GLOBAL HEAD OF INVESTMENT STRATEGY
Global Market Outlook 2020 – Q3 update: The great reopening
Well, that was historic. The fastest 30% drawdown in the history of global equities in the first quarter was followed by the largest 50-day advance in market history in the second quarter. The S&P 500® was back above 3,100 on June 3 and the Nasdaq hit a record high on June 10. Meanwhile, commentators have been lining up to claim that markets are detached from fundamentals.
We’re not so certain that investors have it wrong. For sure, markets seem to be priced for an optimistic outcome of no meaningful second wave of infections as lockdowns are lifted. But record levels of fiscal stimulus, sustained low interest rates and ongoing low inflation create a supportive environment for risk-asset outperformance.
Our previous quarterly report in late March laid out a cautiously optimistic case for riskier assets, such as equities and credit, to outperform defensive assets like cash and bonds. This was based on our cycle, value and sentiment (CVS) investment decision-making process. Value had improved following the market crash, the cycle outlook was turning positive with central banks and governments in “whatever it takes” mode and, most importantly, our composite contrarian indicator of market sentiment was providing one of its most extreme buy signals. Oversold conditions imply that investors are cautious and worried about downside risks. These conditions provided a springboard for risk assets to rebound as the economic impact of the lockdowns turned out less bad than feared and as a possible second wave of infections failed to materialize by mid-June.
The market rebound means that value is no longer compelling for global equities or credit. On the other hand, the cycle outlook has improved as fiscal and monetary stimulus announcements continue and economies start to emerge from lockdown. The bottom of a major recession when stimulus is flowing is one of the few times it is possible to have a relatively confident view on the cycle. Sentiment, unsurprisingly, is no longer as supportive. Our composite contrarian indicator, as of mid-June, is providing a neutral signal. This means that the support from oversold conditions is waning and markets are at greater risk of pulling back on negative news.
Neutral value, neutral sentiment and a supportive cycle give us a more balanced view on the investment outlook. Looking near-term, markets are vulnerable to negative news after a 40% rebound and with sentiment on the verge of triggering our overbought signal. Over the medium-term, the supportive cycle outlook should allow equities to outperform bonds.
The main risks come from a second wave of virus infections and the approaching U.S. federal elections in November.
- There is little evidence so far in mid-June of a meaningful second wave of virus infections following the easing of lockdowns across Asia and Europe. COVID-19, however, is highly contagious and has only been contained through the imposition of severe lockdowns. We should know in the next couple of months whether a second wave is underway. On the plus side, most countries are now better placed to manage a second wave in terms of healthcare capacity and treatment. Also, the news on vaccine development is promising, although 2021 is the most optimistic timeline.
- The U.S. federal elections are too close to call. They will become a bigger focus for markets if the Democrat nominee, Joe Biden, takes a decisive lead. Biden plans to at least partially reverse President Donald Trump’s 2017 corporate tax cuts. This could deliver a hit to earnings per share in 2021. One of the key watchpoints will be the election outcome of the Republican-led U.S. Senate. Democrat control of the White House, Senate and House of Representatives would make a corporate tax hike more likely. It would also create the risk of more corporate regulation.
- The other election risk is a re-escalation of the U.S./China trade war. A recovery in the stock market and the economy provide President Trump with his best chance of re-election. We expect he will not endanger this by re-starting trade hostilities. This calculus could change if Trump’s poll ratings show him in a losing position a couple of months from the election. He may conclude that nationalism and China-bashing increase his chance for victory.
Longer-term COVID-19 implications
Here are five likely longer-term impacts of the pandemic.
- Low interest rates for longer. The global economy has taken a huge hit from the pandemic and interest rates are zero or lower at all the major central banks. There is a lot of economic spare capacity which will keep inflation low for the next couple of years at least. This means central banks will keep rates low, which will keep bond yields low. Furthermore, after experiencing zero rates, central banks are likely to keep rates low once inflation rises. They will be reluctant to tighten too quickly.
- Less globalization. Globalization was already in reverse before COVID-19. The 2008 financial crisis undermined the trust of western voters in the free market capitalist model. The backlash continued with Brexit, the rise of Trump and the U.S./China trade war. The virus is accelerating the anti-globalization trend. Global supply chains are being unwound and the pandemic has created fears about food security and pressure for domestic production of medical supplies.
- More government debt and a bigger share of government in the economy. The lockdowns are leading to the largest rise in government debt levels since World War II and higher levels of government support for industries. Eventually, the political debate will turn to how to pay for the lockdown support measures and how to address the inequalities that have been worsened by the pandemic. Well-paid white-collar workers have been able to isolate at home while lower paid workers have been laid off or had to work in less-safe conditions.
- Higher inflation, eventually. Inflation shouldn’t be a problem for the next couple of years due to economic spare capacity caused by the recession. Longer-term, inflation could rise by more than expected. Globalization was deflationary and its reversal will be inflationary. On the supply side, it would be inflationary from higher input costs, less cheap foreign labor and rising tariffs and protectionism. On the demand side, central banks likely would take a lax approach to rising inflation and governments would see higher inflation as a way of reducing debt burdens.
- Pressure on profit margins. Slower trend economic growth, less efficient capital allocation, just-in-case instead of just-in-time inventory management, higher taxes and higher labor costs will place profit margins under pressure. One potential offset is that the increased use of technology encouraged by the lockdowns will generate cost savings and productivity improvements.
These trends should favor domestic stocks over those exposed to global revenues and supply chains. Mid- and small-cap stocks should do better than large-cap stocks, in a reversal of the trend of the last decade. Developed markets should benefit relative to emerging markets as there will be less technology transfer and less export-led growth. The unwinding of globalization is a headwind for emerging markets. Ongoing low interest rates favor higher yielding assets such as stocks, property and infrastructure over government bonds and cash.
Our subjective probabilities on the following three scenarios for the next 12 months suggest some caution is warranted.
- Bull (35%): A trade deal sets the scene for a deeper agreement on intellectual property rights and market openness. Uncertainty clears. Purchasing Managers’ Index (PMI) surveys rebound as monetary stimulus kicks in. Corporate earnings rebound through 1H 2020.
- Central(40%): Mini-deal puts trade tensions temporarily on hold and does not reverse tariffs. The global economy responds to monetary easing, but trade-war uncertainty remains. Central banks maintain easing bias.
- Bear(25%): Q4 trade talks fail. The trade war escalates further. The global economy dips into a mild recession. PMIs decrease. Corporate earnings suffer a double-digit decline.
We’re giving the Bear scenario a significant 25% probability despite our bias toward a glass-half-full 2020 outlook. There are several factors that suggest an elevated risk of a recession and bear market:
- This year’s inversion of the U.S. yield curve
- The damage already sustained to business confidence and global supply chains from the trade war
- High corporate debt levels that create vulnerability to rising interest rates or declining profits
The signal that concerns us most is flashing from the Business Cycle Indicator (BCI) model. This model estimates U.S. recession probabilities based on the yield curve, credit spreads, bank credit risk, consumption growth and employment. The BCI forecasts a 33% probability of recession in one year, which extends slightly above the model’s warning threshold. The rising recession probability looks similar to the model’s predictions in mid-2006 prior to the 2008 Financial Crisis.
We suspect the model is overestimating recession risk given the lack of consistent yield curve inversion. The 10-year/3-month curve has spent most of 2019 inverted, but the 10-year/2-year curve was only very briefly inverted in September. We also suspect that the three ‘insurance’ rate cuts by the Fed and the easing in trade tensions have reduced recession risks. There are similarities to 1998, when the yield curve inverted, but recession was avoided. The Fed quickly cut rates three times, and the issues that triggered recession fears in 1998 – the Asian economic crisis, the Russian bond crisis and the Long-Term Capital Management collapse – turned out to be less damaging than feared.
The challenge of investing late in the cycle is that the upside for equity markets is likely smaller than the downside. The last five bear markets saw the S&P 500® Index fall by an average of 43%. An optimistic assessment would give global equities, at most, low double-digit upside. This asymmetry adds a degree of caution to the outlook.
The U.S. economy experienced a historic slowdown through April with, at one point, 95% of Americans under stay-at-home orders. The fiscal and monetary response, however, has been equally extraordinary. The U.S. Federal Reserve cut interest rates to zero, announced unlimited quantitative easing, and committed to buy investment grade and high yield corporate bonds. The fiscal stimulus packages include forgivable loans to small businesses and unemployment benefits equal to wage income for the median worker who loses their job. This is the most significant fiscal thrust since World War II, and more stimulus appears to be on the way. We are positive on the economic outlook.
Unprecedented stimulus and the potential for a few years of non-inflationary growth suggest investors may earn a larger than normal equity risk premium going forward. The U.S. still has relatively high infection rates, so a second wave is an obvious downside risk to monitor. A further deterioration in U.S./China relations would also be a concern. Conversely, news of an effective vaccine, with results expected in June or July, could drive markets significantly higher well in advance of doses becoming widely available. The risks to markets from here are two-sided, not purely to the downside as many commentators are suggesting.
European economies are emerging from lockdown and, so far, there has been no evidence of a significant second wave of infections. The economic cost, however, has been large with the Organization for Economic Co-operation and Development (OECD) forecasting a Eurozone gross domestic product (GDP) decline of 9.1% in 2020 followed by a 6.5% rebound in 2021.
Europe’s disadvantage heading into the COVID-19 crisis was its lack of policy ammunition. The European Central Bank (ECB) policy rate was already negative, there were strict rules around increasing fiscal deficits, and high-debt countries like Italy were at risk of a re-run of the 2012 debt crisis. The policy response has surprised to the upside. The ECB has increased its asset-purchase program by more than 12% of GDP. Rules on fiscal deficits have been temporarily relaxed, resulting in fiscal stimulus of around 3.5% of GDP across the region. The work subsidy schemes implemented in most countries have kept the Euro area’s unemployment rate near record lows. The most far-reaching policy response is the proposal by Germany and France for a €750 billion (6% of GDP) recovery fund that would be financed by the first-ever issuance of bonds jointly guaranteed by all 27 members of the European Union. This is still to be agreed upon but represents an historic step forward in European unity and stability.
The MSCI EMU Index rebounded by 33.3% from its March lows through June 10 but lagged the 43.2% rebound in the S&P 500. Europe’s exposure to financials and cyclically sensitive sectors such as industrials, materials and energy give it the potential to outperform in the second phase of the recovery, when economic activity picks up and yield curves steepen.
The U.K. has been hit hard by the COVID-19 crisis. It has suffered high infection and death rates, which are delaying the easing of lockdowns. The OECD is forecasting an 11.5% GDP decline in 2020 followed by a 9% rebound in 2021.
Economic uncertainty is compounded by the Brexit negotiations. There is a year-end deadline for a European Union/U.K. trade deal, but negotiations seem to be at a stalemate. Our assumption is that a deal will be reached, but the risk of a no-deal exit, with negative consequences for trade and the economy, cannot be ignored.
This has been reflected in the FTSE 100 Index, which has been the worst performer of the major developed stock indices. We like the value in the U.K. market on a longer-term basis. It offers a dividend yield at mid-year of 4.5% with a trailing P/E ratio1 of 14.5 times. Brexit uncertainty and the slow decline in virus cases could continue to hold the U.K. market back.
The Japanese economy was struggling before the COVID-19-led downturn. Fiscal policy has become supportive, with the Japanese government recently approving a second stimulus package worth close to 117 trillion yen ($1 trillion U.S. dollars). The Bank of Japan has expanded its toolkit and is providing commercial banks with the funds to make loans. The boost to the economy from the postponed Olympics has been delayed to 2021.
Japan’s structural weaknesses in terms of weak monetary policy and persistent deflation mean it will likely remain an economic laggard relative to other developed economies.
After being the first country to enter the COVID-19 crisis, China has emerged from the shutdown. The recovery in China has continued through the second quarter of 2020, with the services sector starting to catch up to the manufacturing sector. Construction activity has seen significant improvement in the last month, and there remains a large pipeline of infrastructure projects to be started.
The Chinese government has announced further stimulus measures, including coupons to households to encourage spending, and the People’s Bank of China is making monetary policy more accommodative. However, the stimulus does not match 2015/16 or the financial crisis of 2007-08, and the government appears worried about excessive debt levels. While geopolitical risks are rising, we think the rhetoric between the U.S. and China is at this stage unlikely to see the Phase One trade deal dissolved in the short term. China seems well positioned for a strong rebound through the second half of 2020 and into 2021 as stimulus kicks in and the global economy recovers.
The Canadian economy is expected to contract by around 9% in 2020 based on industry consensus estimates. The path forward looks more optimistic. The phased reopening of the economy, recovery in the price of oil, and historic fiscal and monetary stimulus are laying the foundation for the upturn. A risk to the outlook is consumption. The Canadian consumer had underpinned the most recent expansion. Rising home values elevated household net worth but also indebtedness. Coupled with a high level of unemployment at mid-year, the cracks may be forming in this foundation.
High frequency data such as credit card transactions suggest April marked the cycle trough. Although a full jobs recovery will take time, 290,000 jobs were added in May. While this recaptures just 10% of the jobs lost in the prior months, it suggests a gradual recovery is unfolding.
Australia and New Zealand have been successful in containing the coronavirus through a combination of stringent border control and lockdowns. The focus now turns to the economic recovery, where some caution is warranted.
High household debt levels and slow growth in wages mean a cautious consumer will be a headwind to the recovery in Australia. A similar situation is likely in New Zealand, where household debt is also elevated. The downturn in tourism will also be a challenge for both economies in the shorter term.
Our cycle, value and sentiment (CVS) investment process for tactical decisions looks for times when fear or euphoria cause markets to overshoot. Most of the time, the market consensus embodies the "wisdom of crowds", and there are no strong tactical opportunities. But markets sometimes descend into the "madness of crowds" where herding creates tactical opportunity.
Our composite sentiment indicator combines a range of indicators, such as technical market measures, positioning signals and surveys of investors.
The market action on March 12, when global equities fell by 10% in a single day saw this indicator provide one of its most extreme “buy” signals.
The signal from our CVS investment process is to cautiously lean into riskier assets. Equity value has improved after the large market decline. The cycle outlook is supported by the substantial amount of stimulus being implemented, even though the near-term outlook is for recession. The message from our composite sentiment indicator is that investors have panicked and herded into a pessimistic outlook, which supports taking a contrarian view.
The main uncertainties are around the duration of the virus threat and whether it will re-escalate when the extreme containment measures in many countries are relaxed. It’s likely that markets will find a bottom when the daily number of new virus cases in Europe and the U.S. begins to decline.
1 Trailing price-to-earnings (P/E) is a relative valuation multiple that is based on the last 12 months of actual earnings. It is calculated by taking the current stock price and dividing it by the trailing earnings per share (EPS) for the past 12 months.