28 May 2020
Markets have continued to make progress in May, encouraged by further evidence in the developed world of an easing of both Covid-19 related deaths and new cases. There is strong evidence that the lockdown measures put in place in Europe have delivered the desired results, with the reinfection rate now estimated at 0.5 or below in many countries.
Countries such as Denmark and Germany, where restrictions have eased more considerably, have not seen a significant spike in infections. As a result, markets believe that an end is in sight to the recessionary conditions gripping Europe during the second quarter. There have been comments in the news about a worse recession than the Global Financial Crisis, but markets have been prepared to look through this, focussing on 2021 and beyond as there is the belief that the second quarter will mark the trough in economic activity.
In the US, with a November election in the offing, Trump has encouraged the economy to re-open and to date, early indications suggest a strong rebound in economic activity. In the US, the main risk revolves around a possible second wave and the impact of the early resumption of economic activity in some areas, but this won’t become clear for at least a further four or five weeks. Tentative signs across the developed world are that economic activity levels are picking up, albeit from extremely depressed levels.
In China, the economy appears to be returning to some level of normality; in Hong Kong restaurants are now packed with diners and face masks are not required whilst they are eating. Estimates suggest that manufacturing activity in China has returned to around 90% of peak levels, although part of this is likely to be a catch up to solve the supply chain issues experienced at the start of the Covid-19 outbreak. A clear concern for China is whether the end demand from Western economies will be strong enough to support these levels of economic activity. China’s share of global manufacturing output, which was below 5% in 1980, is around 20% today. Within China’s service sector, activity has been slower to re-bound but has seen significant improvement. To date, the view that it is easier to re-boot a manufacturing orientated economy than a service one seems true. So much of the service sector seems dependent on businesses that either require large amounts of human interaction, or significant numbers of people being present.
In the UK, lockdown measures were put in place relatively late and the test and trace system was abandoned in mid-March, making it more difficult to control the disease. However, the test and trace system has now been launched and restrictions are starting to ease across many sectors. Globally, airlines, hotels and hospitality remain the sectors hit hardest and are consequently the most dependent on government support measures for recovery. ECB president Christine Lagarde has warned that in Europe, GDP is expected to shrink by 8-12%, which would dwarf the problems of the Financial Crisis. Within Europe, countries with the most fiscal space and the least exposure to hardest hit sectors such as tourism are likely to be able to emerge from the pandemic in better shape on a relative basis.
In the last few days, European markets have been encouraged by the European Union’s proposed €750bn recovery fund. European Commission president, Ursula von der Leyen, has urged a transformation of the EU’s central finances, allowing it to raise unprecedented sums from the capital markets. The bulk of the proceeds would be handed out as grants to hard pressed member states, involving transfer payments from Northern Europe to Southern Europe. This proposal has been agreed by Germany and France but there is opposition from the Frugal Four: Netherlands, Austria, Sweden, and Denmark. For this to go through, the EU still faces the difficult task of forging a consensus across its 27 member states and, with further opposition likely from countries in the East such as Poland and Hungary, this could prove difficult. The EU has proposed that new taxes and levies, including a reform of the EU carbon market and a levy on large businesses in the form of a tax on big tech companies such as Facebook and Google, could fund much of the bill. These measures will benefit the hardest hit sectors the most in the short term, which has been reflected in recent days in stock market performance.
On the medical front there is some positive news. In mid May Moderna, the Boston based biotech company, reported that its potential vaccine boosted the immune system of participants to the same or higher levels of protection as patients who had recovered from the disease. The number of participants in the early stage trial was low but the vaccine worked effectively in its lowest dose format and there were no serious side effects. This vaccine candidate is known as mRNA-1273 and was welcomed by the market, improving sentiment globally. Moderna was the first US company to put a vaccine into human trials, creating the initial vials just 42 days after receipt of the genetic code of the vaccine. Its messenger RNA method allows it to effectively programme a vaccine, but this is a ground-breaking approach and is yet to be approved by a Regulator. Moderna is now expected to start a large Phase 3 trial in July. Most vaccines show the immune system as an attenuated version of the virus, but Messenger RNA translates a protein from the virus into human cells and shows it to the B cells that secrete antibodies. Antibodies wane over time, so the more antibodies that are created at the start, the more likely they are to remain effective.
Continued progress has been reported on the vaccine being developed by Oxford University, with Astra Zenneca looking to put it into full scale production. China has also announced that a vaccine has entered human trials. Research groups in China have spent years working to combat similar Coronaviruses such as Sars and Mers and this accumulated knowledge has allowed scientists to move at incredible speed, but never has science advanced so much in such a short period of time to combat an epidemic.
Gilead’s Remdesivir drug treatment has now been adopted in the UK and some other European countries. Remdesivir seems most effective in treating non-serious cases and has also effectively shortened patients’ time in hospital. Other cocktails of treatment, some based on drugs originally developed to combat Ebola or Aids, are also now being trialled, including a triple antiviral therapy in Hong Kong, which has shown early promise. Clearly, a vaccine is important to allow the world to return to normality, but progress on the drug front should not be underestimated. Effective early treatment can prevent patients from becoming seriously ill, significantly reducing the mortality rate.
Central banks have recognised the severity of this downturn and understood that a black swan event event such as Covid-19 requires unprecedented responses, not just from the central banks, but also from governments. Chair of the Federal Reserve, Jerome Powell, has cautioned that there could be lasting impact on the US economy and investors should be sceptical about economic modelling due to the lack of data available for accurate forecasting. Within the US, larger companies seem better placed to react to the pandemic than SMEs and this can be seen with the huge divergence in performance between large tech companies and their median US company with the median company in the US still down over 15% (Russell 2000) despite the NASDAQ hitting positive territory year to date. On the commodity front, the oil price is likely to be supported by the re-opening of the US economy ahead of its important driving season.
Leading economist, Gavyn Davies, has commented that attempting to make sense of this recession is like peering through a thick fog. To fully understand, data for the second quarter GDP published in July will need to be available, together with a third quarter economic upturn. This recession is unusual due to global income support measures. Consumer spending has slumped but there hasn’t been a decline in personal incomes. While some estimates suggest that the US second quarter GDP will fall at an annualised rate of over 40% and unemployment rates may rise by as much as 20%, lost wages have, by and large, been made up of government unemployment benefits in the developed world. Typical recessions show a squeeze on real disposable income which causes a slowdown in consumer spending, whilst savings ratios remain relatively unchanged, but this recession is different. Within the US, the Cares Act has resulted in disposable income being supported. Goldman Sachs estimate that in the US, 75% of the newly unemployed will receive more in government payments than they previously earned in wages. This is an unprecedented change in US public policy.
Despite income support and government restrictions, consumer spending has collapsed in service sectors and for many discretionary goods such as autos. There are now estimates in the US that the savings ratio could well rise to above 20% of household income. This pattern is being mirrored throughout the developed world, so a key question for the economic recovery is how much of this increased savings rate will be reversed as the lockdown is eased. In other words, will consumers go out and spend, meaning that pent up demand helps drive a more robust economic recovery than many expect? Previous work on pandemics, referenced in ‘Pandemics and Interest rates - What next, April 2020’, based on work undertaken by the University of California Davis, suggests that post-pandemic savings rates are higher than the pre-pandemic comparison, as consumers either take precautions against a resurgence of the disease or rebuild lost savings where these have occurred.
Although part of the decline in spending has been involuntary due to the closure of restaurants and many stores, big ticket items may take longer to recover. Another test for global economies will be when the emergency unemployment benefits finish, which is planned for the end of July in the US. It will be important for central banks to continue their high levels of fiscal stimulus, estimated at around 13% of GDP in the US, particularly when emergency pandemic payments are no longer available, and many households are faced with unemployment rather than being on furlough. How governments wean populations off wage support will be a critical factor for economies in the second half of 2020 as hard hit sectors are unlikely to return to anything like normal levels of employment for the remainder of this year at least, with a vaccine necessary for full recovery in these parts of the economy.
After a strong run in stock markets and with the US election due in November, trade and geo-political tensions with China have escalated. The Financial Times leading economist, Martin Wolf, has commented that history would imply that a threat to globalisation can have ominous results. In the early 20th century, tensions between Germany and other European countries resulted in the First World War. This was a period when the relative economic might of the UK (the established super-power) fell to Germany, Russia and the US. It took place in an era of economic globalisation and rapid technological innovation. Latecomers to the economic party, then Germany and China today, are unlikely to accept permanent disadvantage. China does not accept the West’s view that the post 1945 world is a lasting arrangement, which is understandable looking at China’s share of global GDP in 1870 which, at around 17%, dwarfed the UK and the US, which was around 9%. Back then, Germany was determined to enjoy its place in the sun, and today the same is true of China where, after a century of foreign humiliation, President Xi has resolved to restore the country to what he believes is its rightful place in the world and this sentiment is backed by the Chinese population. Wolf cautions that a conflict which began in Europe in 1914 and took in most of the world did not finally end until 1945 when Europe, East Asia and the global economy was in ruins. Hopefully, this apocalyptic outcome can be avoided this time.
Post the Financial Crisis, some aspects of globalisation have been under pressure. This subject was referenced in the paper ‘If globalisation is so good, why has it become unpopular?’, written by IRC in the summer of 2018 and updated last year. With the US now announcing it will no longer consider Hong Kong autonomous from China, trade tensions are likely to escalate ahead of the election and could well result in an increased focus by markets on geo-politics at a time when the world needs coordinated efforts to restore economic activity in the post-pandemic period.
Xenophobia is a long used tactic by political leaders under pressure, and a paper by the Federal Reserve Bank of New York argues that the Spanish Flu pandemic in 1918-20 was correlated with societal changes in Germany, ultimately resulting in extremist voting, as foreigners were blamed for the large numbers of deaths, and consequently the election of the Nazi Party.
Markets are clearly now prepared to look through the issues of 2020 in the belief that, even if a full recovery takes two years of corporate earnings, in 2022 will be back at previous peaks. In markets outside of the US, valuations remain relatively attractive with estimates of the non-US Shiller PE having fallen to around 11x from 17x and in both Asia and Emerging Markets, together with Japan, price to book valuations for equities versus history are still tempting. One risk is permanent damage to either consumer or business sentiment resulting from the pandemic, meaning a full recovery is not achieved, even over a two-year period, with this being evidenced to date by a rise in the savings ratio. Clearly, it is too early to see whether either consumer spending or corporate capex has been permanently damaged and with so many businesses shut down by government directive, spending plans by chief executives cannot even be discussed.
Western economies have come through the worst stage of Phase 1 of this pandemic, although when the northern hemisphere hits winter, the risk of a second wave of the virus remains. The containment of the virus in Australia and other warmer countries suggests that the summer months in the northern hemisphere are not likely to represent a period of extreme risk, and that easing lockdown measures in a relatively timely manner is justified. The emerging world continues to suffer, possibly through its lack of efforts to contain this pandemic. India has now seemingly given up on its lockdown and Brazil, Indonesia, Mexico and India seem to be moving to a strategy of herd immunity, driven by economic necessity.
Whilst markets are today focused on an improving outlook for economic activity and corporate profits, geo-politics will once again need to be closely watched. During 2018, protectionism became an economic extension of nationalism and, if such policies are stepped up, they can pose a threat to economic activity and corporate earnings in normal times. It is unlikely that President Xi will sit back and allow America to make the running with no form of response.
There are increased concerns about geo-politics and the possibility of a resurgence of the disease in the US after a fairly rapid reopening of its economy, but it looks likely that a trading range of the S&P 500 in the 2800-3100 level will be maintained for some months. Catalysts to break this on either the upside or downside would include clarity on the economic rebound, news on vaccines or medical treatments, or a serious escalation/de-escalation in trade tensions between the world’s two super-powers, the US and China.
Graham O'Neill, Senior Investment Consultant, RSMR
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