27 Aug 2020
Since the outbreak of Coronavirus, dire economic news has dominated the media. In the second quarter the US economy contracted by the greatest margin in post war history, with the Bureau of Economic Analysis revealing in late July that Q2 gross domestic product, or the value of all goods and services produced in the US, shrank at an annualised rate of 32.9%. When this data came out, 11.6% of the workforce were receiving unemployment benefits. Seasonally adjusted GDP decreased by around 12.1% in the Euro area and in the UK, estimates predict a decline of 20.4% in GDP. Investors may wonder why the US is reported to have suffered a far worse GDP decline than other developed Western economies, but this is a statistical anomaly; if common methodologies for GDP calculation are used, the fall in the US was 10.6%. The UK’s underperformance was due to the length of its prolonged late stage lockdown and the fact that the consumer facing services sector has a bigger weight in GDP, accounting for 80% of the economy. Until there is a credible vaccine delivering herd immunity, consumer facing businesses relying on a high degree of human interaction will continue to fare extremely poorly.
The way in which US GDP is calculated has caused some confusion. GDP in the US in Q2 2019 was $4.76trn. Initial readings of the statistics would suggest that there has been a decline of $1.81trn, but in fact US GDP only fell by $0.45trn to $4.31trn, or around 9.5% without seasonal adjustments. An economist called Conrad DeQuadros of Brean Capital (source Oaktree Capital) has shed some light on this. The reported 32.9% decline in second quarter GDP is the percentage by which Q1 2021 GDP would be below Q1 2020 if GDP were to decline in the next three quarters at the same rate as it did in Q2 2020. Actual second quarter real GDP was down 7.0%. The figure shown assumes that this decline continues over the three subsequent quarters. This means that the 32.9% decline is a highly misleading and exaggerated figure, proving that there are lies, damn lies, and statistics. The US economy didn’t decline by a third and is not likely to do so. Conrad wrote that annualisation is useful in normal times for comparing a quarter to recent years, but not very useful in current circumstances. Most estimates now expect US GDP over the full year to decline in the region of 5-6%, clearly demonstrating that annualised quarter over quarter changes are meaningless.
Where lockdowns have eased and the virus is under control, economic activity is starting to recover. As suspected, it has been easier to reboot manufacturing than the service sector. It has also become clear that in areas of the world, both in the US and Europe, where there has been a pick-up in numbers, economic activity can once again come under pressure. As an investor it’s important to remember that there is a significant time lag between when official data is produced and the period of time it covers, so with a fast moving situation such as the Covid-19 pandemic, it can be out of date before it is even published. Some things remain clear, such as the significant rise in employment figures, despite the artificial depression in place in many developed economies through furlough schemes. In countries such as the US, where furlough schemes haven’t been introduced, there has now been some pick-up in employment levels.
In the West, most economies are service sector oriented, making household spending an important part of the economy. There has been a recovery from the lows, although spending and retail footfall remains well below normal levels. Part of the initial bounce in spending may well have reflected pent up demand from consumers who were unable to purchase non-essentials. After this catch up phase in spending, especially with higher levels of unemployment, there is unlikely to be a full recovery in terms of overall spending, nor a return to regular retail spending patterns. Other areas, such as cinemas and theatres, will experience much lower levels of spending than pre-pandemic times due to social distancing measures. There has also been a significant hit to industrial production, with factories supply chains disrupted and lockdowns/distancing reducing output.
Tourism has been one of the sectors most impacted by the strict lockdown and travel bans that remain in place in many parts of the world. The UN World Tourism Organisation expects global arrivals to decline by 58-78% year on year in 2020. Countries that have opened their doors to tourism such as Greece, Spain, and Malta, have seen case numbers pick up significantly. When lockdowns ease, if individuals return to their old habits and abandon social distancing, this virus will return; it remains extremely contagious, especially within indoor settings.
The Chinese economy is an interesting one to study as it was the first to experience severe disruption and the first to begin to recover. China is now the world’s second largest economy, with links to supply chains around the globe. After initial improvements since the trough in February, more recent data has shown a slip back in recent weeks. Traffic congestion is back to 98% of previous levels, perhaps reflecting a desire to avoid public transport. Other measures such as air pollution are only 77% of the level in early January and power plant coal consumption is only at 81%, whilst container freight is at 89%. Box office admissions are only 13% of what they were at the start of the year, with the service sector lagging. Global trade rebounded in June, rising 7.6% compared with May, although once again, whether this is a short term catch up is unclear.
The Covid 19 pandemic has been full of surprises and for some no more so than the bounce back in global equities. After the fastest fall into bear market territory in the US in March, there has been the most rapid rebound into a bull market. The most recent fund manager survey from the Bank of America shows that a growing number of fund managers accept that this is now a new bull market, rather than a bear market rally. It doesn’t seem that the rapid fall in markets, or the rebound, was driven solely by alterations in growth expectations. One contributing factor could be the expectation of a decline in corporate earnings, since analysts expect a rebound to occur in 2021. Equities are based on the present value of all future earnings so one year in isolation only accounts for at most around 5% of a total value of a share. The decline in the risk-free interest rate has meant that future earnings are discounted back at a lower rate and explains why markets trade on higher PE ratios when long term interest rates fall. Although hard to measure, there are also likely to have been swings in the equity risk premium, which appeared to jump when the pandemic first hit, but returned to normal levels when central banks introduced quantitative easing and other support measures to restore investor confidence. The Fed now appears to be willing to take unlimited action to prevent further market illiquidity and disruption, which means the equity risk premium should be much less volatile going forward, even if a second wave of the virus emerges.
The most recent data from the US has shown a slowdown in the recovery as both the service sector and manufacturing has been hit by the acceleration of cases, particularly in the South and West. There are also some tentative signs that the bounce back in European manufacturing is following the same pattern, with concerns, especially in Germany, that the recovery could soon run out of steam. While manufacturing activity and output in the Eurozone continue to rise in August, it’s at a slower pace than in previous months. The most likely GDP outcome would seem to be a rapid bounce from the most depressed levels, aided by pent up demand resulting from the lock down, but then a plateauing out of activity below previous levels pertaining at the start of the year until a vaccine emerges or a form of treatment which significantly reduces mortality.
The type of recovery that has emerged has also been noticeable in the divide between stock market winners and losers. Whilst the S&P 500 has hit the news for reaching a record high recently, most of the companies in the benchmark have far less reason to celebrate as the advance has been propelled by the tech giants and other companies which have strengthened their market position during the pandemic. Small and mid-caps have lagged as larger companies in the technology space have benefitted from network effects, allowing the strong to get stronger. As of last week, share prices of a fifth of the S&P 500 companies were at more than 50% of their all-time highs, while the average or median stock in the index is 28% below its peak, according to research group Cornerstone Macro. A handful of well-represented stocks in the market index have delivered significant gains to investors but there has been an unprecedented divergence in stock market fortunes between these and the average company. Going back to the previous stock market peak in February, sectors in the US such as energy (down 34%), financials (21%), utilities (15%), and real estate (13%) still show significant losses. In the consumer space, Amazon accounts for 43% of the discretionary index which, when considering its share price is up around 80% this year, helps to explain why this sector has been a strong performer at a time when many smaller bricks and mortar retailers such as Brooks Brothers and Ralph Lauren have suffered significantly.
Apple, Microsoft, Amazon, Alphabet, and Facebook have accounted for more than a quarter of the US stock market rally since late March, explaining the significant divergence between growth and value stocks since the February peak. The market wants growth, and there is now a greater differentiation between businesses with pricing power and those without. Perhaps the market is now looking further forward and deciding some businesses will be worth considerably more in 10 years’ time with higher levels of profit, while other businesses are going nowhere, with their decline accelerated by the pandemic. A positive vaccine announcement, if and when it comes, is likely to spark a sharp rally in value stocks but for this to be sustained, a significant pick up in both growth and inflation is necessary.
Markets look expensive on short term forward earnings multiples, but it’s the valuation change that has driven equity returns in 2020. There has been a collapse in real yields with even 10 year US inflation linked bonds rising to a level where investors are prepared to lock in a negative real return of -1%, and in this context, equities have become the TINA (There Is No Alternative) asset class for investors looking for a return ahead of inflation. Investors have underestimated the impact of low yields on stock market multiples and, even for the strongly performing technology giants, their earnings yield, minus the 10-year treasury yield, looks attractive. The current earnings yield on the S&P 500 at around 3.8% is approximately 3% higher than the 10-year Treasury yield and compared to bonds, US equities are still not expensively priced.
Markets have clearly been indicating for some time that the economics of the post pandemic world will be different. Some businesses and practices have leapt forward by more than a decade. Central bank largesse in tightening credit spreads has helped equity markets and this type of environment is rarely negative for investors. Covid-19 has altered the prospects for many sectors in very different ways: homeworking, home schooling and home entertainment have all benefitted technology names and the increase in eating at home has boosted food delivery stocks, further accelerated by the trend in home deliveries. Markets are looking forward and the progress to date, both on vaccine trials and improved treatments, continues to allow markets to look across the valley to the better times of 2021 and 2022. With Covid-19 in circulation, we won’t see a recovery across all sectors and disruption means that the Schumpeterian process of creative destruction has polarised the world of winners and losers to a greater degree than many investors will have ever thought possible.
Graham O'Neill, Senior Investment Consultant
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