The cross-currents facing investors
For investors, the coronavirus crisis has largely been about assessing the relative strength of two opposing forces: on the one hand the unprecedented economic disruption and uncertainty wrought by the outbreak, and on the other, the equally unprecedented policy support from central banks and governments around the world.
After falling sharply for four weeks, global equity markets (as measured by the MSCI AC World index) bottomed out on 23 March, and have since recouped nearly 70% of earlier losses. It is no coincidence that 23 March was also the day that the US Federal Reserve (the Fed) introduced unlimited quantitative easing (QE) and a barrage of other measures to support the economy and financial markets. Since then, the combined balance sheet of the G4 central banks (the Fed, the European Central Bank, the Bank of Japan and the Bank of England) has expanded dramatically to reach a record 47% of GDP – a gain of around 10 percentage points from pre-crisis levels.
The monetary ‘bazooka’ has also been accompanied by generous fiscal support. The IMF estimates that governments around the world have spent around US$10 trillion to counter the economic fallout from the coronavirus pandemic. Even the fiscally-conservative German government of Chancellor Angela Merkel has announced a large stimulus package in recent weeks, while also pledging support for a pan-EU recovery plan funded by jointly-issued debt.
Never mind the contraction
Such extraordinary intervention has enabled investors to ‘look through’ the dire economic numbers that have graced the pages of the financial press in recent weeks. A report showing UK GDP falling 20.4% m/m is just one of many from around the globe to reveal output falling off the proverbial cliff in April, when lockdowns were at their most stringent.
At first glance, the rally in global equity markets seems out of place against the backdrop of vertiginous declines in economic activity. However, markets are forward-looking; rather than worry about “yesterday’s news” of slumping output and profits, the focus has been on the better times ahead, as economies come out of lockdown. Stronger-than-expected economic data in the US in recent weeks – payrolls rose 2.5 million in May despite forecasts for a 7.5 million drop – have bolstered expectations for a swift recovery.
This said, in the absence of an effective vaccine or treatment for the virus, there are clear obstacles to a rapid normalisation of economic activity. The maintenance of social distancing suggests a return to normality is still a long way off for certain industries, notably travel, hospitality and leisure. Even though lockdown measures are being eased, fear of infection will dissuade many from venturing out to spend. Such fears might be accentuated by suspicions that lockdowns are being eased prematurely amid reports of a reacceleration in infection rates in parts of the developing world and some US states. A second wave of fatalities prompting renewed lockdowns is a clear risk.
With many idled workers in advanced economies seeing their incomes maintained throughout the lockdown by government-funded furlough schemes and benefit top-ups, there is scope for pent-up demand to usher in a near-term bounce in activity. However, the risk is that the uncertain outlook will prompt consumers to keep precautionary savings balances high. A degree of wariness is understandable given that unemployment threatens to step higher as temporary furlough schemes and other support measures are wound down during the coming months. The Fed’s latest forecasts anticipate that by the end of next year, the US unemployment rate will still be two percentage points above pre-covid levels.
Earnings optimism
All of this suggests that expectations for a sharp bounce-back in corporate profits in 2021 could prove optimistic. Factset notes that the consensus amongst equity analysts is for S&P500 profits to decline 21% during 2020 before rebounding 28% next year, leaving 2021 earnings per share (EPS) slightly up on 2019 levels. Such a quick recovery would not be typical; JP Morgan note that during the last three US downturns, it took on average four years for EPS to return to pre-recession levels.
The political fallout from the pandemic could also pose a threat to US earnings. Amid criticism of his handling of the coronavirus crisis and recent Black Lives Matter protests, President Trump’s approval rating has fallen markedly; betting markets now see Joe Biden as most likely to win the presidency in November, with the Democrats also seen taking control of both houses of Congress. Such a ‘Democratic sweep’ would raise the prospect of less market-friendly policies, including a possible roll-back of the 2017 Trump tax cuts. Moreover, with the pandemic hardening attitudes towards China amongst Republicans and Democrats alike, the election is unlikely to usher in an easing of Sino-US relations whoever wins in November.
With earnings under pressure, equity valuations are looking stretched. According to Factset, the S&P500 forward price/earnings ratio (which compares price against earnings expected for the next 12 months) stands just above 22 – its highest since May 2001. This elevated valuation is in part due to the sharp run-up in some big US tech stocks seen as beneficiaries of the accelerated digitalisation trend resulting from the pandemic (see our commentary of April 2020). Outside of the US, valuations are not so extreme, but are still generally trading at multi-year highs.
Don’t fight the Fed?
Do high valuations mean stocks are heading for a renewed period of weakness? Equity market bulls argue that investors should focus on long-term earnings streams, the present value of which is boosted by the prospect of an extended period of near-zero interest rates. Indeed, accommodative central bank policy is likely to remain a significant tailwind for risk markets going forward. At their June meeting, policymakers at the Fed indicated that the key US policy interest rate is likely to remain close to zero until the end of 2022. A prolonged period of near-zero/negative interest rates and government bond yields in most developed market economies enhances the relative attractiveness of equities. Moreover, with the Fed, the ECB and the Bank of Japan all now conducting open-ended QE programmes, liquidity conditions are set to remain supportive. For now at least, central bankers have investors’ backs.
16 June 2020
This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.