Investors are counting on a divided U.S. government and positive news on a COVID-19 vaccine. We were particularly active in 2020 and expect to do more as we proactively rotate risk positioning to adjust to the market.
Filmed on November 9, 2020.
Nancy Rooney:
Hi, Richard.
Richard Madigan:
How are you?
Nancy Rooney:
I’m good. It’s nice to see you over there.
Richard Madigan:
As well. Yes. Distant, but yes.
Nancy Rooney:
So I want to talk a bit about markets. And, and, uh, this has certainly been an interesting time.
Richard Madigan:
It has.
Nancy Rooney:
Let’s start on the election first. It’s clear from watching markets that they like these results. It looks like we’re going to have a divided government.
Richard Madigan:
Yes.
Nancy Rooney:
Does it surprise you the way the market has reacted so positively?
Richard Madigan:
It, it doesn’t at all. And I think to put it very succinctly, it takes away some of the risks, I think, markets perceived in terms of left tail negative opportunity cost. I think first and foremost, we didn’t position portfolios based on the view for the elections and the election outcome. The thing I always care the most about are the policy outcomes that we’re going to talk about with the next administration. Um, I will also add that we took advantage of a market pullback in October and dialed back up some of our exposure in equities. So we bought equities in October as markets sold off. But that was purely driven on a view that markets had been oversold. And we just tactically wanted to add to equity risk.
Nancy Rooney:
And certainly that’s been a good trade. I know we took risk off in March, and we’ve been, uh, gradually adding that back. Do you feel like some of it, though, is predicated on this perception that we’re gonna get this large stimulus bill, and I guess then would put the market at risk if we didn’t get it?
Richard Madigan:
I actually don’t. With regard to the size of the stimulus, I think markets care that there is stimulus. And I think the expectation is if it’s a smaller package, um, if we need more, we’ll continue to see them coming out. So markets really aren’t looking through, I guess, downside risk to big stimulus versus small.
Nancy Rooney:
So divided government, generally good for markets. Because less surprises. And you don’t feel like this is all at the risk of a big stimulus bill happening?
Richard Madigan:
I do not.
Nancy Rooney:
So let’s talk about a divided government. And what’s the right way, in a portfolio—because I’ve got long-term goals that I’m trying to meet—uh, what’s the right way to be positioned for that division?
Richard Madigan:
We’re neutral in our equity allocations right now, and specific to the U.S. equity market. Although I feel I’ve said this for the last four years, uh, we’ve been overweight the U.S. We’ve been overweight what I’m going to call big tech, uh, and we’re overweight healthcare and pharma. Uh, we’ve been dialing those back this year and actually starting to lean in to some of the laggard sectors. So you're going to watch us dialing up--
Nancy Rooney:
The tech and the healthcare.
Richard Madigan:
Correct, yes. We’ve been adding to things like financials. I think we’re looking at the banks in general as being very well capitalized, and feeling good about that opportunity, but we’re going to be very, uh, thoughtful, methodical, in terms of how we put that exposure on. The other one’s been industrials. And that’s been much more off of what we’re going to see from infrastructure spending out of Washington. And that, to your divided government, is probably less than people thought coming into the election. But we still expect that to happen.
Nancy Rooney:
So I think about tech and healthcare in one way, and certainly growth sectors. But I think about industrials in a very different bucket. And so help me with how they’re both in a portfolio together.
Richard Madigan:
So part of it is just offsetting risks. And I think a big view from the team has been, as we’re watching the U.S. economy, but the global economy, transition back to more stable state, um, to get the sustainability of markets’ current valuations, laggards need to play a little bit of catch up in here.
Nancy Rooney:
Yeah.
Richard Madigan:
And so we’re targeting places where we see a, a, dysfunction with regard to relative valuation, meaning a large gap, uh, and we’re going to be patient as we rotate some of that risk. But it’s playing to a more pro-cyclical environment. Um, which, given the, the, course of the last six months is certainly where we are right now.
Nancy Rooney:
So all of that sort of brings to mind emerging markets.
Richard Madigan:
Yes.
Nancy Rooney:
And you started building a position this year.
Richard Madigan:
We did.
Nancy Rooney:
You recently added to that. And all your comments about cyclicality sort of go into that.
Richard Madigan:
Yes.
Nancy Rooney:
But, but, I guess, my question is more about emerging markets in the absolute opportunity there, or is it more a relative comment about some of the other global markets that are out there?
Richard Madigan:
It’s a relative value trade…
Nancy Rooney:
Okay.
Richard Madigan:
... in my mind’s eye, and in particular, offset from Europe. And, and I think a couple of things on emerging markets, because they’ve changed in terms of construct so dramatically over the course of the last five years. Uh, if you look at broad emerging markets, about 80% of that from a market capitalization base is Asia today. And where I’m most interested in is markets like China, domestically, um, Taiwan and Korea. They represent about two-thirds of the broad EM capitalization. Um, and this may surprise you, but that segment, in terms of emerging Asian markets, are actually going to see modest earnings growth this year. That’s certainly not the case in the U.S. or across Europe.
Nancy Rooney:
And I know within EM, tech is one of the largest allocations.
Richard Madigan:
Yes. Consumer discretionary as well.
Nancy Rooney:
Great. And so in a way for clients, could we think about it as maybe a lesser expensive way of getting access to some of those higher growth areas?
Richard Madigan:
Yes, absolutely.
Nancy Rooney:
Let’s talk a little bit about the very welcomed vaccine news that we have, or possible vaccine. And so you mentioned that you’re neutral weight equities, but overweight risk from a portfolio standpoint because you have extended credit. As you look at some of the efficacy numbers that are still coming out, does that make you want to change your position on risk in the portfolio?
Richard Madigan:
With regard to market positioning and kind of what we own in portfolios, I feel really good about the amount of risk we have in portfolios. But as you kind of alluded to in the question, from the simple reason that since literally the last two weeks in March, the only thing we’ve been doing is adding risk to portfolios as we found the right opportunity. So in my perspective, uh, this is not a point to be chasing after a market. We actually came in a position right now that I think we can ride through some of the optimism, and then figure out the balancing points between fundamentals and valuations, just to make sure that markets don’t get ahead of themselves. Um, right now, I don’t believe they have.
Nancy Rooney:
So you mentioned extended credit. And you’ve been adding to that position. March, April, May, adding to that. And and it’s certainly been the right call. You know, it’s, it handedly beat core bonds. As you look at the levels and the spread levels and where it’s trading right now, does it kinda make you wanna take some profits there, and, and maybe put some more money into cash?
Richard Madigan:
So it doesn’t. But it’s making us rethink return expectations. So if we were having this conversation back in March, April, May, I would’ve said the beta component of high yield. So the risk component was something that offered an awful lot of upside in our mind’s eye, uh, with regard to price appreciation, which is exactly what we’ve seen. And I think the balance for markets right now around high yield is that, given the amount of new issuance that we’ve seen this year, uh, the default risk in my mind has actually come down on the margin across the asset class. So expectation over the next six to 12 months is not the double-digit returns from when we were adding it. Uh, it’s going to be about carrying, about the yield embedded in there. But it’s high yield, so I feel much better about that relative to core bonds.
Nancy Rooney:
Mm-hmm. So still tactical allocation.
Richard Madigan:
Absolutely.
Nancy Rooney:
Thank you, Richard.
Richard Madigan:
Pleasure.
Side note:
Legal disclosures appear.
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Side note:
Background music plays.
Text on screen:
Market Thoughts: November 2020. Positioning Portfolios For Changes in Government.
On screen:
In a spacious room overlooking Manhattan, a woman with long blonde hair, Nancy Rooney, sits (socially distant) across from a man with short salt-and-pepper hair, Richard Madigan.
Nancy Rooney:
Hi, Richard.
Richard Madigan:
How are you?
Nancy Rooney:
I’m good. It’s nice to see you over there.
Richard Madigan:
As well. Yes. Distant, but yes.
Text on screen:
Nancy Rooney, Global Head of Managed Solutions, J.P. Morgan Private Bank.
Nancy Rooney:
So I want to talk a bit about markets. And, and, uh, this has certainly been an interesting time.
Richard Madigan:
It has.
Nancy Rooney:
Let’s start on the election first. It’s clear from watching markets that they like these results. It looks like we’re going to have a divided government.
Richard Madigan:
Yes.
Nancy Rooney:
Does it surprise you the way the market has reacted so positively?
Text on screen:
Richard Madigan, Chief Investment Officer, J.P. Morgan Private Bank.
Richard Madigan:
It, it doesn’t at all. And I think to put it very succinctly, it takes away some of the risks, I think, markets perceived in terms of left tail negative opportunity cost. I think first and foremost, we didn’t position portfolios based on the view for the elections and the election outcome. The thing I always care the most about are the policy outcomes that we’re going to talk about with the next administration. Um, I will also add that we took advantage of a market pullback in October and dialed back up some of our exposure in equities. So we bought equities in October as markets sold off. But that was purely driven on a view that markets had been oversold. And we just tactically wanted to add to equity risk.
Nancy Rooney:
And certainly that’s been a good trade. I know we took risk off in March, and we’ve been, uh, gradually adding that back. Do you feel like some of it, though, is predicated on this perception that we’re gonna get this large stimulus bill, and I guess then would put the market at risk if we didn’t get it?
Richard Madigan:
I actually don’t. With regard to the size of the stimulus, I think markets care that there is stimulus. And I think the expectation is if it’s a smaller package, um, if we need more, we’ll continue to see them coming out. So markets really aren’t looking through, I guess, downside risk to big stimulus versus small.
Nancy Rooney:
So divided government, generally good for markets. Because less surprises. And you don’t feel like this is all at the risk of a big stimulus bill happening?
Richard Madigan:
I do not.
Nancy Rooney:
So let’s talk about a divided government. And what’s the right way, in a portfolio—because I’ve got long-term goals that I’m trying to meet—uh, what’s the right way to be positioned for that division?
Richard Madigan:
We’re neutral in our equity allocations right now, and specific to the U.S. equity market. Although I feel I’ve said this for the last four years, uh, we’ve been overweight the U.S. We’ve been overweight what I’m going to call big tech, uh, and we’re overweight healthcare and pharma. Uh, we’ve been dialing those back this year and actually starting to lean in to some of the laggard sectors. So you're going to watch us dialing up--
Nancy Rooney:
The tech and the healthcare.
Richard Madigan:
Correct, yes. We’ve been adding to things like financials. I think we’re looking at the banks in general as being very well capitalized, and feeling good about that opportunity, but we’re going to be very, uh, thoughtful, methodical, in terms of how we put that exposure on. The other one’s been industrials. And that’s been much more off of what we’re going to see from infrastructure spending out of Washington. And that, to your divided government, is probably less than people thought coming into the election. But we still expect that to happen.
Nancy Rooney:
So I think about tech and healthcare in one way, and certainly growth sectors. But I think about industrials in a very different bucket. And so help me with how they’re both in a portfolio together.
Richard Madigan:
So part of it is just offsetting risks. And I think a big view from the team has been, as we’re watching the U.S. economy, but the global economy, transition back to more stable state, um, to get the sustainability of markets’ current valuations, laggards need to play a little bit of catch up in here.
Nancy Rooney:
Yeah.
Richard Madigan:
And so we’re targeting places where we see a, a, dysfunction with regard to relative valuation, meaning a large gap, uh, and we’re going to be patient as we rotate some of that risk. But it’s playing to a more pro-cyclical environment. Um, which, given the, the, course of the last six months is certainly where we are right now.
Nancy Rooney:
So all of that sort of brings to mind emerging markets.
Richard Madigan:
Yes.
Nancy Rooney:
And you started building a position this year.
Richard Madigan:
We did.
Nancy Rooney:
You recently added to that. And all your comments about cyclicality sort of go into that.
Richard Madigan:
Yes.
Nancy Rooney:
But, but, I guess, my question is more about emerging markets in the absolute opportunity there, or is it more a relative comment about some of the other global markets that are out there?
Richard Madigan:
It’s a relative value trade…
Nancy Rooney:
Okay.
Richard Madigan:
... in my mind’s eye, and in particular, offset from Europe. And, and I think a couple of things on emerging markets, because they’ve changed in terms of construct so dramatically over the course of the last five years. Uh, if you look at broad emerging markets, about 80% of that from a market capitalization base is Asia today. And where I’m most interested in is markets like China, domestically, um, Taiwan and Korea. They represent about two-thirds of the broad EM capitalization. Um, and this may surprise you, but that segment, in terms of emerging Asian markets, are actually going to see modest earnings growth this year. That’s certainly not the case in the U.S. or across Europe.
Nancy Rooney:
And I know within EM, tech is one of the largest allocations.
Richard Madigan:
Yes. Consumer discretionary as well.
Nancy Rooney:
Great. And so in a way for clients, could we think about it as maybe a lesser expensive way of getting access to some of those higher growth areas?
Richard Madigan:
Yes, absolutely.
Nancy Rooney:
Let’s talk a little bit about the very welcomed vaccine news that we have, or possible vaccine. And so you mentioned that you’re neutral weight equities, but overweight risk from a portfolio standpoint because you have extended credit. As you look at some of the efficacy numbers
that are still coming out, does that make you want to change your position on risk in the portfolio?
Richard Madigan:
With regard to market positioning and kind of what we own in portfolios, I feel really good about the amount of risk we have in portfolios. But as you kind of alluded to in the question, from the simple reason that since literally the last two weeks in March, the only thing we’ve been doing is adding risk to portfolios as we found the right opportunity. So in my perspective, uh, this is not a point to be chasing after a market. We actually came in a position right now that I think we can ride through some of the optimism, and then figure out the balancing points between fundamentals and valuations, just to make sure that markets don’t get ahead of themselves. Um, right now, I don’t believe they have.
Nancy Rooney:
So you mentioned extended credit. And you’ve been adding to that position. March, April, May, adding to that. And and it’s certainly been the right call. You know, it’s, it handedly beat core bonds. As you look at the levels and the spread levels and where it’s trading right now, does it kinda make you wanna take some profits there, and, and maybe put some more money into cash?
Richard Madigan:
So it doesn’t. But it’s making us rethink return expectations. So if we were having this conversation back in March, April, May, I would’ve said the beta component of high yield. So the risk component was something that offered an awful lot of upside in our mind’s eye, uh, with regard to price appreciation, which is exactly what we’ve seen. And I think the balance for markets right now around high yield is that, given the amount of new issuance that we’ve seen this year, uh, the default risk in my mind has actually come down on the margin across the asset class. So expectation over the next six to 12 months is not the double-digit returns from when we were adding it. Uh, it’s going to be about carrying, about the yield embedded in there. But it’s high yield, so I feel much better about that relative to core bonds.
Nancy Rooney:
Mm-hmm. So still tactical allocation.
Richard Madigan:
Absolutely.
Nancy Rooney:
Thank you, Richard.
Richard Madigan:
Pleasure.
Text on screen:
Market Thoughts: November 2020. Positioning Portfolios For Changes in Government.
Side note:
Legal disclosures appear.
Text on screen:
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KEY TAKEAWAYS
- A divided government creates less risk for investors to be negatively surprised by policy changes. For the moment, markets are celebrating political gridlock.
- Investor sentiment got a booster shot from news about the efficacy of two new virus vaccines. That news is more important to the near-term market outlook than the U.S. election.
- We continue to lean into the rotation of risk positioning across portfolios. We’ve been particularly active this year. I expect there is more to do, driven by market volatility.
- Economic recovery and reflation will take longer than investors anticipate. There is simply too much excess capacity globally. Disinflation remains a challenge to central banks.
Markets have settled on a narrative that ends with a divided U.S. government come January. Joe Biden is President-elect, awaiting state-by-state certification. The Senate is expected to remain in Republican hands. We already know that the House majority stays with Democrats.
A divided government creates less risk for investors to be negatively surprised by policy changes. We’ll see how it plays out when the recounting, contesting and run-off elections are over. For now, markets are celebrating political gridlock.
With a divided government, investors see hindered many of the more progressive policies promised pre-election by President-elect Biden. Concern that corporate taxes would be increased have been put aside. So has concern that stock buybacks might be curtailed or even eliminated.
Investors may have moved too quickly in assuming all policies seen as negative for the equity market have gone away. That’s a market observation, not a political statement. I believe we may see tax hikes along with a Congress that, from a regulatory perspective, challenges specific industries.
There remains an investor emphasis on the need for Congress to sit down and negotiate another pandemic support program. Given the division we have in Washington, I don’t know whether we will see a package this year, or if we’ll have to wait until the next administration.
I think too much is being made of the size of a program. It is more important that there is a stimulus package agreed to in short order. Something is needed, but rather than a one-and-done “big bazooka” program, I expect a more modest proposal.
If there is a need to do additional stimulus, they can do it. By pacing stimulus, Congress retains an anchor on and clear authority over fiscal spending. That helps take some pressure off rising U.S. interest rates and inflation expectations.
It’s generally foolhardy to position a portfolio for an election outcome. What I care about are the policy consequences of the election. Those remain to be seen. We have a long, winding road ahead of us with regard to politics, policy and for markets.
It’s not a matter of if, but when. Just as investors were settling into a more constructive market outlook after the U.S. election, sentiment got a booster shot from news about the efficacy of new virus vaccines from Pfizer/BioNTech and Moderna. That news is more important to the near-term market outlook than the U.S. election.
Putting aside the impact on markets for a moment, I’ve counted on the collective ingenuity of the scientific community to find remedies that ameliorate the health, emotional and economic costs of the pandemic. It hasn’t been a matter of if, but when. I’ve also counted on the resilience of humanity to see us though an absolutely shattering year.
As we see the virus resurge, vaccine optimism has come at a critical moment. With more targeted lockdowns ahead, growth over the next quarter will slow. In Europe, we expect to see a double-dip economic contraction in the fourth quarter.
News of progress on a vaccine is important, as it allows investors to look through challenging economic news and focus on the “other side” of the pandemic. There’s been a light turned on with regard to sentiment. It will ebb and flow with headlines over the next few months, but I hope we’ve seen a floor put under confidence in the recovery.
Markets are reacting rationally to the vaccine news. Risk assets are well supported and bond markets have seen longer-dated interest rates move higher. Some of the pressure in government bonds is coming from expectations that, with a treatment, second-half growth next year may look brighter. Also, that with an improving economic outlook, the Federal Reserve (Fed) will be buying fewer government bonds.
I challenge the view that the Fed is stepping back from its willingness to support economic growth. That doesn’t mean it may not temper balance sheet expansion at some point next year. I believe it has no intention of letting rising long-term interest rates run the risk of stalling recovery. The Fed remains “all in” on doing its best to get the economy back on track. So are other central banks.
Interest rates may have moved higher, but the starting point matters. Rates remain incredibly low and supportive of market valuations, along with economic recovery. A steady move higher in interest rates signals a global economy that is slowly on its way to mending. That’s good news.
Rotation, recovery and reflation. “The three Rs” of investing have been reinterpreted. While reading, writing and arithmetic are essential, investors need to focus on rotation, recovery and reflation.
We continue to lean proactively into the rotation of risk positioning across portfolios. We’ve been particularly active this year, and I expect there is more to do, driven by market volatility.
We are neutral in our equity allocations, favoring U.S. and emerging markets over Europe and developed Asia. I don’t expect that regional view will change soon. We continue to hold a significant overweight to extended credit versus core bonds.
While risk assets are reacting rationally both to the U.S. election and vaccine developments, I’m keeping a close eye on valuations across equity and credit markets. Right now, investors expect positive outcomes. I’m focused on the underlying fundamentals and that valuations remain in line with our outlook. Markets don’t only move in straight lines. Currently, investors seem to be modestly overreaching.
Thanks to the Fed’s direct intervention to stabilize fixed income markets, we’ve seen broader markets find their footing. Core bonds set the stage for all markets. If the risk-free rate isn’t stable, there is nothing to price risk assets off of. That’s a key reason markets collapsed back in March. We’ve continued to see risk-free rates stabilize as the global economy, in fits and starts, does the same.
Economic recovery and reflation will take longer than investors anticipate. There is simply too much excess capacity across developed economies, in particular as it relates to labor markets and the service sector. As both Europe and the United States continue to prove, disinflation will remain a challenge to central banks over the coming year. The death of the bond market remains, for now, exaggerated.
A change of the guard. With regard to the next U.S. administration, there is bipartisan support to create greater regulatory accountability for “big tech” companies. There is also a willingness to address the outsized cost of medicine in the United States, relative to the rest of the world. That said, left-tail risks of extreme legislation, in each instance, are less than they were pre-election.
There has been renewed focus on the rotation happening from growth stocks into cyclical laggards. That’s good news for markets as outperforming sectors see profit taking and a rotation into sectors that have trailed because of the pandemic. With greater optimism around treatment for the virus, underperforming cyclical sectors are playing catch-up. That’s healthy.
While we’ve been trimming our tech overweight this year, we haven’t given up on technology. Big tech gets the benefit of having been particularly exposed to corporate tax hikes. That will come back into focus now that more aggressive tax increases seem off the table. So will free cash flow generation and strong earnings. It’s valuations that needed a little adjusting.
As we’ve trimmed back tech, we’ve been building up positions in sectors that have lagged, including U.S. financials and industrials. That’s allowed portfolios to navigate the current growth to cyclical sector market rotation. We’re a little overweight tech and cyclicals, but don’t own too much of either. That’s helped keep portfolios stable, relative to the sector dispersion we’re seeing across the market.
Post-election, we’re looking at our overweight to U.S. industrials. We’re doing work as it relates to infrastructure spending. With a Republican-led Senate likely to stay focused on fiscal propriety, big infrastructure spending that had been expected with a Blue Wave needs to be recalibrated. That said, I believe there is bipartisan support for spending on infrastructure. The United States needs it.
Energy stocks may remain “unloved” for longer, as I believe a Biden administration will be particularly vocal about a pivot to clean energy and climate change. A lot of that pivot can be accomplished by executive order—the same way the Trump administration dialed it back.
We’re looking again at U.S. financials, where we currently hold a modest overweight. Large banks look inexpensive and well capitalized. Higher interest rates can help net interest margins. Robust mortgage lending with tighter lending standards, along with strong investment banking revenues, can create an opportunity for a valuation “catch-up” trade to the market.
Do markets care who won the White House? I’ve been asked if I think it matters to markets who won the White House. I want to emphasize my qualifier: to markets. If the Senate holds to a Republican majority, I think markets prefer a Biden presidency.
A Biden win likely establishes a more predictable pattern with regard to U.S. engagement with allies, as well as foreign policy and trade. There is a view that Biden will re-anchor the leadership role the United States has traditionally played globally. Each combines to reduce uncertainty, which helps support valuations across risk assets. Investors are willing to pay a little more for a “more certain” investment environment.
Does the election make me want to change allocations across portfolios? Not yet. We came into the election well positioned. I am rarely, if ever, prone to taking a tactical investment position ahead of an election, especially one this important.
In late October, we added to equities when markets pulled back. I’m glad we did. We thought it was a good entry point because of the drawdown. We added to emerging equity markets and increased our underweight to Europe. I continue to like that positioning.
We’ve just wrapped up third-quarter earnings season. We’ve seen few negative surprises and, in majority, solid earnings relative to expectations. I’ve been disappointed about guidance for next year. We expected to hear more this quarter and didn’t. We’ll have to wait another quarter for greater clarity on what companies believe lies ahead.
