Indexology^® Blog

How might inflation impact retirement income? S&P DJI’s Hamish Preston, DFA’s Grady Smith, and DCIIA Retirement Research Center’s Warren Cormier discuss.

Learn More: https://www.spglobal.com/spdji/en/documents/performance-reports/dashboard-sp-stride.pdf

2020 has certainly been an extremely unusual year as economies, companies and individuals have grappled with the impacts of COVID-19.  Although this year’s market movements have arguably been even more difficult to predict than usual, and many active managers were wrong-footed earlier this year, investment outlooks have kept at least one eye on the outcome of one extremely well-telegraphed event – the U.S. Presidential election.  With November’s election less than three months away, what is the S&P 500^®’s historical record around U.S. elections?

Exhibit 1 shows that the S&P 500 typically rose during U.S. Presidential election years: the benchmark posted a positive price return in 17 of the last 23 election years, giving it a hit rate of roughly 74% and an average return of 7.05%.  But there was substantial cross-sectional variation in election returns: there was a return spread of over 75% between the S&P 500’s best election year (1928) with its worst (2008).

Before anyone uses Exhibit 1 to make inferences about the potential impact of the 2020 election on the S&P 500, it is important to recognize that the performance of the S&P 500 during election years has typically been similar to its performance during other years.  Exhibit 2 shows that the average (and median) calendar year S&P 500 price return, volatility and risk-adjusted returns have been similar across election and non-election years.  Similar results were also observed during the fourth quarter, albeit with slightly greater differences.

Although it can be difficult to identify a clear impact of U.S. Presidential elections at a market level, there appears to have been considerable impact at a sector level.  Exhibit 3 shows the average range in monthly S&P 500 sector returns – calculated as the best-performing sector minus the worst performing sector – between 1990 and 2019.  The highest average range (15.18%) was observed in November during election years, far above the 10.8% average difference across all months.  Notwithstanding the relatively small sample size, this suggests that election impacts were typically observed when investors priced-in the anticipated impact of the election winner’s policies on different market segments.

One recent example of this dynamic came in the 2016 election. While the S&P 500 rose around 4% in November 2016, a whopping 19.34% separated the best-performing sector (Financials) and the worst-performing (Utilities). Hence, correctly identifying who would win the 2016 Presidential election and the anticipated sector impact offered considerable value in 2016.

As a result, although the S&P 500 has been unperturbed by election outcomes, historically, evidence suggests it may be worthwhile to consider the potential benefits of using sectors to express views.  Indeed, not only can picking sectors offer around half the potential value of stock-picking – Exhibit 5 shows that the average monthly S&P 500 sector dispersion (3.08%) was around half the average S&P 500 stock dispersion (6.77%) – but S&P 500 sectors have offered greater capacity for investors looking to express views.

In its Q3 2020 refunding statement¹ released on Aug. 5, 2020, the U.S. Treasury announced its plan to increase auction sizes across all nominal coupon tenors over the August-October quarter, with larger increases in longer tenors (7-year, 10-year, 20-year and 30-year).

To gauge the demand appetite for U.S. Treasuries, let’s review the size and composition of U.S. Treasury holdings by one of the larger buyers these days, the Federal Reserve. Since March 2020, the Federal Reserve has stepped in with a broad array of actions to limit the economic damage from the COVID-19 pandemic, including the resumption of security purchases. On March 23, 2020, the Fed made the purchases opened, saying it would buy securities “in the amounts need to support smooth marketing function and effective transmission of monetary policy to broader financial conditions.”

Exhibit 1 shows the significant increase of the Fed’s security holdings. Since the end of February 2020, the total amount of securities held in the Federal Reserve System Open Market Account (SOMA) increased from USD 3.8 trillion to USD 6.2 trillion, with 69% of that increase (USD 1.6 trillion) in U.S. Treasury notes and bonds. Exhibit 2 shows that as of the end of July 2020, the Federal Reserve held 28% of outstanding U.S. Treasury notes and bonds, the highest since 2003, compared with 11% in March 2009, when the Fed announced U.S. Treasury purchases in QE1.

The increase in the Fed’s share of outstanding U.S. Treasuries since March 2020 shows that the Fed’s purchases have outpaced net issuances of U.S. Treasuries. However, looking closer at the composition of the Fed’s holdings, we find that 24% of its holdings are in U.S. Treasury bonds with maturities longer than 10 years, much lower than the 59% in U.S. Treasury notes with maturities between 1 and 10 years (see Exhibit 3).

As a result, the Fed’s aggressive purchases are not immediately easing pressure on long-dated U.S. Treasury yields. Since the refunding announcement to Aug. 14, 2020, the end of the week that included three auctions of 3-year, 10-year, and 30-year U.S. Treasury bonds, 10-year U.S. Treasury yields went up by 16 bps, while 30-year U.S. Treasury yields rose by 23 bps. Weak demand for the record-sized 30-year U.S. Treasury bond auction on Aug. 13, 2020, may indicate an early sign of indigestion. At the same time, a short position has been built up, as Commodity Futures Trading Commission data show net non-commercial positions in long bond futures (15-25 years) as of Aug. 11, 2020, were at a record high level since 2000.

¹  https://home.treasury.gov/news/press-releases/sm1081

Home bias has been a prominent theme in India since the beginning of the mutual fund industry. Investors historically questioned why they should diversify their high GDP growth portfolio (India) with lower growth economies such as the US. This hypothesis has been tested over the last decade. India has delivered a high GDP growth but has fallen short in terms of profitability. The US has had the opposite effect. Despite low GDP growth, profitability has been better than any analyst would have predicted a decade ago.

Investors, as a result, have finally started to realize the importance of geographical diversification. It is a concept well accepted in developed parts of the world, such as the US and Europe, where most investors tend to have globally diversified portfolios.

So global investments have delivered good returns over long-term horizons. What else is there for Indian investors?

Low Correlation with Indian Equities

Commonly, investors have invested in multiple equity mutual funds with the hope of diversification. Historically, domestic mutual funds have tended to move in the same direction. Most Indian mutual funds have a correlation of 90%+, giving very little diversification to the investor. Investors in India who are looking to diversify their domestic portfolio tend to accept asset classes with traditionally lower yields such as debt, gold, and real estate.

However, international equity is an asset class where investors have experienced equity-like returns and lower volatility due to diversification. The following chart shows calendar returns of the S&P 500 vs. broad-based index funds across categories.

With a lower correlation, investors have seen India and the US deliver good yield returns when combined with lower volatility.

Currency as an Asset Class

The S&P 500 offers Indian investors two asset classes: US Stocks + USD as a currency. With the rupee falling most years (~5% CAGR) over the last ten years, international diversification can potentially give added protection over a falling currency. With investors increasing their spend in USD terms (foreign trips, education, electronics, etc.), it has become attractive to have some wealth invested in dollar-based assets such as the S&P 500.

Higher Dividends and Stock-Level Diversification 

The S&P 500 provides higher dividends in addition to sector-based diversification to Indian investors. India tends to be heavy on financial services, whereby the US tends to have a higher allocation towards Technology and Telecommunications. Access to some of the leading companies with globally diversified revenue streams adds well to the mix of stocks in an Indian investor’s portfolio.

In conclusion, international diversification has taken off partly due to high historical returns over the last decade and partly due to the disappointment in domestic markets. However, diversification is key when considering international investments.

Despite the drop in volatility in many asset classes over the summer, some broke through key support and resistance levels.

The S&P GSCI Gold (TR) was one of them, reaching a new all-time high of USD 1,056.83 on Aug. 6, 2020, eclipsing the previous high from the summer of 2011. The underlying gold futures had reached new highs in several different major currencies over the past year, and they finally broke through in U.S. dollar terms.

Gold’s unprecedented rise is driven to a great extent by the bearish sentiment surrounding the U.S. dollar. Lower real rates and widespread fiscal and monetary stimulus measures have boosted demand for bullion, which is seen as a hedge against inflation and currency debasement. With many government bonds paying investors a negative return, the fact that gold is a financial asset that offers no income has become increasingly irrelevant.

Weakness in the U.S. dollar against a range of currencies is also supporting gold prices. The broad S&P U.S. Dollar Futures Index fell to a two-year low at the end of July 2020; in the eyes of some investors, gold is likely replacing the U.S. dollar as the ultimate safe currency. This break lower was a positive catalyst for gold to make new highs in the last week of July. Historically, there have been periods when the correlation between gold and the U.S. dollar was significantly negative. Current market conditions are ripe for the strength of negative correlation we are seeing in 2020 (see Exhibit 1).

Why is there such a strong negative correlation between gold and the U.S. dollar? The original use of gold was as a form of monetary exchange and store of value, just as the U.S. dollar is used today. The complementary nature of the two create an environment in which market participants tend to move from one to the other. When the U.S. dollar decreases, market participants look to other asset classes as alternative stores of value. Given that gold and most commodities are denominated in U.S. dollars, any depreciation in the dollar, by definition, increases the purchasing power of other currencies, potentially increasing the demand for commodities in those regions.

Faced with both an unprecedented shock and policy response, it remains unclear how inflationary the economic recovery will be, but inflation has certainly returned to the vocabulary of some investors. Gold is an inflation-sensitive asset. Inflation protection is a typical reason people look to commodities, and gold, to hedge their exposure. Over the long term, gold does not always move with inflation, but the two tend to be positively correlated (see Exhibit 2). Gold tends to be a better hedge than crude oil, especially during times of unexpected inflation. Over the past 40 years, the S&P GSCI Gold had a positively correlated performance to the U.S. CPI. Late business cycle environments tend to be a time for gold to shine—possibly more so than times of high inflation.

For more insight on gold, check out our previous blog that highlights why now is Gold’s Time to Shine. S&P DJI also released the first Spotlight on Commodities newsletter, containing relevant content for market participants looking to understand the performance of commodities this year.