June investment strategy - The virus has not gone away

Key points

• A genuine gap is emerging between the US and Europe on the pandemic front
• So far differences in policy initiatives on either side of the Atlantic have made up for this short-coming
• Interdependency of virus control, policy and rising activity is key to markets remaining positive
• We need to see a turnaround in earnings to relay the flow of money into risky assets

More cases, more stimulus?

A gap has emerged within advanced economies between the US and Europe on the pandemic front. True, large clusters continue to be discovered in the Euro area and the jump in the virus reproduction ratio in Germany calls for attention, but overall, the decelerating trend continues. In the US the re-acceleration is spreading across more states every week and the rise in hospitalisations suggests this is not a by-product of more testing.

While the reluctance of political authorities to delay the re-opening of the US economy is crystal-clear, focus may shift from “top down” directives to decentralized decisions by businesses and behavioural changes by consumers. This should affect the balance of risks around the shape of the recovery. The consensus view was firmly that every country would be heading – with some lags – towards at least a pause in the pandemic in Q3. Focus was more on the risk of a “second wave” next winter. A risk now is that the re-opening in Q3 could be slower or less effective than expected.

Still, the resilience of risky assets in such a configuration is striking. So far, policymakers have always been able to respond to market wobbles with more stimulus. For instance, last week the Federal Reserve (Fed) announced that it would start intervening on the secondary market for corporate bonds providing the market with another “sugar rush”. In truth, this scheme had already been pre-announced in the 23 March package, but some investors might have feared that the Fed would be content with its approach so far (supporting the corporate bond market indirectly by purchasing Exchange Traded Funds). A news release from Bloomberg according to which the Trump administration was working on a USD1tn fiscal stimulus plan focused on infrastructure investment – thus providing more long-term support than the current emergency response – also helped.

European policymakers are showing more restraint though. The success of the European Central Bank’s latest Targeted Longer-Term Refinancing Operation (TLTRO) is a reminder of the extraordinary support from monetary policy, but the fiscal push is, on aggregate, more cautious than in the US. While we expect a generic political agreement on the EU’s “Recovery and Resilience” fund in July, many thorny technical details will still need to be hammered out and we don’t expect much effective disbursement for 2021.

The markets are counting on unlimited firepower from economic policy. So far, they have been right, but we look with some concern at the autumn of 2020. By then a lot of emergency support measures are due to expire. Governments may by then move to longer-term stimulus (e.g. infrastructure spending) which could leave demand exposed for a few months. Our baseline is that by then the pandemic is well under control across all advanced economies, which would reduce the need for direct income support. If it is not the case, we should brace ourselves for another “wobble”.

We need to see the turnaround in earnings

A “wobble” in the recovery process would prove troubling, especially for equity markets. Many indices are within 10% of their pre-virus highs with some – the NASDAQ and the S&P Growth index – even above. On some counts equity valuations look stressed. Dividends have been cut across the board and the latest consensus estimate of earnings per share for the coming 12-months is anywhere between 20% and 35% lower than recent “peak” estimates. Yet market level multiples have increased. Simply put, investors are paying more for less earnings in the short-term.

We have consistently stressed the importance of the policy measures put in place. The reduction of risk-free rates and the decline in corporate credit spreads go a long way to explaining the performance of the stock market since it bottomed on 23 March. The strength of the credit backstop – particularly in the US but also in Europe – has allowed credit markets to function well. Importantly, issuance has been up 100% on the equivalent period in 2019. Companies have raised funding to counter the impact of reduced revenues on their balance sheets. In other words, the functioning of the credit markets and the lower cost of funding has reduced the risk of insolvency for many companies.

Companies that remain in business can participate in the recovery in earnings when it materialises. Buying stocks today is like buying a call-option on future earnings. Price-earnings ratios always spike when the market is at trough earnings and will come down as and when earnings start to be revised higher.

Reduced bond yields and credit spreads can only go so far in supporting equity valuations. We need to see the turnaround in the earnings cycle which is very dependent on the broader macro recovery. Analysts are tentatively forecasting some improvement in numbers for next year with the 18-month ahead consensus for the S&P500 now some 12% ahead of the 12-month number. Yet companies themselves are still reluctant to provide much guidance so we attach the usual health warnings to equity analysts’ optimism.

At some point credit risk premiums will bottom out. We are probably not far off in the major investment grade markets where spreads have re-traced a good two-thirds or more of their widening. Our credit teams do expect some further modest declines in spread, but the big moves are behind us. Fundamentals should become more important in sustaining the equity price gains already achieved and allowing positive returns to be sustained into 2021. This means the recovery remaining on track and policy remaining in place long-enough to allow companies to benefit from a pick-up in sales. Positive momentum has played a role in the equity rally to date and that itself is driven by a combination of the weight of money coming into risk markets and the news flow.

And therein lies the risk. If our baseline does not materialise and some of the recent trends in infection rates in the US and emerging markets cause a wholesale reassessment of the macro outlook, a significant equity set-back might be seen. The inter-dependency of virus control, policy support and rising activity is core to the market outlook. Disappointment on any of those factors would undermine returns to investors and probably require even more policy commitments to stabilise markets and investor confidence. By contrast, a breakthrough on finding a vaccine would constitute an upside surprise to markets and investors’ expectations.