Financial Markets Flash - 12 May 2020 -
How to interpret the relative resilience shown by the markets?
Deputy Chief Executive Officer,
Chief Investment Officer
US equities have fallen by “just” 10% year-to-date. This does not seem very steep considering that the global economy is facing one of its worst recessions in modern history. How can we explain this situation and what investment strategy should we adopt?
Having recently plummeted when panic levels hit a high in March, the equity markets have since rebounded in spectacular fashion: by more than 30% for the US large caps S&P 500 index, by +38% for the tech-heavy Nasdaq index which has thus moved back into positive territory this year, by +25% for European equities… This is a logical response to the measures introduced by central banks and governments. But the markets have proved very sturdy indeed in recent days, so their reaction seems to be more than just one of relief.
What signals are the markets currently sending Out?
We can see three signals:
- The technology sector is going to widen its gap with other sectors even further. With economies in lockdown, technology and the online universe in general have emerged as being the main beneficiaries of this crisis. And they are very heavily weighted in equity indices. The S&P 500 index’s 5 biggest market capitalisations account for over 20% of the index. The Nasdaq index’s 10 biggest market capitalisations account for around 45% of the index’s 2,700 stocks. The large caps in question are well known, the famous GAFA (Google, Amazon, Facebook, Apple) alongside Microsoft, Cisco etc. The 12-month forward PER (Price to Earnings Ratio. A stock market analysis indicator: market capitalisation divided by net income) of the Nasdaq index’s 10 biggest stocks lies in the region of 47. Such valuations are very high. But in contrast to the tech bubble of 2000, these companies are profitable and will benefit from increasing investment in networks and in the cloud business. Meanwhile, stocks in “physical” sectors like airlines, automotive, industry and oil have been hit hard for obvious reasons.
- The economy has bottomed out in the second quarter and interest rates will remain at 0. The epidemic appears to have peaked and infection spread charts are beginning to trend downwards more or less everywhere. Lockdowns will therefore gradually be lifted, and economies will get going again. The markets seem to indicate that they will once again be operating with some degree of normality by September, with interest rates even lower, debts absorbed by the central banks and oil going cheap. So where is the problem? As past statistics have shown, therefore, we can logically assume that the markets will have bottomed out a few months before the end of the recession. So far so normal. Moreover, governments are providing a huge amount of support and the support is likely to last given how far it’s already gone. Economic stimulus plans (direct spending and various guarantees) have been on a larger scale than in 2008, accounting for around 3% of GDP in the euro zone and over 5% of GDP in the USA. In addition, monetary policies are going to remain extremely accommodative with money- market rates kept at around 0% and asset purchase programmes being extended (to the High Yield market in the case of the US Federal Reserve), perhaps even more so than they are currently. The ECB might do likewise. In short, the central banks offer some very powerful “put options” (Implicit protection from the central banks).
- The sentiment is that governments will react differently if there is a second wave of the epidemic. Some are beginning to say that the lockdown as a cure might end up being worse than the disease... Despite the state support given, there is a risk of more bankruptcies (especially in services industries and among smaller businesses), unemployment is likely to rise and so will precautionary savings rates. In such circumstances, and if a second wave occurs, there is no guarantee that governments will once again turn to health specialists for advice. There is a reasonable chance that economic considerations will prevail, and it will also be difficult to reimpose equally strict lockdowns on the population, especially as the holidays are approaching and people might not appreciate a second round.
What is the best strategy to adopt in such circumstances?
We do not fully adhere to the messages being sent out by the markets, and we maintain a rather cautious stance for the near future. We believe we will emerge from this crisis only very gradually as it will take some time for the situation to return to “normal”. There are lots of natural obstacles to a strong recovery and they will prove rather robust in preventing the markets from continuing at this pace. The recovery in most Western economies will depend on whether consumer confidence is healthy enough to kickstart demand again; only then will companies begin investing again. This road could be a rather long one given that unemployment is on the increase.
In addition, a certain number of issues have begun to raise their ugly heads again in recent days:
- The “trade war” between the USA and China. Donald Trump is looking ahead to the possibility of being re-elected and needs to present the nation with the most decent record possible. He had a decent record until two months ago, with Wall Street at a high and the jobless rate at a low. China is a popular theme as the cause of many of the USA’s ills. With the country now in the midst of a severe economic crisis, and his popularity ratings on shaky ground, Donald Trump is looking for scapegoats. China is one such scapegoat, and the markets would react negatively if the trade agreements signed last year end up being compromised.
- Possible tension in the euro zone. It is well known that Europe’s northern and southern countries, including France, have very diverging views on how to manage their public finances. The rather “lopsided” construction of the single currency has been concealed in recent years by pragmatic action on the part of the ECB, which has done its utmost to find solutions. International investors struggle to understand how this incomplete construction manages to hold. Further tension could arise eventually as Germany’s highest court has been asked to rule on whether the Bundesbank’s participation in the Quantitative Easing (massive purchases of debt securities by a central bank) programme is legitimate, reviving a touchy topic at a very bad time.
These issues could dampen investor optimism at a time when corporate earnings are proving mediocre and stocks are still somewhat overvalued.
Judging by the severity of the crisis, we can estimate that earnings will drop by between 35% and 40% this year, implying a 2020 PER of around 27 for US stocks and 18 for euro zone stocks. If we acknowledge that 2020 is an exceptional year, PER ratios based on known 2019 earnings would work out at 18 for US equities and 15 for euro zone equities. This does indeed seem more reasonable, especially with govie yields hovering close to zero, but it allows for little obvious upside potential.
We therefore think the markets will behave more erratically in the coming weeks, with some phases of consolidation. In the event of a downturn, our view is that a PER ratio of 15 based on “normalised” earnings close to 2019 levels for S&P 500 stocks would constitute a robust support zone. This would place the S&P 500 at around 2,250, implying a possible decline of around 20% from current levels; we would consider this an extreme scenario in current circumstances. It is during such a bearish phase - which is quite plausible in our view - that investors should slowly but surely move back into equities.
In the meantime, we believe there is value to be found in the bond markets, both in the Investment Grade segment and the High Yield segment and applying a buy and hold strategy.
Document completed on 12/05/2020