Three Key Thoughts:

1. Markets Ignore COVID Resurgence

2. Election Cycle Heating Up

3. China Flexes its Muscles

Markets Ignore COVID Resurgence

COVID-19 is demonstrating that it intends to be with us for a long time. As we emerged from the lockdowns of March and April, it was certainly reasonable to expect that we would see some increase in the number of cases. However, the volume of cases in certain states has been surprising, prompting many cities, counties and states to re-establish restrictions or closures. While these measures will most certainly delay the economic recovery to some extent, the financial markets have yet to react in any meaningful way. Indeed, US stocks have recovered almost all their losses from the first quarter as have the credit markets.

We think there are several possible reasons for this. First, the Federal Reserve has launched an extremely strong response, intended to stabilize the credit markets and provide liquidity to the economy. And they have said their programs will continue for as long as needed. That is about as supportive as a central bank can get! Second, the initial economic reports – jobs and consumer confidence, for example -- have been surprisingly positive so even if they become a bit less so, the trend remains in the right direction. Third, the stock market’s more recent gains have been focused on stocks that are seen as winners in “a living with COVID” world. Fourth, the choice between Joe Biden and Donald Trump for President may be perceived as less threatening to the markets.

Looking forward, the Federal Reserve’s stance is not going to change anytime soon so the course of the virus and its impact on our daily lives remains the biggest wildcard. It really is impossible to predict how this will play out over the coming weeks and months. Progress has been made in treating serious infections more effectively and unprecedented work on a vaccine continues. But we think the market is increasingly focused on what happens as we learn to live with this threat for some time to come. Some of the early winners in this world are already apparent but there will be profound changes to how we live and work that will take time to understand and play out.

The Election Cycle Heats Up

As if we do not have enough uncertainty in our daily lives, we are facing very important national elections in November. The participants in the presidential race are largely decided and battle lines are being drawn. Usually, an incumbent president has an enormous structural advantage over any challenger but two partially overlapping developments have diminished the advantage this time. First is the economic devastation created by the pandemic – in just a few months, we went from a strong economy and extraordinarily low unemployment to a tumbling economy and record joblessness. The second is the discussion surrounding systemic racial injustice and the appropriate policy responses. We believe that both issues will dominate the campaigns, not only for president but also many congressional races.

We said these issues are partially overlapping for two reasons: (1) COVID-19 infections have hit minority communities harder and (2) the economic impact from the shutdowns and restrictions have also been felt disproportionately by minority and lower wage workers. Income inequality has been a lurking issue for some time and the pandemic has blown it wide open. We expect to see civil unrest continue as politicians search for policies to address the problems.

More broadly, the markets will certainly be watching for specific policy proposals from Mr. Biden and gauging those against the odds of his winning election. Of special interest will be his stance on corporate tax rates.

China Flexes its Muscles

As the source of the COVID-19 pandemic, China is hardly held in the highest esteem by the rest of the world. However, to the Chinese, the success of their harsh, swift shutdowns and the government’s use of technology to control the spread of new cases are sources of national pride. The economic data coming out of China supports their view of a successful handling of the crisis. Correspondingly, their domestic stock market has been on fire. Of course, like any good autocratic leader, President Xi has been quick to seize on the national pride theme to expand his power and influence.

Most notably, Xi has effectively torn up the handover agreement regarding Hong Kong and is moving to place it under full control of the Communist Party. It is not yet clear what impact this change will have on Hong Kong as a financial hub. Regardless of the specifics, we do not think it is a positive for international companies doing business there. With the rest of the world pre-occupied with their own pandemic-related problems, there is no one to challenge Chinese assertiveness.

It is no surprise that China, having come so far economically in the last 30 years, would be in the position of challenging the US for global economic influence. But President Xi’s strategy of combining continued market reforms with ever tighter controls over the personal lives of Chinese citizens is puzzling, even to many students of the country. As China continues to build its economic power and influence, and Xi consolidates his domestic power further, we should expect more clashes with the rest of the world. But that does not necessarily mean we should avoid investing in a market that is growing and increasingly innovative.

Investment Implications

The investment lesson of the 2008-2009 bear market was to stay invested, while harvesting tax losses to the maximum extent possible. This is a playbook we followed over the last few months but most important was staying invested to take advantage of the bounce. Expecting a difficult road ahead for the economy, we have yet to add exposure to “early cycle” investments like US small cap and lower quality credit and will look for signs of more sustainable recovery before doing so.