Markets continued their roaring comeback in the third quarter of 2020 as extremely accommodative central bank and fiscal stimulus coupled with a budding recovery in the economy outweighed the continued overhang of COVID-19. The near-term outlook continues to rely chiefly upon the pandemic and the economic developments arising from it. As we write, we are seeing many states experiencing an increase in reported cases with some reversing recent loosening. Many expect cases to rise materially during the traditional flu season and potential vaccines sow seeds of optimism, which the market has been reflecting.
The election rapidly approaches, and current odds favor a Democratic sweep. It is sometimes difficult but extremely important to separate one’s personal convictions from an objective assessment of an election’s outcome on a portfolio. A Democratic sweep likely means higher corporate, personal (for high earners) and capital gains taxes. The timing and degree of increase will depend upon the size of any new majorities. While tax increases are likely with this outcome, an extreme scenario seems less likely as Biden is known as a more moderate Democrat, certainly compared to those he defeated in the primaries. Nonetheless, his tax proposal, including a foreign profit tax, would create downward pressure on after-tax corporate profits, with some of the more impacted being large multinationals, including technology companies which have benefited from low effective tax rates. On a positive note, there is growing talk of significant additional stimulus which could add to GDP growth in 2021.
The Federal Reserve has responded aggressively to the COVID-19 pandemic, expanding their balance sheet far more aggressively than that seen in Europe or Asia year-to-date. The U.S. debt-to-GDP is now at levels only before seen during and just after the second world war. Yet, the U.S. remains embattled with the pandemic and associated economic malaise. A potential shift left, with more postelection stimulus, has the potential to further weaken the dollar.
Large capitalization technology shares have driven the market in 2020. Dominant operators at the outset, many of these businesses were extremely well-positioned for the restricted mobility, work-from-home environment wrought by COVID-19, and the market has rewarded them greatly. The Nasdaq has returned 27% through October 7 compared to -3% for the Russell 2000.
While this handful of leading businesses are amazing franchises, there are hundreds of other fine companies that over the long term should fare just fine. With technology at close to 39% of the S&P 500, yet only accounting for 6% of GDP and 2% of employment, it may be a good time to consider making some portfolio allocations to other parts of the market, both domestically and globally, that would have the ability to grow in a post-COVID world.
If the strong dollar is nearing the end of its cycle, this could be an additional catalyst to drive increasing allocations to international investments. Long term growth rates in emerging market nations are projected to significantly outdo developed ones as the emerging market middle class grows. At the same time, international and emerging markets have materially underperformed the S&P 500 over the past decade and currently are valued well below the domestic market. A weaker dollar combined with cheaper valuations and better growth prospects could prove to be a powerful combination in the years to come.
As much as the elections will grab headlines throughout the quarter, the upcoming results of the numerous Phase 3 trials for a COVID-19 vaccine and progress toward a Phase 4 stimulus package will likely have a more meaningful impact on the economy. Passage of another stimulus package would help businesses and consumers coping to navigate the economic challenges brought on by the pandemic. In fact, looking back over the past 60 years, markets have historically fared well both prior to and after presidential elections regardless of who is in office. While many consumer and service businesses were effectively shut down and may not re-emerge, others are adapting and should ultimately emerge with more dynamic business models.
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