Key takeaways

• Low rates and ample liquidity continue to support market gains. 
• The Federal Reserve signaled that rates would remain low, emphasizing the benefits of full employment in its policy framework update.
• The economy bounced back faster than expected but remains dependent on fiscal stimulus.

Volatility remains elevated in the run up to the election. 

Despite the unwelcome return of volatility which saw the S&P 500 decline almost 10% from its early September peak, markets ended up for the quarter. The S&P 500 returned almost 9% in the period, and commodities were up over 7%. Real Estate Investment Trusts (REITs), up only 1.4%, remain under pressure as this sector is vulnerable to the continuing pandemic. Investors remain convinced that the Federal Reserve (Fed) will continue to provide a backstop to credit markets. High grade investors easily absorbed record corporate issuance totaling more than $1.5 Trillion so far this year. High-yield and investment grade corporate bonds outperformed treasuries by 4.37% and 1.40%, respectively, as spreads tightened during the quarter.  Interest rates traded in a fairly narrow range with most points on the treasury curve within 5 basis points of where they were in June.

The Fed unveiled its new policy framework while reiterating its goals of maximum employment and price stability. The Fed’s new guidance indicates that rate hikes won’t happen until realized inflation reaches 2%, and inflation is on track to moderately exceed 2% for some time. Policymakers want to see enough job growth to fully absorb labor slack, even if that means the economy runs “hot” before raising rates. This reflects the view that the benefits of job gains are distributed more broadly as the economy approaches full employment. The Fed’s move towards a more flexible inflation target wasn’t a surprise. Investors believe that the new policy factors in a 1-2% overshoot of the 2% target to ensure the economy reaches full employment. Real rates are likely to remain depressed in this scenario.

Even with a fiscal tailwind, it will take some time for the economy to recover.

The economy is a good news/bad news story.

On one hand, the early recovery has been V-shaped and faster than expected. On the other hand, it’s questionable whether the recovery is self-sustaining at this point. This is likely to be the shortest recession on record after a 31% annualized quarterly decline in real GDP in Q2, the deepest quarterly downturn ever. Policy support, focused on Main Street, has been effective in delivering relief to battered consumers and affected businesses. Expanded unemployment benefits supported spending but, without another stimulus package, what had been a tailwind could become a headwind quickly. While we expect a strong rebound, the consensus Q3 growth of 25% still leaves the economy far below where it was in 2019. We still expect the economic activity to shrink by 4-5% for the full year and unemployment to remain elevated at 7-8% at year end. Consumer sentiment is weak in spite of a big decline in unemployment. Volatility in the lead-up to the election, political posturing around further stimulus, mixed public health messages, and ongoing layoff announcements are contributing factors. This leaves us in a spot where the recovery has been better than expected, yet still too fragile to maintain escape velocity without further stimulus. This paradox weighs on investors’ confidence since indefinite reliance on government support is untenable. 

Growth is dependent on fiscal support for now.

The big question on investors’ minds is whether we’ll see growth slow more than expected as the fiscal impulse dwindles and the “new normal” comes into view. Another stimulus package would help hold the line until we have a vaccine. Until then, corporate earnings remain under significant pressure. Temporary stimulus actions and less reliable data for hard hit small business make the state of the underlying real economy unclear. Large companies are doing better but won’t escape unscathed. As management teams refocus on longer run prospects and the pandemic drags on, we expect further restructuring and less positive labor market momentum. Against a backdrop of continued uncertainty, growing corporate and government borrowing have reduced the resilience of the economy to an unexpected shock. An effective vaccine is a game changer if it’s widely accepted. However, the timing – and the public’s faith in the process – are key uncertainties. Our political system seems less responsive than ever to growing imbalances that could threaten longer run growth prospects. The lack of any consensus in even defining the nation’s most pressing problems has limited a serious, and much needed, policy debate. We expect continued volatility until the election is settled, and the policy direction is clear.