Hazy market outlook as U.S. elections loom

Putnam Investments, 10/19/20


Q3 2020 Putnam Dynamic Asset Allocation Funds Q&A

  • U.S. economic recovery will likely flatten without more fiscal policy support from Congress.
  • High valuations and volatility, driven by the pandemic and the presidential election, keep us mostly on the sidelines.
  • We believe that longer-dated U.S. Treasury bonds are an effective diversifier to risky assets.

How were market conditions in the third quarter?

Equity markets corrected a bit in the waning days of the third quarter but ended the period on a strong note. All major U.S. equity indices have climbed for a second consecutive quarter, continuing the market’s run from the downturn earlier in the year. The S&P 500 Index, a broad measure of U.S. stocks, rose 8.93% and the Dow Jones Industrial Average rallied 8.22% over the past three months. The Bloomberg Barclays U.S. Aggregate Bond Index, a broad measure of U.S. investment-grade fixed-income securities, gained 0.62%.

The rally was largely fueled by signs of economic recovery, stimulus from the Federal Reserve and Congress, and progress toward a coronavirus vaccine. In September, the Fed committed to keep its policy rate anchored at zero until average inflation reaches the central bank’s 2% target and the economy achieves maximum employment. The Fed’s shift in how it sets the policy rate indicates it will tolerate “lower for longer” rates. The yield on the 10-year Treasury note ended September at 0.69% from 1.88% at the beginning of the year. Central banks across Europe, Asia, and other regions also rolled out COVID-19 stimulus measures.

Still, investors are bracing for potential headwinds, including slower global growth, spikes in COVID-19 cases, and a prolonged U.S. legislative gridlock on a new stimulus package. U.S. legislators — Democrats and Republicans — have been at an impasse over the next virus relief bill. In addition, the November election campaigns have kicked into full gear.

The three Dynamic Asset Allocation Funds gained during the quarter. The Conservative Fund, with its more fixed-income-centric investments, rose 2.76%. The more equity-centric Balanced Fund and Growth Fund advanced 4.98% and 6.76%, respectively. The funds slightly underperformed their custom benchmarks.

What strategies affected performance?

All of the Dynamic Asset Allocation funds finished with positive returns, reflecting equity market strength. During the quarter, we held allocations relatively close to the benchmarks, which resulted in a roughly flat contribution from dynamic allocation. On balance, the portfolios were slightly underweight equity risk and interest-rate risk, and slightly overweight credit risk relative to their benchmarks. Entering the period, we were slightly underweight equity risk, which detracted from performance as equity markets continued their rally. We moved our position back to neutral toward the end of the quarter. In fixed income, our slight overweight position to credit risk aided results as spreads tightened, offsetting the loss from equities. Our slight underweight position to interest-rate risk had a muted impact on performance.

Our active implementation decisions slightly detracted from performance relative to the benchmarks. Security selection within U.S. large-cap equities drove this negative result as there was significant weakness across both our quantitative and fundamental strategies. International equity selection slightly added to performance. In the Growth Fund, emerging-market equity selection was a strong positive contributor. Fixed income selection, specifically a strategy focused on structured mortgage credit, experienced strength, helping to mitigate the loss from equity selection.

What is your near-term outlook for the markets?

The global economy is recovering at an uneven pace after an initial burst of activity and somewhat of a slow-down in the early part of the summer. The development of a vaccine or vaccines for COVID-19 could help provide a boost to economic growth. That said, risks to steady growth and corporate earnings included newly emerging coronavirus hotspots, slowing job gains, and cooling investment. The recovery in the United States has continued but is likely to flatten out without more fiscal policy support.

We don’t expect to see a significant pullback in equity markets. Investors are waiting for clues on what will come next, either on the economy or action from lawmakers in another stimulus bill for Americans. The Fed has also signaled that rates would stay near zero until at least 2023. We conclude that, on the surface, the Fed’s message of looser policy should be bullish for risky assets as long as the United States does not experience outright deflation. We also believe that longer-dated U.S. Treasury bonds will continue to be an effective diversifier to risky assets while inflation and inflation expectations stay low and the yield curve remains upward sloping.

As we near the end of 2020, high valuations and bouts of volatility driven by the pandemic and the U.S. presidential election keep us mostly on the sidelines with tactical asset allocation. The election has the possibility of an uncertain outcome and could drag on for weeks or months. However, the removal of concerns about monetary policy becoming restrictive will provide a tailwind once we view risks as being properly priced. We see in the Fed’s policy shift reasons for bullishness after the election is resolved.