Q2 Summary and Outlook

July 8, 2020

Global equity markets have overcome their first real test since the March crash, with the S&P 500 steadily recovering from a one day fall of 6% in early June. Markets have otherwise not wavered in their rally from mid-March lows with UK equities rising 8.8% in Q2, European equities up 16% and US equities gaining over 19%. The NASDAQ index, which tracks technology shares, rose a whopping 30% over the quarter. The recovery in markets has been spurred by the actions of global central banks and led by the Federal Reserve which has committed to unlimited and open-ended QE with the inclusion of high yield bond purchases for the first time.

The course of the market has been tracked by the West Texas Intermediate Oil price which is now $40 after turning negative for the first time in April as lockdowns decimated demand. It appears that R values for most countries have now fallen below one, meaning the spread is no longer exponential, but cases are still growing on a straight-line basis. The concern from here is that, as the population begins its return to work and economies reopen, case numbers may begin to rise again.

China provides a positive example in that they have experienced resurging pockets of the virus but have, so far, managed to lock-down locally and restrict any national outbreak. There are reports of flare-ups in the number of cases in several US States but Treasury Secretary, Steve Mnuchin, has reaffirmed that the US economy will not be shutting down again. Moreover, the mortality rate appears to be falling despite a growing number of cases, suggesting that either the virus is becoming less potent, or that we have become more effective in protecting our most vulnerable - either by improved PPE, better distancing practices or through a greater understanding of the effects of various drugs.

The most recent revelation is that the low-cost and widely available corticosteroid, Dexamethasone, can reduce deaths by up to a third, according to one study. On top of that, the WHO reports that there are more than 100 vaccine candidates, with ten already participating in clinical trials, half of which may release results in the next couple of months.

The impact of the virus on the global economy has been extreme. Global GDP fell by 6% in Q1 and looks set to fall by a further 8% in Q2. UK GDP fell by 24.5% in April alone when compared to a year earlier, while more than 33 million Americans had filed for unemployment by May. These numbers are some of the worst on record, but they are now very much behind us.

High-frequency global indicators such as driver route requests, electricity consumption and workplace visits point to increasing activity. Composite PMIs have bounced significantly from their lows and the Baltic Dry Bulk Index spiked in June, both an indication of recovering productivity and activity. As more economic data is released, despite being far from pre-crisis levels, the relative improvement is continuing to bolster sentiment. 

Likewise, concerns over consumer spending have so far abated, with a strong rebound in both US and UK retail sales in May, most of which reflected increased online activity. Even house prices have held up, which is critical for the consumer.

We now enter a period of ultra-loose monetary and fiscal policy which seems likely to last for more than the one or two years in which timeframe Global GDP is expected to reach pre-crisis levels. In the UK, the measures introduced by the government to combat the crisis have already pushed the debt to GDP ratio above 100% for the first time in over 50 years. Loose monetary policy will be required to keep borrowing costs low so that government debt doesn’t spiral out of control, and we may be looking at another decade before central banks begin to unwind QE.

A widespread round of austerity is not anticipated with debt burdens more tolerable in a low rate environment and research indicating that fiscal multipliers are much higher than previously thought. With interest rates having little further to move and the benefit of negative rates in question, fiscal stimulus will adopt most of the responsibility for boosting the economy in the decade ahead. The Trump administration in the US is already weighing up a $1 trillion infrastructure spend, and we may see other countries introduce further proposals in this vein.

So, whilst there may be worse to come for public finances, there may also be worse to come for the labour market; so far employment data has not been as dramatic as expected - UK unemployment for April was 3.9% against a forecasted 4.7%, and US unemployment for May was 13.3%, falling from April instead of the expected rise to 19.7. But these numbers may exclude a proportion of the population that find themselves inactive, with little expectation of finding work until the economy reopens. The US data was also marred by a misclassification error which means the figure could be 3% higher than reported.

The remarkable success of furlough schemes may only serve to delay unemployment rather than avoid it altogether. If the recovery doesn’t continue to pick up pace, we could find ourselves in a cycle where job losses damage confidence, reduce spending, and lead to further job losses.

The persistence of weak demand is expected to hold down inflation in the near term and an extended recessionary environment could be deflationary, but the pandemic brings with it a unique set of circumstances. If demand is continually restricted by virus outbreaks, and the provision of stimulus measures are continued, there is every possibility that the demand-supply imbalance could lead to higher inflation. If the decade following the Global Financial Crisis is anything to go by, runaway inflation is unlikely to emerge, but it is important to recognise that there is a structural element which, this time, is different.

Some pre-crisis risks still linger. US-China trade tensions resurfaced in May as Beijing looked to impose new security laws on Hong Kong. Brexit negotiations have been accelerated: the EU now accepts that the UK won’t extend the transition period and Michel Barnier has now indicated a willingness to compromise on fishing and state aid rules. A deal could be coming very soon, giving ample time for businesses to prepare for the new arrangements.

While there is still scope for the pandemic to develop and much further for the recovery to run, portfolios should remain well diversified. Attention should be paid to assets which can weather an extended recovery period and to those which benefit from trends that are being accelerated by existence of the virus.

The market’s recovery has unsurprisingly been driven by healthcare stocks, not only for their defensive nature, but in anticipation of crisis-induced investment in this sector and the possibility of a breakthrough in curing or treating the virus. Technology stocks have also outperformed, with resilient earnings, limited disruptions, and as businesses have had to invest in this area to cope with the new environment.

More broadly, it is growth stocks that have outperformed their value counterparts. Price-to-book and price-to-sales spreads now appear to be at their highest levels ever, while gross profitability spreads remain at historical averages. There is evidence to suggest that these spreads have been driven by value depression instead of euphoria in a small subset of technology stocks. Select value assets may therefore present attractive opportunities, should the recovery continue to gain traction. It may also give rise to some M&A activity and consolidation.

The gold price is near $1,780 having drifted gently higher during the quarter; at this level, it sits $250 above its March low and, in a lower for longer interest rate environment, could continue to be an attractive diversifier, particularly when there may be inflationary concerns. Yields on global government bonds yields remain low with no meaningful change.

According to Bank of America’s June survey, 78% of fund managers believe the market is overvalued, as do the majority of hedge fund managers. However, hedge fund managers also predicted that markets would jump higher from here, and their net equity positioning soared to its highest level in two years. During the crisis over $1 trillion has flooded into dollar money market, providing scope for further participation as this continuing rally may draw money in.

Global liquidity has soared and world financial asset values have yet to catch up. JP Morgan suggest that that stock prices could rise 50% if the implied equity allocation of non-bank investors rises from current levels to post-Lehman highs – this seemingly ignores any fundamental valuation metrics.

In the short term, any signs of economic data topping could dent the sentiment that is driving this market, while the third quarter is likely to see gains being much more muted than the second. On balance, though, we still retain our preferences for risk assets like equities over bonds at this stage, though many risks still remain, not least the danger of a ‘second wave’ in the virus, and any attendant economic impacts.