in some areas). As such, a large number of service sector jobs could potentially be at risk as we move into fall.
What Could Change it All?
Don’t forget that monetary policy remains hyper-supportive, and most importantly, we are likely not too far away from having an effective vaccine available. While there are many vaccine sceptics in the U.S., a larger number of people are willing to take the shots. Mass inoculations will speed up the economic recovery.
Globally there are 213 COVID-19 vaccines in development with 35 currently in clinical trials – numerous of which are in phase III trials.3 During Q4 an effective vaccine is likely to start being distributed. This is a significantly faster schedule than the historical path for most vaccine development. The vast amounts of financial resources going into COVID-19 research has permitted vaccine developers to run stages concurrently without concerns regarding the financial repercussions should any step need to be repeated. This should also help vaccine development companies have a significant supply of the vaccines available prior to the final approval of the vaccine.4
Vaccine development progress is encouraging. However, there remains a long road to ensuring that the population is effectively vaccinated against COVID. The segments of the population most in need of protection against COVID-19 – such as healthcare worker, essential workers and the elderly – are expected to be prioritized in the distribution of any vaccine. At this stage, a vaccine is only expected to be widely available in mid-2021.5
Has the Great Rotation Started?
Improving macroeconomic data combined with extremely supportive monetary policy is favorable for cyclical sectors. This was clearly seen during the third quarter with cycle sectors generally performing very well. With a vaccine likely to be released during this quarter, there is the potential that the market continues to favor sectors that closely relate to the market cycle such as Materials and Industrials.
Despite these positives for economic growth, value investing has continued to face challenges and there does not yet seem to be a concerted rotation from growth to value. At the beginning of September, questions started to be raised regarding the valuations on growth focused investments. Were investors paying too much for a company’s ability to continue growing their business despite the macroeconomic environment? We recently put out a piece on valuations in a low interest rate environment, which dealt with some of these concerns.
Value outpacing growth during the month of September was exclusively driven by the first week’s growth selloff. Thereafter, growth has regained its lead.
Growth Maintained its Upper Hand
Growth maintained a commanding lead during Q3 despite September’s pullback and large-cap continued to dominate. The Russell 1000 Index rose 9.5% while the Russell 2000 Index only increased 4.9%. This has further increased the YTD performance difference between large and small-caps.
The Russell 1000 Growth Index took the lead followed by the Russell 2000 Growth Index with a return of 13.2% and 7.2%, respectively. Value continued to lag with the Russell 1000 Value Index and Russell 2000 Value Index returning 5.6% and 2.6%, respectively.
The size and style trends seen during this quarter reinforced the YTD trends. During the year the Russell 1000 Growth Index maintained the lead with a return of 24.3% followed by the Russell 2000 Growth Index with a return of 3.9%. While both growth indexes have made it back into positive territory, value has yet to reach this milestone. The Russell 1000 Value Index and Russell 2000 Value Index brought up the rear with a YTD decline of -11.6% and -21.5%, respectively.
Getting Back to Business
Ten of the 11 GICS Sectors had positive returns during the third quarter. Consumer Discretionary (+15.1%), Materials (+13.3%) Industrials (+12.5%), and Information Technology (+12.0%) were the top performing sectors during the quarter.
The Consumer Discretionary sector continued to lead the rebound for the quarter. As discussed last quarter, this sector was hard-hit by lockdown restrictions and is a good test ground for reopening progress. It is encouraging to note that while internet retailers continued to perform well, the strength in Consumer Discretionary has become more broad-based during this quarter. While this sector has been strong the last six months, the colder weather may pose some challenges, especially if we continue to see increased COVID spread through the fall.
Materials had a strong quarter with the building materials, homewares and chemical industries having a strong performance. This sector is highly correlated with global growth expectations. Synchronized central bank support provided a favorable environment for this sector. The extremely dovish Federal Reserve (Fed) has put downward pressure on the USD. A weaker USD improves the competitiveness of U.S.-based Materials companies. Growing demand from China, rising commodity prices as well as improving industrial activities have added to the strength of the sector.6 While commodity prices are generally an input for companies within the Materials sector, improving commodity prices are supportive for the outlook of the sector.7 During the September selloff, the Materials sector held up very well and was the top performing sector.
The Industrial sector is starting to see some improvement but there is a long way to go. Industrial capacity utilization has been increasing off its April low of 64.06%. While remaining below its long-run average, during Q3 industrial capacity utilization has been in excess of 71%. Additionally, the manufacturing ISM PMI Index has indicated growth, and improving growth, for the last three months. While this is encouraging, there is still a long way to go. Industrial production declined 7.7% y/y in August with manufacturing production declining 6.9% while mining was down 17.9%. This is a substantial improvement relative to April when industrial production was 16.5% below its level the previous year.8 Going forward it is important to see how industrial production continues to improve.
Despite a challenging September, the Information Technology sector had a robust performance. Disruptive technologies such as Cloud Computing and Cybersecurity have grown in importance this year. Increased adoption levels are likely to continue to provide benefits in the coming years.
On the other side of the spectrum, Energy (-19.7%) was the only sector that declined during the quarter. Renewed growth concerns and September’s sharp decline in WTI Crude oil prices had an adverse impact on this sector. Real Estate (+1.9%), Financials (+4.4%), Health Care (+5.9%) and Utilities (+6.1%) had a subdued performance.
On a YTD basis the top performing sectors were Information Technology (+28.7%), Consumer Discretionary (+23.4%), Communication Services (+8.6%), Materials (+5.5%), Health Care (+5.0%) and Consumer Staples (+4.1%). Q3 has increased the number of sectors with a positive YTD return to six from only two at the end of the first half. Energy (-48.1%) and Financials (-20.3%) remain the weakest sectors. These two sectors remain the only sectors with double digit YTD declines.
Despite a wobble in September, the risk on sentiment dominated the quarter. As such, Treasuries took a backseat.
Preferreds and High Yield Debt had a strong performance within the U.S. while the USD weakness boosted the performance of international developed market debt. Both local currency and USD denominated EM debt was adversely impacted by September’s risk-off environment.
On a YTD basis, the risk-off environment from March continued to dominate. As such, only Treasuries outperformed the Bloomberg Barclay Aggregate Bond Index, with long-duration Treasuries being the star performer due to the sharp decline in yields during the first quarter.
Where Do We Go From Here?
While macroeconomic data has been improving, we could see an uncertain path without taming the virus and additional and much needed fiscal stimulus. The market is telling us that market volatility is expected to remain above its long-term average until there is a viable solution to the pandemic and election uncertainty is behind us.
Thus far the macroeconomic data has been encouraging. As discussed last quarter, these initial months of rebounding growth are the easiest to achieve. They reflect the early stage of the recovery when the data reflects the benefit of reopening the economy. Continuing this progress is likely to be the real test. As we go into fall, we will be closely monitoring the employment and consumer story as well as keeping an eye on the corporate debt market and whether bankruptcy risk is rising or abating.
Within this environment, it is essential to remain ahead of the thematic trends shaping the economy. As such, thematic investing remains a bright spot within the current market conditions. Increased adoption of thematic equity combined with improving economic data and a potential vaccine on the horizon help provide some glimmers of hope into the final quarter of 2020 – the strangest start to a new decade.