Author: Alastair George
The continued decline in infection rates in developed markets and progressive re-opening of national economies is clearly a welcome development for investors. However, we continue to believe investors should inject a note of caution into asset allocations, despite equity market bullishness. Significant uncertainties in terms of the duration of social distancing measures remain. The final totting-up of the damage to the medium-term trajectory of GDP is yet to be determined. As importantly, the remarkable recovery in asset prices in the last 90 days places market indices close to all-time highs in the US and at levels seen as recently as October in Europe. There is in our view little accommodation for the 25%-35% decline in 2020 consensus earnings forecasts since then, nor the prospect of a deep global recession directly ahead.
Good news behind us, tougher headlines ahead
In many respects, the good news for asset prices such as easier monetary conditions and looser fiscal policy was delivered early in the pandemic has already been discounted by markets. Central banks are likely to be satisfied that early and forceful actions headed off a potential credit crunch in an arguably over-leveraged corporate sector.
Exhibit 1: Looser monetary and fiscal policy mix has driven recovery in markets
Source: Refinitiv. Price indices in US Dollars.
However, with funding markets remaining stable and equity markets buoyant there appears little need to add further octane to the monetary mix at this time. In this recession the absence of blame, particularly in comparison to the initial questions of moral hazard during the bank sector meltdown of 2008 has enabled the political consensus necessary to deliver a rapid fiscal response to the impending economic slowdown.
However, in contrast to high-profile stimulus announcements the economic and corporate collateral damage incurred in the battle to control COVID-19 remains largely under the surface as it is focused on the SME level of the global economy. We expect over coming months that it is this data which will gain increasing prominence and as unemployment and insolvencies rise this may temper the animal spirits evident in the market today.
Uncertainties remain in terms of the evolution of the pandemic
Incoming data show a welcome reduction in the number of new reported cases per day in major developed markets. Due to incubation periods, uncertainty remains in place but there has to date been no resurgence in infections in any developed nation of a magnitude similar to the first wave, even after strict lockdown conditions have been relaxed.
Where lockdowns remain in place, compliance appears to have moderated – but without a corresponding increase in cases. Within the space of a fortnight, investors will also have the benefit of knowing whether the recent worldwide protests have triggered another round of infections. If not, lockdowns are unlikely to make a return as political attention turns to restoring economic activity.
Our fears of a second wave sufficiently severe to require the re-imposition of strict lockdowns have also eased somewhat with the passage of time, even if not entirely dispelled. Economic activity measures in Europe have been accelerating since the lows of April, but without any re-acceleration of cases. There is now an active academic debate on the possibility of a significant proportion of the population having some form of pre-existing immunity, possibly from earlier exposure to other coronaviruses.
We also note the recent response to a question from the World Health Organisation Technical Director Van Kerkhove, who suggested that the WHO’s own unpublished data is indicating that the vast majority of infections are transmitted by those already exhibiting symptoms and asymptomatic transmission rates are low. While these comments were later downplayed, if true it may facilitate a relatively rapid withdrawal of social distancing requirements once effective contact tracing has been established. This would be enormously beneficial to the outlook for the service sector of the global economy.
Nevertheless, even as probabilities are slowly shifting towards a more benign outcome in terms of the COVID-19 epidemic, we believe markets would take the re-imposition of lockdowns very poorly in the event of a significant second wave of infections, having now discounted a return to normality. Furthermore, while we talk of a return to normality in developed markets the continents of Africa and South America are only in recent weeks suffering the full impact of the pandemic and new cases on a global basis remain close to their all-time high. At current valuation levels, the risk/reward balance for global equities is no longer skewed in investors’ favour in our view, in contrast to the situation mid-March.
A deep recession in 2020 is now likely – but also the consensus forecast
Consensus GDP forecasts continue to indicate that 2020 will be the deepest recession of the post-war era versus earlier bullish expectations for a further year of expansion, following a US/China trade deal and the perceived resolution to Brexit at the end of 2019. In tandem, consensus earnings forecasts for the corporate sector have fallen by 25% since year-end in the US and 35% in Europe. These are quite extraordinary downgrades.
Exhibit 2: Deep economic contractions expected in on a global basis
By sector, there are few surprises in the earnings revisions data as companies exposed to social activities such as hotels, travel and leisure have seen 2020 estimates decline by as much as 50%, while more defensive sectors such as healthcare and utilities have emerged relatively unscathed. In recent weeks, estimates have also largely stabilised at these lower levels – weekly global downgrades are the mirror image of new cases – boosting investor sentiment.
Exhibit 3: 2020 earnings forecasts cut by 25% (US) to 35% (Europe and UK)
Source: Refinitiv, Edison calculations.
We understand that for many investors the outlook for corporate profits may feel a less important factor than the recent extraordinary easing of monetary and fiscal policy. Yet in our view, this enormous decline in the outlook for corporate profits in developed markets in 2020 is important, especially in Europe and the UK where indices do not have the weighting towards structurally faster growing digital businesses, such as those based in the US.
Exhibit 4: Weekly global earnings downgrades mirror COVID infection rates
Source: Refinitiv, Edison calculations.
The most striking impact of reduced earnings prospects has been a surge in forward P/E multiples but this should not be over-emphasised in our view. It is more important for investors to focus on how a period of reduced corporate profitability will impact balance sheets in the most affected sectors – and the net supply of shares from rights issues versus share buybacks, for the market as a whole.
Germany’s shift on fiscal transfers is a notable positive for the EU project
One of the big surprises of the COVID-19 crisis has been the shift from Germany towards a fiscal support model which embraces grants rather than loans and supports funding backed by the EU rather than at a national level for the periphery of Europe. The German veto on fiscal transfers within a monetary union has been a bone of contention between the north and south of Europe for over a decade and largely responsible for pushing the ECB to keep credit flowing to the periphery indirectly.
The Franco-German proposals for the EU to issue debt to allow for EUR 500bn of grants to fund the COVID-19 recovery have significantly reduced tensions in government bond markets within the eurozone. The spread between German and Italian 10-year government bond yields has shrunk back to more typical levels of 1.4% after peaking at 2.6% at the peak of the financial disruption during March.
This Franco-German proposal is yet to receive the necessary approval from other northern European nations, which to date have been opposed to debt mutualisation of any form. However, if approved it represents a significant milestone in respect of the acceptance of the requirement for a mechanism for fiscal transfers to ensure the sustainability of monetary union over the long-term.
Together with the recent German initiative to drop a long-standing opposition to a common deposit insurance scheme this suggests a direction of travel which has only been accelerated by the economic crisis caused by COVID-19.The near-term benefit is that the risk of a COVID-19 induced eurozone debt crisis focused on Italy has been largely taken off the table, contributing significantly to the improvement in market sentiment.
Valuations no longer attractive given COVID-19 uncertainty and recessionary conditions
Even as we argued initially that markets were oversold in March, we have been surprised by the rapidity and extent of the rally in risk assets in recent weeks. Valuations at present offer little margin of safety for the remaining COVID-19 uncertainty nor the certainty of a major recession in coming quarters, in our view.
We believe therefore that both these risks should be avoided in portfolios by maintaining a relatively cautious asset allocation overall and by focusing on those sectors less exposed to these factors. We continue to believe investors have at this point good reason to keep powder dry in anticipation of increased equity issuance.
Exhibit 5: Forward price/book of largest global companies closing in on 15-year highs
Our suggested sector focus may lead to some difficult decisions at the stock selection level, as these names will invariably be among the market outperformers year-to-date. Nevertheless, at this stage we believe focusing on quality and growing business franchises exposed to future multi-year trends is the preferable equity strategy, compared to short-term recovery plays or weaker companies which risk needing balance sheet repair.