25 Jun 2020
Many investors have been surprised at the continued strength in equity markets, with this quarter on track to be one of the best in 45 years, according to reports in the Financial Times. As we approach the end of June, one point to remember is that we are also approaching a quarter end and fund managers and institutions may wish to show that, after a strong market recovery in Q2, they are not holding excess levels of cash.
It could help to consider the market framework over three different time frames. In the short-term, news flow will drive market direction and volatility, taking into account new cases of coronavirus, vaccines/treatments, and economic data such as PMIs. Technical factors such as whether markets are overbought or oversold and the ratio of puts to calls are also important over shorter timeframes.
Over the medium term in 2021 and 2022, markets could remain positive. Previous eras of financial repression (when governments hold real interest rates below zero) have often been profitable for equity investors, especially in the early stages. In other words, markets front run negative real rates with a lower discount rate, driving equity valuations higher. Next year, the global economy is likely to return to trend growth, especially with the prospect of vaccines/better treatments being widely available. Gilead have just announced that their Remdesivir treatment, which is currently administered intravenously, is being trialled in an inhaler form, which would enable patients to take it at home, rather than needing to be in hospital. Next year there will still be huge stimulus in the financial system in both monetary and fiscal forms, and this will happen at a time of increasing corporate earnings. With a backdrop such as this, it's unlikely to be a time to be too bearish on the medium term prospects for equity markets.
In the longer term, from 2025, threats to valuation levels could emerge in the form of higher inflation, the withdrawal of stimulus and less globalisation, but these are not an immediate concern to markets.
After a brief selloff period of around one week in June, when market technical indicators showed the S&P500 was significantly overbought, markets quickly recovered their poise quickly. JP Morgan Strategist Marco Kolanovic, who tracks the positioning of risk parity and quant funds, commented that systematic traders such as these, including CTAs, were not heavily exposed to equities before the selloff, which helps to explain the rapid rebound in markets. Whilst coronavirus cases have increased in the US, officials had indicated that the economy would not be locked down, so markets have been prepared to look through this in the belief that flare ups will be limited in number and geographically contained. The most recent numbers in the US show the biggest increase in new coronavirus cases since the pandemic began and a number of states, including California, Florida and Texas, have reported record one-day increases. This is a serious concern, especially when combined with news of Apple re-closing several stores and the governor of North Carolina pausing the state’s reopening. In the short-term, after such a strong rebound, markets are clearly vulnerable to bad news, should it occur.
There have been some encouraging economic data points with US factory and services activity contracting at a slower rate in June, demonstrating progress as businesses slowly re-emerge. The IHS Markit survey data rose from 37.0 in May to 46.8 in a preliminary reading for June, indicating a contraction, but at a much slower rate. This market composite output index indicates an improvement in both manufacturing and service sectors. US new home sales have also risen, indicating that housing activity has begun to recover. UK and Eurozone PMIs beat expectations in June, with both services and manufacturing benefitting from the ease in restrictions and increase in consumption. The Eurozone flash purchasing manager index for services rose to 47.3 in June from 30.5 in May and far exceeded the level expected by economists polled by Reuters.
Clearly there are challenges ahead, optimists can point to what appears at this stage to be the early stages of a classic V shaped recovery, but the impact of the removal of wage subsidy schemes, or higher unemployment benefits across the world, will be a challenge for consumption in the second half of the year.
There is no doubt that Covid-19 has transformed the world in an uneven and unequal way. The global economy has seen only muted growth in the 10 years post the Financial Crisis. Lawrence Summers, the former US Treasury Secretary, described this as ‘secular stagnation’ in his address to the IMF in 2013. Since then there have been stronger arguments for a Keynesian response to downturns. He argued that a chronic excess of savings, relative to capital investment, was developing in the global economy, forcing down long-term interest rates with a persistent threat of shortage of demand. Interestingly, work by academics at the University of California Davis looking at long term economic implications from pandemics, demonstrates that previous pandemics have resulted in an excess of savings at a time when a savings glut had not been a pre-existing condition in the world.
Since the speech by Summers, there have been brief periods of strong output growth, notably in 2017, but these stronger cyclical upswings have proved temporary, which is why growth stocks have outperformed value to such a large degree. In the post Financial Crisis period, there has been a long running decline in global long-term interest rates to zero and below. The world was already experiencing disinflationary or even deflationary trends prior to the Covid-19 lockdown when governments put in place measures that reduced demand through restricting consumer spending. Pandemics have also historically increased risk aversion in the private sector, resulting in higher savings rates, both by households and by businesses who invest less; individuals and corporates will require higher levels of ‘rainy day’ money. Until an effective vaccine is found, consumer spending in sectors requiring high levels of personal service will remain under pressure and way below pre-pandemic levels. Covid-19 is only likely to increase the trend towards secular stagnation that has manifested itself in the post GFC period.
Post the Financial Crisis, central banks have responded by cutting rates lower than during the depths of the crisis itself. With rates at, or in many cases below zero, lower bound traditional monetary policy has become redundant. Central banks have responded to this with unconventional policies of negative rates and Quantitative Easing (QE). They have also accepted that, in a zero rate world, there is a need for increased levels of fiscal spending, a message that the Fed Chair reiterated in his address to Congress on the 16th June. In the short term, the rise of populism demonstrated by concerns over inequality, which resulted in the vote for Brexit, the election of Donald Trump, and the global spread of the Black Lives Matter movement, strongly suggest that austerity policies will not be adopted. How debt is paid for over the longer term will become more of an issue down the road but is likely to involve some form of higher taxes and debt monetisation. A continued positive is that the annual cost of servicing debt is likely to remain negative in real terms and below the nominal growth rate of an economy. Central banks seem set to keep rates at these levels, which is a form of financial repression.
With interest rates below the growth rate, the debt/gross domestic product ratio is likely to eventually stabilise and, as long as an economy is growing, the post Financial Crisis period would indicate that markets have become less concerned about fiscal deficits when governments are running primary budget surpluses. In other words, a surplus pre debt servicing costs. To an extent, Greece has proven this point; they were not running primary surpluses, so the debt to GDP ratio was forecast to continue to rise. Even if real bond yields gently rise, equities are likely to continue to respond positively to better growth prospects, as long as inflation remains within central bank targets. The risk here is that market sentiment can change if it believes that low debt servicing costs will not prove sustainable over the medium term if, for example, there was a sharp rise in inflation, forcing central banks to raise rates around the world. In the short term, this seems unlikely as the economic shock caused by the pandemic will remain disinflationary, but this will need to be monitored by long-term investors. Another option for governments is to extend debt maturity at low levels. This approach was adopted by the US Treasury in the immediate years following the Financial Crisis. At present, there is an unusually low-term premium for issuing longer-term bonds and clearly the more extended the payment period for reducing debt, the lower the necessity for immediate deficit reduction strategies. There are strong economic arguments for reducing debt levels over unusually long periods by locking in low cost funding now.
The world is enduring the deepest peace time recession in the past 150 years and the distribution of the downturn has not been equal. Countries in the emerging world have suffered more due to inadequate healthcare systems, high density and overcrowding in cities, and a lack of means to put in place a strong enough fiscal response to protect the income of the population. Until the rate of growth of the pandemic slows significantly in these countries, the prospects for emerging markets, including Brazil, Mexico, India and Indonesia, remain poor compared to the developed world. North Asia remains best placed within the emerging world.
At the outset, some politicians described Covid-19 as a disease that equally affected the rich and poor, but looking at mortality rates, this has been far from the case. In the developed world the poorer parts of the population, especially ethnic minorities, have suffered the most and this has reignited the debate about inequality, now seen through Black Lives Matter. Inequality has been a simmering feature of post Financial Crisis society, implied by the votes for Brexit and Donald Trump and the general rise of populist parties. Previous pandemics have been linked to rises in political extremism, as highlighted by the New York Federal Reserve paper which argued that Spanish Flu was one of the factors behind the rise of the Nazi Party in Germany, who were elected in the 1930s.
There has been continued progress on the vaccine front with a number of drugs now entering final stages of human testing, including potential treatments developed by Moderna in the US and the Jenner Institute Oxford vaccine, together with other trials within China. Until a vaccine is found, the impact on the service sector is likely to be long lasting due to behavioural changes by consumers. There has been further progress on the treatment front with Dexamethasone proven to be successful in treating serious cases, reducing mortality rates and the Remdesivir treatment now being developed in an inhaler form. Remdesivir has been shown to work on milder cases, so the ability to administer this to patients outside of hospitals would be extremely useful.
Economic data now suggests a rapid initial economic bounce. How long lasting the recovery is remains to be seen, as does the shape; will the V continue or morph into an initial sharp recovery that flat lines? At present, consumers in the West have been sheltered from the worst economic impacts of Covid-19 through wage subsidy and in the US through increased levels of unemployment benefits. In the US, this stimulus is due to end in the latter part of July and European governments have indicated that these support schemes will gradually be phased out between August and October. Sectors reliant on high levels of human interaction are likely to remain subdued, which will prove a challenge to consumption.
Markets are now once again entering an era of financial repression where central banks deliberately hold interest rates below the level of both inflation and nominal economic growth, which will aid deficit reduction over the medium term. Post the Financial Crisis, periods of financial repression have provided positive returns for equity investors. However, these returns have been front loaded with markets anticipating economic recovery benefitting from the lower discount rate applied to corporate earnings. This remains an environment likely to favour high-quality growth stocks with visibility of earnings or revenues. While there is still huge stimulus in the system, investors will focus on the likely return to trend growth in the next couple of years, together with the prospects of vaccines and treatments and, albeit from a low base, an improvement in corporate earnings. The longer-term threats of higher inflation, withdrawal of stimulus and less globalisation are unlikely to pose a threat to markets in the short-term. The debt overhang and savings glut all point to subdued rates of growth and inflation and consequently low interest rates.
Markets are not factoring in any major problems or setbacks to the economy. Clearly a second wave would cause concern, but this should not be confused with small localised flair ups that have already occurred in some European countries. Many US states eased restrictions at a very early stage compared to countries in both Asia and Europe. President Trump seems to be an advocate of herd immunity and is prepared to tolerate higher case numbers, rather than re-impose restrictions which would be damaging to the economy and his chances of re-election.
Both geo-politics and the US election have the potential to upset markets. Trump has seemingly pulled back from conflict with china, stating that the trade deal remains intact. He is losing ground in opinion polls due to what some would describe as increasingly erratic actions potentially over fears of an end to his term in office, which could result in prosecution.
In the short term, valuations remain on the expensive side, but current levels of bond yields would suggest that alternatives to equities are not attractive either. Cash rates in many economies remain negative. The US Federal Reserve have sent a “do whatever it takes” message to the markets and the ECB are now countenancing buying non-investment grade debt. While the Fed have made pessimistic comments on the longer-term impact of coronavirus, this means that accommodative policy is here to stay. The likelihood is that a second wave, or localised flare up would be dealt with differently now and the level of economic risk isn’t as great with governments wanting to avoid a full lockdown. In this environment, medium term investors should remain committed to equity markets but should expect continued heightened levels of volatility in both directions. The strong differentiation between winners and losers in this new world looks set to continue. The US market seems likely to stay in a wide trading range as suggested in the last market update of 2600-3100 and investors should look to add to equities on bad rather than good news. Markets have once again proved that it is better to buy when the price is right and the news is bad than when the news is good and the price is high.
Graham O'Neill, Senior Investment Consultant, RSMR
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