Where Are We Now?
Equity markets have responded positively to the high probability that the worst case health, economic and financial outcomes will not be realised. The US market bottomed on the 23rd-24th March and since then shares are up over 40% from the intra-day low of 2000 and 30% from the closing low of 2200. Market rallies have been seen across most countries in the developed world, although in most cases have been less strong than this. One other point to note is that their median share in the US market has not rallied nearly as strongly with market leadership in the large cap technology related space as can be seen by the performance of the Nasdaq this year.
A combination of the peaking or at least plateauing of new COVID cases in developed countries and fiscal and monetary action which has reminded markets of the, whatever it takes approach, by Draghi in 2012, has convinced investors that while there will be a short, sharp and painful recession, a prolonged depression is no longer in prospect. Countries are now focused on exit strategies and with this in mind investors have been prepared to look across the valley to the forthcoming re-opening of economies. Any one calendar years earnings are not the principal component of the value of a business, so if most companies can survive 2020 and regain profitability in 2021 a market rebound is justified.
In most geographies in the developed world an easing of restrictions is expected by June, although in some European countries such as Denmark this has already started. It seems in Europe countries which implemented stricter lock down measures early will emerge first. This has already been seen in countries in Asia such as China and South Korea. In Hong Kong over the past month most new cases have not been a result of community transmission, but rather ex patriots returning home. There have only been four deaths in Hong Kong. In Singapore the recent flare up started in migrant worker dormitories and their contact with the general population of Singapore has resulted in further community transmission. Sweden is a country which has not had a formal lockdown, although social distancing measures have been in place, and whilst deaths here are higher than in Norway two factors explain most of this, the number of people in large old people’s homes which have been badly hit as seems the case in many countries, with the other clusters in areas where migrant workers live where density of population is higher.
The Emerging world remains an area of concern as policies in Brazil and Mexico have done little to contain the virus and in South Asia many economies remain hard hit including India, Indonesia and Pakistan. Commodity exporting countries have seen a deterioration in their terms of trade and those with current account deficits a significant weakening of currencies. Few countries have the fiscal firepower to put in place temporary income support measures. Countries in the southern hemisphere are now approaching their winter and many countries are even less well prepared than the west looking at healthcare systems. This remains an area where investors need to proceed with caution until there is evidence disease levels are under control. A more nationalistic agenda had already been seen in many western countries prior to COVID-19 and protectionism is the economic extension of nationalism. The Emerging world is vulnerable to this and the re-shoring of supply chains in the guise of an increased desire for ‘national self-sufficiency with some economies quite reliant on FDI flows.
The question then is where will markets go from here? This will be determined by three factors:
1).How successfully governments exit from their containment measures. Markets are currently expecting the easing of these restrictions to result in an economic recovery in the third quarter, which from a comparison perspective with the second quarter will have a V-shaped appearance, although the actual levels of output will be well below earlier peak readings. Any pushing out of this timeframe in terms of easing of restrictions which would hamper an economic rebound would likely see renewed equity market weakness. This could also occur if some governments relax measures too early, with this once looking a potential problem in the United States, although President Trump now seems to be pushing back on this, looking at his comments about the re-opening of the State of Georgia. If the characteristics of the virus changed in an adverse way, in other words mutated, this also would cause angst to equity markets.
Whilst Trump has pushed back against the early reopening of the economy in Georgia, his unfortunate comments supporting lockdown protestors elsewhere may encourage other States to go too early. Within certain parts of the United States, especially the more rural mid West areas there have been few restrictions on movement or social contact which could result in a flare up in a lagged response to what has occurred in the major US cities. Testing and monitoring arrangements are as yet not fully in place in the States, although this is being now ramped up. In the UK after his near death experience and poor handling of the disease in its early stages, Prime Minister Johnson will likely want to see more definitive evidence of low reinfection rates before lifting lockdown measures. It is possible that a stop-start pattern to the imposition/lifting of restrictions could consequently occur and this has already been seen in both Hong Kong, although there a total lockdown never occurred, and Singapore where measures have been tightened dramatically post the spread of disease from migrant centres to the wider community. This is a new virus so there is still huge uncertainty surrounding it and when looking at treatments doctors have found that in some cases ventilating patients is not appropriate, as the virus attacks organs in a different way causing blood clots. As a result there remains huge uncertainty surrounding the disease and how it might evolve. Whilst there is some evidence of immunity for individuals affected, the length of this immunity is unclear, and also there is speculation about whether recovered patients who subsequently test positive have ever fully got over the disease, or have the ability to re-infect others. Whilst to date there is no evidence of negative developments such as a lack of immunity, or mutation, some risks clearly remain.
2). There continues to be debate whether any form of anti-viral drug that inhibits the progression of the virus is as yet effective. Markets will be looking for something which prevents serious cases deteriorating into death, or prevents moderate cases becoming serious ones. A number of human trials are under way, although last week there was a disappointment when Gilead’s Remdesivir announced disappointing results from its trial within China. Many believe that normality can return without a severe strain on healthcare systems, in other words less hospital, and particularly ICU, admissions would be greeted favourably by the markets. There are still reports from some investment banks who have contacted doctors in a number of countries that hydroxychloroquine combined with azithromycin is an effective treatment if and this is the key point it is administered early before damage to the lungs occurs. In one European country, possibly Germany, 40% of cases are being treated with this prescribed cocktail.
3). Markets are also focused on possible vaccines. While the testing regime is much longer, there are now a number of candidates showing promise and many of the world’s largest investors have now written to the leading pharmaceutical companies urging them to share information with each other. There are already five vaccines in early stage human trials, with preliminary results likely within the next three months. Once again, any positive news here would allow investors to look ahead with more confidence about the 2021 corporate earnings outlook even though further extensive testing may be required before a vaccine can go into mass production.
Unfortunately, a number of different pathways from the current point can be envisaged. At one extreme successful relaxation of restrictions without further disease flare ups could see the world successfully navigate its way out of the crisis with an upturn in economic activity starting during the third quarter, boosted by encouraging news on treatments and vaccines. At the other extreme, if a second wave of infections occurred requiring a re-imposition of restrictions, in other words another lockdown, and lack of positive news on vaccines or anti-viral treatments, would see markets severely disappointed. In between these extremes there are many varying scenarios.
Equity markets have now risen sharply from their March lows, greatly aided by the liquidity support provided by central banks who are now even prepared either to purchase or accept as collateral non-investment grade bonds. This is in marked contrast to the GFC. The US from a technical perspective is in an important area of resistance at the 2800 to 3000 level, as the 200 day moving average is at the top of its range. Markets will now be driven by short term news flow. Without definitive news positive or negative, a trading range of the States between 2600-3000 would seem a plausible outcome for the time being.
Progress in European markets has been more muted than in the States, hampered by the lack of cohesion in the fiscal policy response. While a rescue fund has been agreed, whether this is made available through grants (favoured by the southern European countries especially hard hit by COVID-19) or loans (favoured by northern Europe) could prove difficult to resolve. Northern Europe, including Germany, has shown no appetite for Corona Bonds, or in other words bonds guaranteed by the EU, rather than a particular country. In recent week some tensions have appeared in the inter-bank lending market in Europe with suggestions some banks are unwilling to lend to those in southern Europe. China on the other hand, has embarked on fiscal stimulus, and there are already signs of increased spending on fixed asset investment and infrastructure. Thus, the stimulus China applies now will be different from that in 2018 when it was more focused on the consumer. This should begin to impact on the Chinese economy in a positive way after a one or two quarter lag, something which happened both in 2009 and 2016.
Many market commentators have looked to previous bear markets for insight, and in those associated with normal recessions, it is quite typical for a significant bear market rally to occur before another decline retesting the earlier low. This, for example, was the pattern seen in the GFC. However, perhaps on this occasion the best analysis is to highlight the difference with previous recessions. This recession will be exceptionally deep and driven by government policy, but in all likelihood will be exceptionally short. Typical recessionary periods last for over a year and consequently the accompanying bear market is also a long drawn out affair. With the re-opening of economies now in view, there is a likelihood of a statistically large rebound in output in the July-September quarter, although absolute levels of output will remain significantly below the previous peak. Arguably, this can already be seen in market moves with the quickest decline into bear market territory ever, with a US bear market lasting only a month with a fall of 35% and a new bull market underway with the US rallying over 40% from its intra-day lows and around 30% from its closing low.
For investors today the most difficult thing is to try to correctly forecast the sequencing of events as the speed of lockdowns, or news on potential treatments, is driven by political/medical factors rather than economic ones. On the treatment front, any indications of medical options which reduce the mortality rate will be viewed positively. Investors need to try and take a view on how the exit from lockdown is priced into markets. It may well be the case that similar to the GFC markets front run economic recovery in an age of continued ultra-low rates and ‘financial repression.’ This needs to be looked at in terms of current market expectations, which at present are for a pickup in economic activity in Q3. While the news flow will continue to look horrific this year, for markets the important factor is how the landscape looks in 2021. The other factor to consider is whether the COVID virus will change long-term prospects for business, either through different behaviour from corporates or consumers. There are some signs in China that despite the re-opening of the service sector, individuals are slow to return to their old ways and voluntary forms of social distancing may persist for a while. Manufacturing activity in China is believed to have returned to around 80% capacity whilst in contrast restaurants are said to be operating at below 50% capacity. It seems easier to reboot a manufacturing economy than a service one and the west had seen a prolonged period of sluggish manufacturing activity prior to the outbreak of COVID-19 and had been reliant on the service sector to drive growth. It seems certain that for a good while in person service will be less so some jobs will not come back. It remains vital for governments to ensure that parts of the economy which have been shut down re-emerge relatively undamaged, so this health crisis does not leave Main Street permanently damaged as then this crisis would spill over into the financial sector with loan impairments hitting banks in a similar way to 2008/9. For banks value of collateral is important and it is loans to the commercial sector where most of the risk lies. The ‘whatever it takes’ policies of both central banks and governments need to remain in place until this health crisis has passed.
G O’Neill 28.04.20