Equity markets continued setting new records this week, with the S&P500, Dow Jones, and Nasdaq all pushing higher on hopes of a rapid vaccine deployment and hints of an economic aid package emerging out of Congress. As infection counts and deaths rise globally from COVID, help is on the way with the promise of vaccine availability in the next several weeks for those most at risk, and hundreds of millions of doses at the ready early next year. Meanwhile, economic data is showing a muddled recovery, with the recent virus resurgence dampening some indicators, but others firing on all cylinders. The most stark differences can be seen in the goods economy versus services, as consumers remain hunkered down but continue to buy goods online, while in-person businesses struggle. This divergence is also reflected in the labor market, with jobs data slowing dramatically for those in front-facing jobs such as retail, hospitality, and restaurants. Generally speaking, the recovery looks to be on firm footing, but several potential risks remain, namely, the need for more help from Washington for the unemployed.
One factor we are keeping a very close eye on is Treasury yields, which are a significant driver of returns across all asset classes. As the bedrock of global risk premia, investors typically use Treasuries as the foundation of their models, theoretically representing the only risk-free asset in the world. Therefore, in determining appropriate prices for risk assets, movements in the risk-free rate can influence everything from equity prices to currencies to gold and commodities. As seen this year, bond yields plummeted during the COVID crisis as investors fled to the safety of government bonds but have trended higher the last several months on an economic rebound and a return to risk appetite. While higher yields are typically a healthy sign of the economy moving back into expansion and rising inflation expectations, yields moving too high, too fast could dampen the rebound through higher borrowing costs and debt burdens, while also tightening financial conditions and making equities look less attractive on a relative basis. Currently, investors believe that the right balance can be struck, with a goldilocks environment of healthy higher yields providing confidence but remaining lower than the historical average, which should keep equity markets stable and on a higher trajectory. The bigger risk remains within bond markets and the US dollar, with negative real yields hurting conservative investors, and the dollar on a downward trajectory versus other major currencies. The potential ripple effects from US government bond yields are many, and we will continue to monitor developments, with a particular focus on Federal Reserve policies to intervene as yields move higher.
At this time, we believe that markets may be slightly ahead of themselves, with valuations looking marginally stretched in the near-term. Much of the good news appears baked into current prices, and earnings will need to catch up to justify investors’ rosy outlook on the future. While seasonality favors risk assets at this time of year, the typical “Santa Claus” rally may be unlikely given how far we’ve come already since the March low this year. We may be trimming back marginally on our overweight to equities, as the possibility for a pull back seems elevated and may provide better entry points ahead. As always, we continue to remain extremely focused on monitoring unfolding market dynamics and reacting only when appropriate. Please feel free to call our office with any questions you may have.