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Monthly Market Commentary - June 2020

After two months of strong gains in risk assets, financial markets ended the quarter with a much more modest set of returns.

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Jon Cunliffe

in Fiduciary news


After two months of strong gains in risk assets, financial markets ended the quarter with a much more modest set of returns. In June, global equities returned 2.7% in sterling terms, with the best-performing industry groups represented by technology, financials and materials. The laggards included more-defensive sectors such as utilities, consumer staples and pharmaceuticals.

If we drill down further, it is evident that many subsectors likely to benefit from the “reopening economy narrative” performed particularly strongly – so we saw outsized gains in travel, leisure and consumer discretionary.

Whilst the second quarter is likely to see the cyclical low point in global economic activity, with annualised GDP as weak as -30%, the rate of change of cyclical indicators has been more positive than expected. This is consistent with a more-rapid reopening of the global economy than was expected a couple of months ago. In particular, the much-followed purchasing managers’ indices (PMIs) have recovered somewhat from their precipitous declines at the start of the quarter.

However, a distinction does need to be drawn between how rapidly these PMIs have risen and the absolute levels of economic activity they indicate. Furthermore, it is almost inevitable that the steep drop in activity levels seen in the second quarter will be followed by an impressive bounce as we head through the second half of the year. However, what is more important for long-term investors is the time it will take to recover to pre-pandemic levels of activity.

In this context, our best guess remains that the ongoing constraints created by the need to maintain social distancing – and the difficulty a number of countries are having in containing the pandemic – is that it will be the end of 2021 before global economic activity levels return
to where they started this year. The measures described above will add to the damage already caused to the supply side of the economy, notwithstanding the impressive growth levels we expect for the second half of this year.

Against this background, corporate earnings – which can be viewed as leveraged GDP – are also unlikely to recover to pre-pandemic levels until we reach the start of 2022. In more usual times this prospect would be particularly bearish for equities, but the high valuation of
the major equity markets remains supported by ongoing central bank policy stimulus. This is taking the form of exceptionally low interest rates, unprecedented levels of quantitative easing and a commitment on the part of the US Federal Reserve to backstop the corporate bond market. These actions have combined to ease financial conditions, boost investor risk appetite and remove the near-term risks of a damaging spiral of corporate insolvencies.

Improving the functioning of financial markets by central bank liquidity injections buys the corporate sector time but does not ameliorate its fundamental solvency issues. Encouraged by low borrowing costs post the 2008-9 financial crisis, many companies have high levels of gearing and a relatively low level of interest cover, with the latter likely to fall further as corporate earnings have come under pressure.

Elsewhere, financial market participants will be watching the second-quarter corporate earnings season closely, and expectations are that the S&P 500 will record a drop in reported earnings of 43% year-on-year, its worst quarter since the height of the financial crisis in the fourth quarter of 2008.

Where does all this leave us? As has been increasingly apparent over the last couple of months there is an intense tug of war occurring in markets. Poor earnings delivery, high valuations and upcoming solvency issues are opposing unprecedented central bank support for financial markets – and an optically impressive bounce in several cyclical economic indicators.

However, as we look ahead, the path to a more normal social and economic environment is a long way off and there will inevitably be a degree of permanent damage to the supply side of the economy, even as restrictions are eased further. Whilst the wall of central bank money has placed a firm “put” under the market, there is currently much less “margin for error” in the pricing of global equity markets.

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