The fast view:
- Growth assets have continued to hold up well in the face of some potentially serious risk factors.
- Our central scenario remains constructive, but many risks remain. We should see a broadening of the recovery in equity markets with stock markets outside the US and China doing better.
- US rates are going to be kept low well into an eventual recovery.
- The dollar should continue its decline, improving risk appetite internationally.
- The current bull market in gold may eventually be properly tested, but not until 2021.
The market environment in 2020 has been truly extraordinary. Coming into the year, markets were responding positively to a global turn up in manufacturing, following over two years of weakness. This was aborted by the spread of COVID-19 – a “black swan” event – which unlike its predecessor, SARS, rapidly evolved into a global pandemic. We saw markets plunge into bear market territory in record time and briefly become illiquid. Thereafter, equity and other “growth” assets staged a V-shaped recovery that few market participants believed could be possible.
Figure 1: Equity markets have recovered most of their losses
MSCI ACWI last 12 months daily close
Source: Bloomberg, 6 July 2020.
The US equity market briefly became cheap, but multiples rebounded from a low of 12.9x on the S&P 500 to a current 22.0x. This has been a P/E-led melt up. The S&P 500 forward price-to-sales ratio rose to a record 2.32 in mid-July, well above the previous two cyclical peaks. In reality, the equity market recovery has been narrow, heavily favouring large-cap growth stocks. This has propelled the tech-heavy Nasdaq Index to new highs. High-yield credit spreads blew out to 730 basis points but now trade closer to 500 basis points.
The equity market recovery has been narrow, heavily favouring large-cap growth stocks.
In the circumstances, a material recovery in traded asset prices can be justified. Markets had become illiquid in March and consequently experienced sharp losses. The US Federal Reserve (the Fed) stepped in rapidly and, having learnt the lessons of 2008, assumed the role of “market maker of last resort”. It acted aggressively to prevent a liquidity shock turning into a far more dangerous credit crisis. Substantial dollar credit lines were extended internationally to mitigate the dollar “margin call” that was wreaking havoc, particularly in emerging markets. The rally began as investors and traders – newly minted bears who had scrambled to cut risk as prices had plummeted – were squeezed. But the initial rally still seemed to conform to the pattern of a typical bear market rally, leaving many on the sidelines. The rally, however, kept on going, with very modest setbacks. In our view, this can be attributed to the success of China’s lockdown policy, which enabled production to resume relatively quickly, coupled with the extent of monetary and fiscal responses around the world. Global stimulus measures were much more rapid and bolder than generally expected.
The inflection point in global industrial production occurred as early as April which, although admittedly from depressed levels, has subsequently provided a positive undertow. It signalled that a relatively rapid return to normal was possible, even at a time when COVID-19 hospitalisations were spiking around the world (ex Asia). Underwritten by governments and central banks, markets were prepared to look through shorter-term negatives, to normal levels of economic activity towards the end of 2021. After all, equity valuations, in particular, are about discounting long-term cash flows.
Figure 2: Markets are looking through near-term data and pricing in an economic recovery
S&P 500 12-month forward PE multiple
Source: Bloomberg, Ninety One as at 1 July 2020
Where to from here?
Given current index-level valuations for US equities, we believe further material progress will require more tangible signs of a return to normal social interaction in 2021. This would allow for a faster and fuller economic recovery than the consensus currently expects. Despite the recent negative narrative surrounding COVID-19 spikes, the actual data seems to be encouraging, as does news about treatment and vaccines. Although hospitalisations have increased in a number of areas, particularly those that have lagged the earlier outbreaks in the United States, mortality rates seem to have improved. This, in part, is the result of “learning by doing” and the consequent improvement in treatment. However, the fact that the mortality rates seem to be remarkably consistent internationally, despite very different national policy responses, suggests that susceptibility is a lot lower than previously feared (and modelled).
We have the prospect of herd immunity levels being lower than previously assumed.
There is also extraordinary momentum around the development of vaccines – a testament to the dramatic advance of biotechnology in recent years. Initially, it appeared that an effective and tested vaccine would not be available for at least 12 months and possibly not at all. Now, at least four contenders are in the final stages of testing and pre-production. This means that there is a real possibility of vaccines being used for emergency cases by October 2020 and, more generally, in the first half of 2021. Should this be so, we have the prospect of herd immunity levels being lower than previously assumed. Apart from its impact on consumer behaviour, it would reduce the risk of excessive policy caution on the part of governments, which seems to be one of the key risks to social and economic normalisation.
The combined fiscal and monetary response, designed to shore up economies and markets, will remain very supportive of asset prices.
While the news relating to the pandemic overall is constructive, the actions of governments and central banks have also been supportive. The combined fiscal and monetary response, designed to shore up economies and markets, has been completely unprecedented, eclipsing in both speed and scale the measures taken in the aftermath of the Global Financial Crisis. This has been, and will remain, very supportive of asset prices for the time being. In particular, Fed policy has decisively changed. The attempt to normalise rates was understandable but to do so pre-emptively before inflation had decisively moved back up to its target, is now seen as a mistake. In a recent press conference, Fed Chairman Jerome Powell stated: “… [I]f we were to hold back … because we think asset prices are too high … what would happen to those people [who are unemployed] ... the people that we are actually legally supposed to be serving? We are supposed to be pursuing maximum employment and stable prices and that is what we are pursuing.” Hence, US rates are going to be kept low well into an eventual recovery.
Change is also evident in the eurozone. Initially, Europe’s response to the pandemic was fragmented along national lines, but Chancellor Merkel, to paraphrase Winston Churchill, didn’t “waste a good crisis”, securing German support for a new budget and a massive reflationary programme that importantly set a new level for financial burden-sharing. The eurozone still faces many challenges, but for now the risk of a break-up has been dramatically reduced. Central to the recovery plan is a green industrial policy aimed at speeding up the energy programme and putting Europe at the forefront of environmental innovation.
Our central scenario is constructive, but many risks remain
In short, our central scenario remains constructive. We should see a broadening of the recovery in equity markets with stock markets outside the US and China doing better, and “value” closing some of its extreme disparity with “growth”. The dollar should continue its decline, improving risk appetite internationally. The current bull market in gold may eventually be properly tested, but not until 2021.
The “false” equilibrium that has prevailed over the last two market cycles has been restored, but at the price of yet more state intervention in markets and financial repression.
As ever, many risks to this central scenario remain. For the current bull market to be sustained, we need to see more evidence that normal social interaction is on track to be fully re-established over the course of 2021, and that the inevitable economic scarring does not worsen. The “false” equilibrium that has prevailed over the last two market cycles has been restored, but at the price of yet more state intervention in markets and financial repression. This will have challenging consequences but those are likely to be manifest beyond the immediate investment horizon.
Markets have so far shrugged off the escalating strategic tensions between the United States and China, which have continued along tit-for-tat lines. Neither side have an interest in allowing these to get out of hand and compromising their respective economic recoveries. However, we are closely monitoring US-China developments, as both countries’ actions could have unintended consequences that materially affect producers and consumers across the globe.
In conclusion
Growth assets have continued to hold up well in the face of some potentially serious risk factors and should continue to grind higher. The Fed is now focused on driving real interest rates lower, even at the expense of asset price inflation. If this is successful, a weaker dollar should benefit non-US (especially Asian) assets, other currencies and gold.
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