29 Apr 2020
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 countries in the developed world, although in most cases in a more diluted form. Another 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-19 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 investors have been prepared to look across the valley to the forthcoming re-opening of economies. Any one calendar year of earnings is not the principal component of the value of a business. If 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. In Europe, countries that implemented stricter lockdown measures early, seem likely to 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 of ex patriots returning home and there have been only four deaths. 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. Although social distancing measures have been in place, Sweden hasn’t had a formal lockdown. Deaths in the UK are higher than in Norway, but differentiating factors go some way to explaining this. Large, residential homes have been badly hit in the UK, as in many countries, with other clusters in areas where migrant workers live, and the 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. In South Asia, many economies are struggling including India, Indonesia and Pakistan. 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, with a focus on healthcare systems, it would seem that many are ill prepared. Investors need to proceed with caution in this area until there is evidence that disease levels are under control. A more nationalistic agenda had already emerged in many western countries prior to Covid-19 and protectionism is the economic extension of nationalism. Some economies are reliant on Foreign Direct Investment flows and the re-shoring of supply chains in the guise of an increased desire for national self-sufficiency could leave the emerging world in a vulnerable position.
This will be determined by three factors:
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. There is also 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.
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.
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.
From the current standpoint, several different pathways 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, and there is little positive news on vaccines or anti-viral treatments, markets could be severely disappointed. And in between these extremes there are of course 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 to purchase non-investment grade bonds or accept as collateral. This is in marked contrast to the GFC. From a technical perspective, the US 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 and without definitive positive or negative news, a trading range between 2600-3000 in the US 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. A rescue fund has been agreed but it is unclear if this will be made available through grants (favoured by the Southern European countries hard hit by Covid-19) or loans (favoured by Northern Europe). Northern Europe, including Germany, has shown no appetite for Corona Bonds (bonds guaranteed by the EU rather than an individual country). In recent weeks, some tensions have appeared in the inter-bank lending market in Europe, with suggestions that 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. The stimulus China applies now will be different from that in 2018 when it was more focused on the consumer. There should be a positive impact on the Chinese economy after a one or two quarter lag, as seen 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. We saw this pattern during the GFC, but this recession will differ in that it is likely to be exceptionally deep and driven by government policy, and it could also 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. The US bear market lasted only a month with a fall of 35% and a new bull market is underway with a rally of over 40% from its intra-day lows and around 30% from its closing low.
For investors today, the issue is to try to correctly forecast the sequencing of events as the speed of lockdowns, or news on potential treatments, is driven by political and medical factors, rather than economic ones. On the treatment front, any indications of medical options that could reduce the mortality rate will be positively viewed. Investors need to take a view on how the exit from lockdown is priced into markets. It may well be the case that we experience a 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, the important factor for markets is how the landscape looks in 2021. The other element to consider is whether the coronavirus will change long-term prospects for business, through different corporate or consumer behaviour. In China, there are some signs 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. Manufacturing activity in China is believed to have returned to around 80% capacity and, in contrast, restaurants are said to be operating at below 50% capacity. It seems easier to reboot a manufacturing economy than a service-based economy. 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 remains vital for governments to ensure that parts of the economy that have been shut down re-emerge relatively unscathed. If this health crisis leaves Main Street permanently damaged, there would be an overspill into the financial sector with loan impairments hitting banks in a similar way to 2008/9.
The ‘whatever it takes’ policies of both central banks and governments need to remain in place until this health crisis has passed.
Graham O'Neill, Senior Investment Consultant, RSMR