Author: Alastair George
We believe investors are still faced with strongly conflicting signals for the future path of risk assets. On the one hand, the combined effect of the extraordinary amount of fiscal and monetary stimulus during 2020 would normally be expected to be highly supportive of market valuations. On the other, the absence of a return to normal life post-lockdown and concomitant decline in GDP and corporate profits points to lower equity prices broadly and balance sheet difficulties for companies in higher-risk sectors.
In some respects, investors have responded by creating a new class of “digital defensives” which have strongly outperformed the overall market. The apparently quasi-monopolistic position of the world’s largest digital technology franchises have been favoured. Not only have earnings estimates proved defensive during the coronavirus crisis but investors’ confidence in a long period of supernormal profitability in future years has been highlighted. As market discount rates have fallen, top-tier franchises have become relatively more highly valued, as the persistence of returns in excess of the cost of capital becomes worth more in discounted terms.
Thinking beyond coronavirus – geopolitical, fiscal and monetary risks on the horizon
There is at present little commentary in respect of the outstanding risks ahead. We do see clouds on the horizon in terms of the evolution of the coronavirus pandemic, the ultimate trajectory of GDP and question marks over future fiscal and monetary policy. Notably, following rapid declines in policy rates in the UK and US, developed market interest rates are now universally close to their effective lower bound. This calls into question what conventional monetary policy response could now be used to offset a longer period of subdued activity, in the event of a persistent level of new infections of COVID-19 over coming quarters.
Implications of souring US/China relationship for global markets
In addition to COVID-19 risks, the astonishingly rapid deterioration of the US/China relationship even in recent weeks has serious implications for geopolitical stability over the medium-term and should be considered carefully by investors in global markets. If these trends in sanctions, tariffs and trade barriers (most recently those impacting the telecoms hardware sector) continue, then regardless of the reasons or intentions, the risk of a real division in the world economy between the Western and China spheres of influence can only grow.
For example, the recent US sanctions in respect of Hong Kong and naval declarations in respect of the South China Sea come after several years of protectionist rhetoric and the imposition of tariffs on trade between the US and China. Compared to only January of this year, when the ink was barely dry on a Phase I trade deal, the US/China relationship has soured significantly. In our view the US concerns towards China extend beyond Trump’s administration, as China seeks international influence commensurate with its economic weight and in conflict with US policy objectives.
During the recent equity rally, investors have chosen to ignore these developments. In more normal times we suspect they would have dominated the headlines and caused ripples in markets similar to the on/off trade deal newsflow of 2019.
After biding its time for many years, China has in many respects merely revealed the strength of its hand and is now willing to risk external criticism and sanctions to achieve long sought after and in its eyes domestic policy objectives. Having revealed its hand, it will be difficult if not impossible to go back to the previous status quo. At this point, each “wolf-warrior” style comment from China will only harden Western public and political opinion.
Following a two-decade period of progressively tighter integration of global supply chains, the potential magnitude of this cooling of relations between the world’s two superpowers on the world economy should not be underestimated, in our view. Arguably, the opening of China’s labour force to the world heralded an extended period of low goods inflation and reduced the bargaining power of the developed market labour force. While demographic change also played a role, this contributed to a very long period of ever-declining long-term interest rates and high corporate profit margins, widening the gap between rich and poor and creating the conditions for populism along the way.
These are big, long-term trends for which it is not possible to put reliable quantitative estimates at this time. However, qualitatively, should the process of globalisation continue to reverse course, this immediately calls into question the very low medium-term inflation expectations currently embedded in very low long-term bond yields. Trade barriers create economic scale inefficiencies and improve the negotiating position of local labour, which in the longer term may create the conditions for higher prices and lower corporate profit margins.
COVID-19 fiscal policies depend on a time-limited pandemic course
Bond yields are already at risk from the new-found willingness to run large fiscal deficits to combat COVID-19. Some nations risk being pushed to the brink of fiscal sustainability unless a relatively quick GDP recovery can be secured. While fiscal policy has been a welcome support for the economy the sustainability of government finances now relies on a critical assumption.
This assumption is that expansionary fiscal policy will be temporary, based on a time-limited period for the COVID-19 pandemic. At present, investors appear to be ignoring the risk that COVID-19 remains in circulation, even at a relatively low level. We previously have highlighted that a vaccine may be available in early 2021 but this does not mean the global economy will necessarily be out of the woods.
Early studies have revealed antibody responses which indicate coronavirus infection may provide only short-term immunity to coronavirus, meaning that by the winter of 2020 little herd immunity could be in place. For example, UK planning documents for the winter indicate worst case scenarios of 120,000 more deaths, or double those recorded to date. The absence of long-term antibodies in these admittedly small studies also raises questions over the duration of the protection afforded by any new vaccine.
It may be a small and sensible price compared to the cost of a major second wave of infections, but the widespread requirement to wear facemasks highlights the absence of a return to “normal”. Even where COVID-19 has been well-controlled, outbreaks across the globe in poorly ventilated spaces such as dormitories, abattoirs, bars and nightclubs highlight the real risk of super-spreader events and the likelihood of continued restrictions on social activity. Even as lockdowns have been relaxed, current UK retail footfall is still down 40% compared to year earlier figures.
Nevertheless, global consensus earnings estimates have largely stabilised in recent weeks and indicate a decline of approximately 25% in European profits for 2020, compared to earlier expectations of an 8% rise. In the US, the decline in consensus forecasts has been less severe but the 9.5% fall now expected for 2020 still implies a decline of 16% from pre-coronavirus expectations. This relative stabilisation of estimates is welcome for investors, given that it tends to underpin the near-term market direction, although we note that European earnings have declined modestly during the past 4 weeks.
Exhibit 1: 2020 consensus earnings forecasts stable at lower levels
Source: Refinitiv, Edison calculations
Global technology sector has outperformed for good reason but now looks overbought
The dominant role of the global technology sector in the recovery from the market lows seen during March should not be underestimated. Based on a sample of the largest 1500 global stocks, the technology sector alone accounted for 40% of the global market recovery by returning 64% in absolute terms since March, leaving the scraps available for other sectors.
Exhibit 2: Technology sector accounts for 40% of market rebound since March lows
Source: Refinitiv, Edison calculations. Share of USD global market aggregate rebound of 35% since 20/3/20
The sector has benefited primarily from a relatively strong earnings performance as the transition to the digital economy has accelerated sharply during 2020. An additional kicker has been the perceived defensive nature of the largest technology franchises, which have become relatively more valuable as long-term interest rates have fallen in recent months.
Nevertheless, we now believe these factors are fully priced-in and the crowded nature of this trade idea among institutional and retail investors alike creates its own risks for the short-term. We have previously highlighted that this sector is now (again) trading at the top of its forward price/book range for the last 5 years.
Furthermore, it may now be fashionable to describe the sector as defensive but it is not immune to recessionary factors which to date have been largely masked by government support.
Those working from home are clearly reliant on technology sector software services and hardware. However, if unemployment rises later in the year both individual workers and the corporate sector are likely to cut back on digital infrastructure spending.
We also suspect much of the additional spend for work-from-home represents a one-off “tooling-up” for office workers whether in terms of software subscriptions or hardware purchases. With hardware lifecycles measured in years, this investment is unlikely to be repeated in the short-term. This is a sector where price performance appears up with events, in our view.
Remaining neutral on equities but recognising uncertainty remains high
We remain neutral on global equities while recognising that uncertainty is unusually high at present. Equity markets are in a tug-of-war between severely weakened fundamentals and the shock-and-awe monetary and fiscal policy response to COVID-19. European case numbers appear to be under control for now, while US data and the re-imposition of restrictions on social activity in many US states highlights the residual risks.
Given currently punchy forward valuations with respect to depressed growth prospects, but on the other hand relative stability in earnings forecasts, we continue to expect global equity markets to tread water over the summer.
We view the rapid deterioration of the US/China relationship with concern as it raises the spectre of a split in the world economy which would be highly disruptive, represents a structural break from a long period of global integration and may have major long-term implications for the direction of inflation and corporate profit margins over the long-term.