Market Update June 2020
Mid-Year Review and Outlook
There is this big disconnect between the fundamental backdrop and where equity markets are - so what’s really driven markets?
Some background
The level of support from a monetary perspective, particularly the amount of money that Central Banks have been pumping into the markets has been enormous. When we look back to the beginning of April the US Federal Reserve were buying $450 to $500 billion of Assets per week. But if you think back to the Financial Crisis, they were buying between $700 to $800 billion of Assets over 9 to 12 months. That level of liquidity found itself flowing into the equity market so that lifted it and has been the real driver from the lows in March this year.
Current position
In the mean-time economies have reopened faster than we would have expected with restrictions being lifted. Across Europe early reopening appears to have worked and we haven’t really seen an increase in case numbers, but obviously in the US we haven’t seen the same trends i.e. case numbers have not come down. They have been flat in the past 4 to 5 weeks and this has spooked the markets in the past few days. Also, there are signs that case numbers are beginning to rise again and particularly numbers in hospitals. It is possible that case numbers are not reducing due to increased testing, but the real figures are the numbers in hospital. There doesn’t seem to be any easing in the hospital numbers so that has given rise to some concerns that maybe we are going to see a reintroduction of restrictions, not on a nationwide basis but maybe across various regions which might mean that the economic recovery may not be as strong as anticipated in the second half of the year.
We have seen the Global Economy encounter the quickest and fastest recession ever. In the space of 2 months the Global Economy went from an expected growth rate of 2.5% + to a potential contraction of 4.5% to 5% over the course of 2020. At the worst point of growth in this quarter we will probably see the global economy shrink by 23% - 24% on an annualised basis. Various data points have been horrendous. For example, we saw it in the labour markets particularly in the US and here in Ireland. The unofficial unemployment rate here has been up to 28% at its height but we are definitely seeing signs of activity pick-up since May and that should improve these figures further as we go into the third quarter.
Looking forward to the third quarter it is possible that we will see a rise in the Global Economy of close the 20% annualised but by the end of the year it is possible we will see a retraction of between 4.5% to 5%. When we look into next year, even with growth of 6% by the end of 2021, the Global GDP will still be below where is was at the end of 2019 - so it will have been two very difficult years even with that big recovery coming through.
When we look at equity markets on a valuation basis they look expensive. At the height of this week (week commencing 8thJune) the Global PE Ratio was about 20 times earnings but the long-time average is about 15.5 times earnings. At these levels we are assuming that earnings are going to contract this year by about 18%. A few months ago, our sense was that initially we thought earnings might contract by between 40% to 50%.
Now however, with economies opening up quicker we are predicting contractions in earnings this year of about 35%. If you plug that in at the peak in markets on Monday 8th June, equity markets were trading at 21.5 times 22 times earnings and that is back to where we were during the Tech Bubble when at its height the PE Ratio was about 24 times earnings. So, in summary equity markets are looking expensive even with the correction on Thursday 11th June taken into account.
However, investors are looking through 2020 having effectively written the year off. They are looking into 2021 in terms of the figures and using that it brings the figure down to 19 times earning - it’s not as bad but it is still high.
What also needs to be kept in mind is that there is obviously an offset with how low bond yields are. We have seen bond yields collapse globally on the back of Covid-19 because of fears around growth and the levels of asset purchases have been stepped up enormously. For example, the ECB recently announced they are going to buy €1.3 trillion in assets by the end of June next year. Accordingly yields have fallen and that has made equity markets look relatively attractive versus bonds and cash. The US Federal Reserve stepped back the amount of QE they are doing. In early April they were doing $450 to 500 billion a week. They are now doing $20 to $25 billion a week so it’s down by 95% which is still big and it’s on a par on what they were doing during the Financial Crisis. There is still a significant amount of liquidity out there and the Federal Reserve said they were going to continue at that level for the next few months at least, as they are still concerned about the growth backdrop. So we effectively have this two way pull - markets look expensive, the expectation is that growth will recover but the question now is how fast will that be and if you do get some row back in terms of the lifting of restrictions particularly in the US, then growth may not be as sharp as some investors are anticipating.
Then the other side is the level of liquidity support in the markets our own sense is that we had thought there would a modest correction in equity markets – we have had a bit now and we could see markets coming back a little bit more.
Where do we think the floor in the markets is? If one looks at the U.S. we think that it’s probably the easiest way to figure this out. If you were to put the US on a PE multiple of 18 times for 2021 earnings, that would put a floor on the S&P 500 of 2700 points against 3100 last night. We think there may be some downside but it’s not enormous compared to what we saw in March and we don’t think we are going to see the lows again that we saw in March, because if you do see markets coming down substantially you will see the US Federal Reserve, other Central Banks and Fiscal Authorities step in again with even more stimulus. So we think the authorities will definitely put a floor on things and also we think the lowest markets might fall will be another 10%, and even that might be a stretch as we think if markets fall another 5% Central Banks and Fiscal Authorities will begin to step in. If you asked for a 12-month view, do we see equity markets being higher than they are today! – yes.
We do have a number of issues with the US Election. We think its increasing likely now that Biden will win particularly if one looks at the polls in the last week or two there has been a huge swing and it’s rare to see the incumbent pick up as much as Trump would require to pick up in the next 4 to 5 months to win. The point is that really the Election will be down to 5 of 6 “swing States” and how they vote and in all of these “swing States” Biden is ahead in the polls.
It does look increasingly likely that Biden will win and he will be seen as more moderate but we think the big point is if the Democrats win both the Senate and the House of Representatives, and it looks increasingly likely, it would give Biden leeway to introduce his policies and one of those is to reverse the Corporate Tax cuts (or partially reverse) which Trump introduced 2 or 3 years ago. If the corporate tax rate were to go to 28% that would have a negative impact on the US earnings by 7%. As we get closer to the Election and depending on how the polls are looking we think you will get volatility and a potential hit to Corporate Tax rates and Earnings in the US. Trump now can’t run his campaign on the positive economy - he has to run on the Anti-China stance.
We do think the anti-China stance, the trade issue and the various sanctions against China will become an increasing issue in the Markets over the next 4 to 5 months so we think there will be bouts of volatility again and one could see dips and spikes in the markets depending on how that news flow goes. We do think we are going to be in for a volatile period for the next 6 months or so and then the other thing is Brexit. It’s very unlikely we are going to get an extension of the transition period. Ultimately, it likely they will come to some agreement whereby there will be some partial trade deal and some roll over, so that we go into 2021 with ambitions to get various aspects of the trade deal done through 2021.
Conclusion
.We think when you look at the Covid-19 there will be a vaccine next year – it’s not going to come through in the next 6 to 9 months. When it is available we will be able to get back to normality and people will then look into the level of growth that you are likely to see through 2021 and 2022 in terms of both the economy and earnings . With the stimulus being put in place it will be difficult for Central Banks to withdraw that. We think we will have a lot of fiscal and monetary support so when we look at a 12 to 18 month view we do think markets will be higher and given where valuations are we don’t think we are going to see huge levels of gains in markets, but if one looks for a 12 to 18 month view, we do think you could see double digit type returns. However, over the next 6 months or so we think there will be volatility in the markets but the downside will be limited. We do think the supports from Central Banks and Fiscal Authorities will put a floor on markets. If we do get more downside for the year we think Investors will see a pickup in policy measures being implemented. From and Investor perspective there is lots going on and timing wise it’s very difficult to find an entry point. From a valuation perspective it would appear that Markets are pricing in a best case scenario at this stage i.e. no second wave, a pick-up in growth coming through next year, no political issues, be it in China or the US and we do think one or two of those will flare up in the next 4 to 6 months.