The spread of Covid-19 around the globe has had a hugely damaging effect on the global economy. News has been unrelentingly grim in the past few months, from the tragic death toll to the loss of income and livelihoods across society. Many businesses, particularly smaller ones in the most acutely affected industries such as travel, retail or leisure are struggling.
Why then should stock markets be in ebullient mood? In the US the S&P 500 is only a few percent below where it started the year and is ahead of where it was a year ago, which was long before coronavirus struck. Meanwhile, in the UK the FTSE All Share has put in a pretty stoic performance despite being identified by The Organisation for Economic Cooperation and Development (OECD) as likely to suffer the worst damage from the Covid-19 crisis of any country in the developed world. The index is down around 16% in 2020 to date – having at one point plunged as much as 35%.
Little encouragement in the data...
At first glance the rate of change of the most recent indicators of business activity look broadly positive, and this may have wrongfooted some of the more bearish market participants. On closer inspection, though, they don’t give much reason for optimism. Even though they have bounced off their lows registered at the peak of lockdowns, absolute levels of activity are still very depressed. That’s not surprising. The damage to large swathes of the corporate sector may be long lasting or even permanent.
Earlier this month, US Federal Reserve Chair Jerome Powell warned that the US faced a "long road" to recovery and confirmed the central bank would keep interest rates near zero for the foreseeable future in order to help support recovery. A forecast released by the Central Bank showed rates remaining low until the end of 2022. "This is going to take some time," Mr Powell stated.
…but what does the future hold?
It’s often said that stock markets try and predict the future, and that goes some way to explaining recent strength. Some investors, perhaps even a majority, believe the virus can be controlled by authorities and things will go back to normal quite quickly. They are assuming that high unemployment will prove temporary, and incomes generated will be enough to boost demand to decent levels once more.
Whether or not this happens, the extraordinary monetary actions being taken by most Central Banks, notably the US Federal Reserve, to combat the negative economic effects of tackling the pandemic is possibly reason enough not to become too pessimistic. Back in March, the Fed intervened decisively at the point of near meltdown in bond and share markets and has essentially made clear it will print as much money as it takes to support the economy and keep asset prices up.
They are not alone. While the Fed busily expanded its balance sheet by $3 trillion in a couple of months, the ECB announced an increase of another €600bn of bond buying and The Bank of Japan and the Japanese government announce another major stimulus equivalent to 40% of GDP. This could just be the start. More quantitative easing (the technical term for printing more money) is expected and markets await more policies from governments to stimulate economic activity, which will likely include infrastructure spending around green and sustainable industries.
With a wall of new money entering the system it is hoped the worst of the Covid-19 economic impact can be averted. But it has an important side effect: there is more money in the market looking for a home. In these circumstances it is not a surprise that assets become more expensive in relation to earnings or against other metrics. With the ‘reflation’ of the economy and assets seemingly assured, the risk – particularly to bonds where yields continue to plunge new depths – is that inflation, the old enemy of investors, lurks around the corner even though in the shorter term it is likely to stay very low.
No amount of money, however, can save companies whose revenue has dried up entirely. It means a period of elevated valuations of a diminished profit and earnings stream for many companies, and reduced or cancelled dividends for some. We would therefore suggest that investors should tread carefully at the current time. There are troubled industries that are likely permanently impaired and many individual companies that will not make it back from the brink.
Lower for longer boosts valuations
Another effect of monetary stimulus through ultra-low interest rates is that investors see less difference between the value of money today and the value of money in the future, which essentially serves to make future profits more valuable. Investors are taking Mr Powell at his word and are assuming interest rates remain low for a long time and that inflation is contained.
This is particularly important for the technology sector where tomorrow’s profits for many companies are expected to be a lot greater than todays. Some of the large tech companies have also been the biggest immediate beneficiaries of lockdown life and the rapid societal changes that it has brought. More widespread home working, online entertainment and internet commerce plays into the hands of the those already occupying the digital world and disrupts those who primarily inhabit the physical one.
The Nasdaq, the US technology stock market index, recently recorded an all-time high with many of the large technology stocks such as Amazon and Apple increasingly seen as a sure thing by investors due to their dominant market positions and the structural growth available from increased digitalisation. These companies have provided the biggest boost to broader stock market returns and are the main reason why US indices have done so well – they make up a significant proportion of that market. In contrast, the UK has few sizable tech companies, with the index more influenced by the energy and financials sectors which have struggled – as well as pharmaceuticals, which has fared better.
All is not rosy
Across all markets, share prices in the most acutely affected industries, including travel, leisure, retail and commercial property, remain far below their pre-Covid levels. We see no reason for this bifurcation in markets to change any time soon. Our Investment Strategy Committee is anticipating that it will take this year and next year for economies to get back to the levels of output achieved in 2019, so we see a growing gap between the earnings outlook for most companies in 2020 and their share prices whose momentum is partly derived from Central Banks stimulus.
Against this backdrop, backing the ‘winners’ looks sensible, as does avoiding the areas where accelerated disruption is resulting in slimmed down businesses, lower profits and, in some cases, financial stress. We worry that overall market valuations are not allowing for a weak recovery, let alone the danger of a second wave or a bad winter with more lockdowns, in which case it is better to back the businesses that are likely to be resilient than the ones most at risk.
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The news is bad – so why is the stock market buoyant?
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