Financial Markets Flash - 02/11/2020 -
Another earthquake or an aftershock?
Deputy Chief Executive Officer,
Chief Investment Officer
The markets have just experienced their steepest correction since March. This makes sense given that we have two major and unsettling events dominating the headlines: the US presidential election and Covid-19. Is this simply the aftershock of the earthquake that hit the markets in March? How should we analyse the situation and which strategy should we adopt?
The main equity indices have fallen by 8% to 10% since mid-October, with share prices sliding even faster last week in a rather jittery environment. At the same time, we would emphasise the resilience shown by Investment Grade (more or less stable) and High Yield corporate bonds, which have been buoyed up by the stimulus packages introduced by central banks and by zero or negative interest rate policies…
To some extent, this is a binary situation as we have two topics dominating the markets and future economic prospects: the US presidential election and Covid-19. Investors are putting other topics (such as Brexit) aside for the time being. That said, the Brexit deadline of end- October has been and gone and negotiations are still underway, at least initially until mid-November.
In a way, the deteriorating economic outlook caused by Covid-19 means that compromises will be easier to reach because certainly no one wants the situation to get any worse. The main bones of contention are 1/ fishing rights (in zones authorised for fishermen on both sides) and 2/ minimum regulatory and labour standards, the aim being to avoid any distorting effects that could skew competition and thus to maintain some form of free trade that would limit customs procedures. In short, both sides seem keen to avoid a hard Brexit which would be detrimental to everyone.
As regards the US elections, meanwhile, the worst-case scenario would be a stalemate if the vote ends with a close result between the two candidates. This could lead to all sorts of unrest and a potentially serious threat to national security; the campaign has been a particularly aggressive one, with two very polarised views of the USA. It is a reflection of a deeply fractured country and a far cry from the spirit of consensus that used to characterize US politics. From an investor’s standpoint, it would above all mean little visibility on the prospects and timing of political decisions at a time when all eyes are on a planned stimulus package.
The most likely scenario at this stage is that Joe Biden will become president and that the Democrats will also obtain a majority of Senate seats; with the Democrats controlling the House of Representatives as well, a Biden administration would be able to implement its programme without facing any real obstacles. This was not initially the market’s preferred scenario as Joe Biden’s programme includes higher corporate taxes, tougher wealth tax regulations and more regulations in general, particularly with respect to the energy transition. But investors would come to terms with Biden’s programme given the current climate: the Covid-19 crisis would result in a large-scale stimulus plan being adopted rapidly (the talk is of a plan worth around 15% of GDP), and it could force Biden to push back his planned tax measures. Moreover, Joe Biden has a more conciliatory nature which would improve the USA’s international relations. The best-case scenario would be a win for Joe Biden as president but a defeat for Democrats in the Senate, which would force the Biden administration to adjust its more controversial plans (i.e. taxes). On the other hand, the markets would probably welcome a big win for Donald Trump; but this scenario seems unlikely.
Covid-19 is currently the big issue and will remain the only one after the US elections are over. The US and European economic recoveries are at stake. China seems to have emerged from its public health crisis, and its economic growth rate is moving back towards its pre-epidemic levels. President Xi Jinping gave a speech last week during China’s “5th Plenum”, an event held to set the country’s strategic roadmap out to 2035. The aim is to speed up China’s transition from an export-driven economy to one fuelled by its domestic market by encouraging consumer spending and moving “made in China” goods and services more upmarket as part of an increasingly technological and decarbonised economy. Signs of this disconnect can already be seen in the markets: the yuan has gained close to 7% against the dollar this year, while Chinese shares have rallied by around 20% YTD and have not fallen all that sharply in recent weeks. Chinese assets are thus showing that they are decorrelated from the real economy, which is appealing for global portfolios.
Conversely, serious doubts are emerging about economic prospects in the USA and Europe. The most recent projections published by the big statistics institutes are now null and void, which is a shame as last quarter’s rebounds seemed encouraging with record year-on-year increases of ~30% in the USA and Europe. But this quarter now seems likely to experience a recession; it is impossible to say how steep it will be, but it will once again take a toll on government debt levels and businesses. So earnings growth forecasts for 2021 (~25% in the USA, 45% in the eurozone) will be revised downwards once again, making it tricky to value the equity markets. In these circumstances, it is advisable to consider equities from a medium/longterm perspective. Assuming that this crisis finally eases off and that corporate earnings double within the next 7 years (which is a real possibility considering historical corporate performances), aggregate earnings for companies listed on the S&P 500 index would reach about USD275 per share in a few years’ time while those on the EuroStoxx Large index would turn in EUR35 per share. With interest rates set to remain low for a long time (today’s monetary policies are needed to revitalise economies and enable governments to refinance their debt), an equity index PER (Price to Earnings Ratio. A stock market analysis indicator: market capitalisation divided by net income) of 20 would make sense; it would point to an S&P index at around 5,500 points and an EuroStoxx Large index at 700 versus their current levels of 3,270 and 338 respectively. So stocks seem to offer more attractive performance potential than bonds.
Given current circumstances and the clear commitment from central banks to provide support, we expect the markets to remain quite volatile over the coming days and potentially create investment opportunities; this could be the case in the bond markets too if spreads widen in sympathy.
We would therefore upgrade our position on equities by a notch if share prices were to fall by an additional 5% or so, more specifically to around 3,050/3,100 points for the S&P 500 index and 2,850/2,900 for the EuroStoxx 50 index (which corresponds to about 4,400 points for the CAC 40).
In recent reports we had explained why investors should avoid being too heavily invested, i.e. we had advised them to adopt a neutral position so that they would still have enough financial firepower to invest gradually and calmly in the event of a downturn. It would appear that this time has come.
And let us also not forget that a Covid-19 vaccine or cure might possibly arrive one day!
Document completed on 02/11/2020
The figures cited deal with past years. Past performances are not a reliable indicator of future performances.