Joyce Chang and Cross Asset Research

We discuss three potential scenarios for the U.S. elections: status quo, “blue wave” and a Biden/split Congress along with the timeline for validating election results. We caution that market participants should prepare for election week(s) rather than an Election Day outcome as the vote count could take weeks to process given the high level of absentee ballots. Market volatility has picked up as the unprecedented level of absentee ballots suggests that it could take days or even weeks to announce the final outcome. A blue wave —Democratic control of the House, Senate and White House—would produce the largest changes in policy, but if Republicans retain the Senate or White House, we expect the major aspects of current fiscal policy to be unchanged until at least the 2022 congressional elections. We estimate the impact of the upcoming U.S. elections to the U.S. dollar (USD) under three scenarios: a blue wave sweep (49% current political betting market probability), status quo continuation of Trump with a split Congress (46%) and a Biden victory with a split Congress (8%). Election-related event risk is much more expensive in equities and rates options markets compared to foreign exchange (FX) and favors overweighting the latter versus the former when buying protection. Further, the USD could trade in an approximately 7-8% range depending on how election probabilities evolve. We are currently short USD/ Japanese Yen and long Chinese yuan versus the basket.

Joyce Chang and Jan Loeys

J.P. Morgan’s Research team assesses the consequences of corporate disruption and transformation brought on by COVID-19 and argue that the real long-term damage on markets is not recession pricing, as this has been reversed, but that the massive rally in asset prices is destroying the likely future returns to pensions and endowments. Our U.S. credit research team notes that U.S. corporate rating downgrades have outpaced upgrades 10:1 in the first half of the year vs. a prior recession average of 2:1. But the post-COVID-19 credit cycle will not be as severe as post-global financial crisis (GFC) given backstops provided by governments and central banks as corporates are on track to raise a record $1.74 trillion in U.S. high grade markets. USD and euro (EUR) corporate debt has increased by 17% over last year, spreading defaults over a longer horizon. Our U.S. equity strategist projects S&P 500 shareholder payouts declining by around 35% which is severe but less than the 50% decline seen during the 2008 GFC, with a 40-50% decline in share buybacks likely for full-year 2020. Finally, we see corporate governance being transformed by greater focus on ESG (environmental social and governance) with the rise of stakeholderism challenging shareholder primacy.

Joshua Younger

Event risk around the Presidential election has normalized somewhat in equities and rates but remains elevated relative to prior cycles and has increased in some FX pairs. Debates can make for good television, but their role as a potential catalyst for shifts in the views of the electorate and options-based risk premium is an open question. Over the past 40 years, live viewership has been static, but polls suggest debates remain central to how voters form a view and statistically significant shifts in polling averages following the first debate (and to a lesser extent, the second and third) are common. Event risk as priced into interest rate options has tended to increase for a week or so following these events, but has not proven particularly durable over longer horizons.

Henry St John

The propensity of the President to make announcements over Twitter still plays a role in driving interest rate volatility and markets have been more sensitive to COVID-19, the election and geopolitics. Should the topics turn to these issues, it could be a bullish factor for volatility heading into November. Since introducing the Volfefe Index back in September of 2019, we have expanded the corpus and reconsidered some elements of the methodology given we have since seen a trade war truce, global pandemic, resurgent geopolitical tensions and to account for the upcoming Presidential Election. An empirical analysis suggests that Volfefe remains a statistically significant driver of volatility and options market pricing.

Daniel P Hui

Market probabilities around election outcomes remain relatively evenly split with a thin margin suggesting a blue wave base case. However, narrow swing state polling, a greater recognition around the complexities of the large expected volume of mail-in ballots and a sudden development around the Supreme Court have all put greater spotlight on contested election scenarios; meanwhile, the first presidential debate on September 29 has the potential to shake up polls and probabilities. FX vol market pricing has started to reallocate November 4 election risk pricing to subsequent weeks on recognition that at least the election outcome will be materially delayed. Risk premium remains concentrated in yuan and yen vol, with yen being de-facto a consensus position and headroom for further repricing is most compelling in Russian ruble and Australian dollar. While skeptical of the yen Nov. 4 vol upside potential, we see value in yen forward vols that cover late Nov-Jan period as an ultimate tail hedge for a lengthy delay.

Cory Kasimov

COVID-19 vaccine updates to remain a key focus in the near term with broader implications for the market and data emerging from the neutralizing antibody class will inform how these therapeutics may slot into the COVID-19 treatment paradigm. In our view, vaccines are clearly the most important modality in the fight against the COVID-19 pandemic given their protective nature and potential for widespread use (and lower cost). Likely relegated to later lines (in the hospital setting) – at least for now – are the antiviral (i.e., Remdesivir) and anti-inflammatory (i.e., Dexamethasone) products, unless more convenient formulations establish clear safety and efficacy. It is unlikely that COVID-19 vaccines are a winner take all market. In our view, it’s not a question of if one vaccine will work, but rather a question of how many will work. There are around 38 vaccines undergoing clinical evaluation (i.e., in humans) and around 150 in preclinical development.

MW Kim and Ling Wang

There is potential for decoupling of developed market (DM) and emerging market (EM) infection curves in the next 6-12 months as just three EM countries, India, Brazil and Mexico, now account for around 73% of new infections in the last three months. DM countries, including the U.S., have reported a relatively small number of new infections post/close to the curve peak. In case of the COVID-19 outbreak, minimizing the number of deaths became a challenging mission at the beginning of the first curve acceleration period and as a result, many policymakers introduced full/partial lock-downs or very strict social-distancing with border closure as the preferred option. In hindsight, perhaps, many policymakers assumed “only one curve of the infection” at that time based on the first-in, first-out concept. In reality, the curve is repeating or continuing. We note extended holidays in Asia (China, Korea and Indonesia) as the biggest risk in October.

Richard Vosser and Ashik Musaddi, CFA

Overall the infection picture continues to worsen across Europe (particularly France), with the exception of Germany and Italy where, so far, the outbreak remains under control. Rates of deaths and hospitalizations remain low but are continuing to pick up in Spain and France. The week September 14 – 20 saw new infection counts rising (week-on-week basis) in eight out of the 10 countries we are tracking. These are the U.K. up 21%, France up 27%, Germany up 27% and Italy up 3% in the EU5 and Denmark up 10%, Austria up 27%, the Netherlands up 60%, Belgium up 78%. In Switzerland, infections fell by 24% and in theory Spain’s infections fell, though these are likely to be revised to a growth in cases in the coming weeks.

Michael Feroli

Given the current environment, we are further lowering odds of getting the $1-1.5 trillion as “Phase Four” stimulus that had seemed quite likely in July which has knock-on implications for growth in coming quarters. We now expect household spending power to contract at a 12% pace next quarter. How this affects consumer spending and overall economic growth will be determined by the evolution of the personal saving rate. We are taking down our fourth quarter (Q4) GDP growth forecast from 3.5% to a still-above trend 2.5% pace. We are also adjusting lower our Q1 2021 estimate from 2.5% to 2.0%. The absence of a Phase Four deal has favorable implications for the fiscal outlook and we are revising our full-year 2021 federal deficit projection from $3.5 trillion to $2.0 trillion. Fiscal (and economic) prospects are subject to heightened uncertainty over the next three months and a blue wave would likely prompt a change in the outlook for a larger fiscal deficit next year and a larger fiscal impulse to aggregate demand. Even with a continuation of divided government, we believe the bias in fiscal policy next year will be toward larger deficits.

Jesse Edgerton

Recent state-level payroll data continues to suggest that the rebound from COVID-19 in swing states is generally proceeding roughly in line with the national average. While some key states like Pennsylvania and Michigan are lagging the national recovery, others like Florida and Arizona are doing relatively well. There is still little relationship, however, between the change in support for Trump since COVID-19 and the change in labor market conditions. We thus suspect that swing state voters are more focused on national issues than on their local economies. Stepping back a bit, support for Trump is still highest in the states that have lost the fewest jobs since pre-COVID. But we think the causation goes in the opposite direction—states where Trump enjoyed the most support saw smaller declines in activity in response to COVID-19 and thus have higher employment levels today.

Michael Feroli

Stimulus support and a recovering equity market took household net worth to a new high last quarter increasing by $7.6 trillion to $119.0 trillion. Households stockpiled cash, which boosted most monetary aggregates. The business sector didn’t come away from Q2 smelling as clean as households as business debt ratios moved higher. Some of the increase in business debt was parked in cash, but clearly not all of it: debt-to-net worth ratios for both corporate and non-corporate nonfinancial businesses increased last quarter. The stock market valuation of the corporation sector relative to the replacement-cost value of its assets—a measure analogous to Q—rebounded to 143%. This is below the all-time high of 167% recorded in early 2000, but almost twice the historical median of 74%. Further, the Q2 Flow of Funds was the first to incorporate the hedge fund sector.

Bram Kaplan, CFA and Marko Kolanovic, PhD

We expect rebalances by fixed weight asset allocation portfolios to provide a tailwind to equities next week that could drive around 1% of equity outperformance into quarter-end (all else equal). The equity buying by monthly rebalancing portfolios (due to equity underperformance month to date) much more than fully offsets the selling by quarterly rebalancing portfolios, meaning these portfolios are expected to be net buyers of equities into month/quarter-end. Equities have significantly underperformed bonds on a month-to-date basis (by around 8%) and although they have outperformed quarter-to-date (by around 5%), our analysis suggests that a large majority of these portfolios rebalance on a monthly rather than quarterly frequency. Historically, the monthly rebalance effect is over 5x stronger than the quarterly rebalance effect.

Stephen Dulake and team

The Federal Reserve announced stress test scenarios but deferred any decision on current capital restrictions. The picture for 2021 is a little more nuanced; the regulators are attempting to thread a needle; requiring banks to retain more capital could limit credit growth and exacerbate economic weakness. Alternatively, the strength of the banking sector has definitely acted as buffer in the current environment. The reasonable scenarios, coupled with all the actions that banks have taken year to date, imply that banks have the capital to resume normal payout ratios and share buybacks next year. The key will be whether the regulators are comfortable with the economic environment and whether the macro outlook is consistent with the current stress test. For European banks, with the European Central Bank’s sector-wide dividend ban in place until 1 January 2021, the debate has now shifted to likelihood of this being lifted short-term, particularly as equity valuations remain close to all-time lows. We think that the guidance is positive, both in terms of upside and downside risk scenarios. While we think that the ECB’s deployment of the macro-prudential tool-kit built in the aftermath of the GFC has been a relative success, we note that credit investors have fared much better than their equity counterparts.

John Ivankoe

In our “Virtual Vegas” forum where we hosted 11 companies, we provide our main takeaways. We now expect 15% of independent restaurants to be permanently closed ‒ revised up from 10% ‒ which is a sector that represents 58% of industry units and 54% of industry sales, assuming any brand not in the top 250 is characterized as an “independent.” This decline in restaurants is a major cushion for those that can survive, as J.P. Morgan economists expect year-on-year total employment ‒ our demand proxy ‒ to be down 5.8% at the end of 2020 and down 2.7% at the end of 2021 (vs 2019). Simplification of menus has led to streamlined operating procedures and marketing messages and many seem to be coming close to previous store margins at 90% of previous average unit volume (AUVs). Delayed back-to-school looks like a positive as of now and is offsetting the falloff of stimulus. Both labor and cost of goods sold look to have modest and manageable inflation, but not deflation.

Jean-Xavier Hecker, Hugo Dubourg, Celine Pannuti, CFA

While “materiality” is the cornerstone of ESG investing, it is a term on which there is the least consensus. Companies and investors tend to focus on material factors when looking at ESG integration. Yet we believe that financial materiality is not sufficient and that the “double materiality” concept which includes sustainable materiality, introduced by the European Commission in 2019, represents the next step for ESG reporting and investing.

Jason Steed

Australian portfolio managers are making a distinct tilt this month towards sectors levered to reopening. The largest move during August was in industrials, where the average overweight increased by 39 basis points (bp) and 72% of managers increased holdings. Cash levels dropped 16 bp during the month, bringing holdings to the lowest level since Jan. 2018. Manager performance through August was particularly strong.