Author: Alastair George
Q2 20 has been one of the best performing periods for global markets in history, despite the enormous economic destruction wreaked by the public health measures introduced to combat the spread of COVID-19. Equity market investors appear to have skipped to the final scenes of the pandemic movie. Market pricing is consistent with the view that COVID-19 effects will be relatively short-lived. Bond markets have on the other hand discounted a relatively long period of lower interest rates and gold is nudging new highs. While equity valuations may have run ahead of the events on the ground in the short-term, the continued progress in re-opening the global economy is likely to maintain market sentiment. In the absence of a downside trigger, we move to a neutral view on global equities despite our outstanding concerns on valuation. During the summer, markets are likely to be range-bound as COVID-19 control measures continue to ease. The strong rebound to date suggests however that any gains from current levels are likely to be modest.
Cutting to the chase – forward-thinking or premature?
While it is claimed that attention spans are steadily getting shorter in the 21st century, the rapidity of the stock market recovery from COVID-19 is still remarkable. At first sight it may appear at odds with bond market pricing, where yields have remained much lower than at year-end. However, in a world where central banks effectively dictate term yields through forward guidance and asset purchases, we believe currently low yields are less a reflection on the outlook for growth as they are for the stated intentions of central banks globally. The underperformance of the banks and insurance sectors during the rally is consistent with this view.
Coronavirus infections are in decline in most developed nations while the decline of approximately 120bps in US interest rates across the yield curve and expanded central bank balance sheets are here to stay. As infection rates decline, it is a scenario of rapid recovery and lower risk-free rates, less the residual damage from the impact of public health measures which markets seem to be factoring in.
Furthermore, new academic research on the susceptibility of the population to COVID-19 is shifting the public health debate, with clinical data indicating that a significant number of people may have a degree of T-cell immunity to COVID-19 from exposure to other coronaviruses. This bodes well for the success of the current re-opening strategies in Europe. We note with interest that markets have not responded to the recent surge in US cases, with close to one-half of US states at the point of re-imposing restrictions on the hospitality and leisure sectors. This highlights the residual uncertainty in plotting the trajectory of the pandemic.
However, it remains the case that for investors the primary concern remains disruptive public health measures and not the virus. At present, the political focus has moved towards re-opening the global economy but with sufficient public health protection measures in place to minimise the risk of a major outbreak, pending a vaccine in 2021. Masks, plastic screens and hand sanitiser have become an accepted if unwelcome prequel to social activities.
Tech looks overbought, sweet spot may be IP-led industrials
Global sector valuations highlight the extent of the rebound in markets in recent weeks and in our view demonstrate that markets are fully up with, if not ahead of these positive events. In particular, as Exhibit 1 shows, the global technology sector is now trading at an all-time price/book high for the past 5 years. Similarly, sectors perceived as defensive such as pharmaceuticals have also strongly outperformed the overall market year-to-date and are also trading at the top of previous valuation ranges. We note that banks, energy, insurance and telecoms stocks (the latter perhaps because of the perceived risks of relatively high debt loads in the sector) have in contrast underperformed and are at a discount to their 5-year price/book average.
The global industrials sector remains at a modest discount to its historical price/book multiple. At prevailing market valuations, companies supplying key components for global manufacturing based on strong intellectual property, technology or market positions within this sector may be of greater interest for long-term investors than the “headline” technology stocks.
Exhibit 1: Historical price/book trading range and current valuations for global sectors
Source: Refinitiv, Edison calculations. Chart sorted left to right by current price/book v 5y average
It remains the case that there will be a quite extraordinary economic contraction during 2020 and even assuming a relatively sharp recovery following the crisis, zero GDP growth is likely to be recorded in developed markets in the 2019-2021 period. This shortfall in GDP versus earlier expectations has crushed corporate profits expectations, particularly in Europe, which remain 16% lower for 2021 compared to January.
Given the societal progress being made in adapting to a post-COVID environment, it may now be rational to look through near-term earnings, but strictly where the longer-term investment case is unimpaired by behavioural changes such as the surge of online commerce or new working from home trends. Furthermore, for valuation calculations some of the damage to earnings will be offset by lower long-term real rates.
In respect of the trajectory of control measures, with the notable exception of certain US states governments are shifting away from lockdowns towards less intrusive measures to control the spread of COVID-19. Uncharitably, this could be described as “muddle-through” but it is the scenario which would enable most of the economy to re-open, provided case numbers remained tolerably low.
This muddle-through scenario is also now our base case. COVID-19 treatment options are improving and social distancing rules and protocols for temperature checks and mask-wearing are being refined and have public support. At least one vaccine appears on the horizon for early 2021. There will also be pent-up demand to be released once consumers regain the confidence to re-start social, leisure and travel activities under new health protocols.
Investors right to feel whipsawed but should look forward to a post-COVID future
We fully understand that many investors may feel whipsawed by equity markets over the past two quarters. At present, outside the US, infection rates are falling and the political focus has shifted towards reopening the economy. Economic activity is therefore likely to continue to improve over the remainder of 2020 while fiscal stimulus continues and this should provide a supportive backdrop for risk assets.
The freefall in markets during March stopped when central banks stepped in to act as buyers of last resort and underpinned pricing in credit markets, thus preventing a liquidity freeze such as that seen in the 2008 financial crisis. Based on previous experiences post-2009, in the absence of inflationary pressure central banks are only likely to withdraw monetary stimulus very cautiously and gradually. This is also due to the proportionally greater COVID-19 impact on the SME sector and unemployment. As a result, global equity valuations have quickly reverted back to historical norms in aggregate, eliminating the “value” opportunity briefly on offer during March and April.
Following this recovery in valuations, which are likely to cap the short-term return potential during H220, and in the absence of a specific downside trigger we now maintain a neutral outlook on global equities. National economies continue to re-open and purchasing managers’ survey data is on an improving trend globally. Furthermore, the risk of economically significant lockdowns continues to diminish and a vaccine program is within sight for early 2021. For stock market investors, it may even be time to put coronavirus to one side and look towards other opportunities and risks on the horizon.