By Kevin Miskin, Hottinger Investment Management
Ben Bernanke, former chairman of the US Federal Reserve (Fed) once said, “I’ve never been on Wall Street. And I care about Wall Street for one reason and one reason only because what happens on Wall Street matters to Main Street.”
During April, economic data confirmed that the US and Europe had entered recession and global activity was in freefall. This dismal scenario was corroborated by government bond markets where the benchmark US and UK 10-year yields posted their lowest monthly closes on record (0.64% and 0.23%, respectively) and the German bund yield slipped further into negative territory. Meanwhile, there was hiatus in the oil market where futures briefly turned negative for the first time in history due to the sharp fall in demand. Yet, in equity markets, April was the best month for the S&P 500 since January 1987, while FTSE All World index of global stocks recorded its best month since 2011. The question is, in this challenging climate, can Main Street take solace from the recent activity on Wall Street?
The International Monetary Fund (IMF) did not pull any punches mid-month with its view of the economic consequences of Covid-19 when it said the loss of output globally would “dwarf” the global financial crisis of 12 years ago, with most economies emerging 5% smaller than planned, even after a sharp recovery in 2021[i].
The economic data, thus far, would tend to support the IMF’s forecasts. In the US, gross domestic product fell by 4.8% in the first quarter and the virus has claimed 30 million jobs to date, which has resulted in a sharp decline in retail sales. Fed chair Jay Powell has warned of “considerable risks to the economic outlook over the medium term”.
It was a similar picture in Europe where the economy shrank by 3.8% over the last quarter, the fastest pace on record, with France posting its worst decline since 1949. Meanwhile, in the UK, the Purchasing Managers Index of service sector activity, which represents 80% of the economy, plunged to 12.3 in April having been comfortably above the expansionary watermark of 50 just two months prior.
Having been quick to respond to the onset of the economic downturn in March, central banks extended their list of policy actions further in April. The Bank of England started to finance the government directly, effectively increasing the latter’s account by an “unlimited amount”, thereby bypassing the process of quantitative easing whereby it buys gilts issued by the government.
Meanwhile, the US and European central banks made their first ever forays into the non-investment grade corporate bond market. They will allow themselves to buy the bonds of “fallen angel” companies, or companies that are downgraded from investment grade to junk. An immediate beneficiary was the Ford Motor Company, which having been downgraded to junk status in late March made the cut for the US programme by one day. More broadly, the pledges to buy riskier corporate bonds effectively placed a floor under the credit market and provided investors with a reason to buy, safe in the knowledge that the Fed and ECB had their back, without the banks themselves having to spend a cent.
For its part, the Bank of Japan (BoJ) removed the limits on its purchases of government bonds to allow it to exercise “yield curve control” by anchoring the 10-year yield at zero. TwentyFour Asset Management caution that the BoJ’s actions could be a prelude for other central bank actions. They believe the huge amount of issuance coming down the tracks to fund the enormous fiscal expansion could be inflationary and deter real money investors from buying longer-dated maturities given the paltry yields on offer[ii]. That would leave central banks as the dominant buyers with the long-end of the curve becoming not only risk-free, but return free, thereby pushing investors further towards the credit and equity markets.
April brought the first batch of US and Pan-European company earnings reports since the outbreak of coronavirus. By-and-large markets were primed for disappointing numbers as analysts had already been quick to cut estimates to 2008-09 levels, according to Barclays[iii]. With almost half of US and European companies having reported, earnings growth has been the lowest in a decade. Credit Suisse forecast that US companies’ earnings are on track to fall by 16% for the first quarter and may not fully recover for years[iv].
Within the banking sector, the central theme was billions of dollars being set aside for loan loss provisions, USD50bn being the latest estimate across the US and Europe. Consumer stocks including Adidas, Coke and Unilever reported sharp, often double-digit, declines in sales. Dividends were cut or suspended; Royal Dutch Shell cut its dividend for the first time since the war and the largest UK banks suspended payouts for this year and next, although the decision had effectively been made for them by the Bank of England. There were bright spots within the technology sector where companies such as Netflix and Microsoft were beneficiaries of the transition to working and being entertained from home; Satya Nadella, CEO of Microsoft, noted that two years of digital transformation had occurred in two months[v].
Nevertheless, almost across the board, companies were unable to provide guidance for future earnings. It is often said that “markets hate uncertainty”, therefore it was somewhat surprising that global stocks rallied to the extent they did. Clearly investors are more concerned with companies remaining solvent in 2020 and are looking to a brighter 2021.
Benchmark equity indices gained between 4% and 6% in the UK, Europe, Japan and China. However, it was the performance of US stocks that stood out with the S&P500 gaining 13%. If ever there was a reminder that the S&P500 has five names (Microsoft, Apple, Amazon, Facebook, Alphabet) making up 20% of the index, rather than a clearer representation of the real economy, this was it.
Following the latest leg-up in equity markets, valuations look rather rich. The MSCI Europe index is trading on a 15.2x forward price-to-earnings multiple, which is higher than its pre-COVID-19 crisis level. Meanwhile, the S&P 500’s forward multiple has risen to 20.1, well above the previous peak in February and now the highest it has been since April 2002. In terms of style, Quality and Growth stocks have become almost the most expensive on record while the more economically sensitive Value stocks trade at historically cheap levels. This would suggest investors are assuming that government bond yields are going to remain at or around zero for the foreseeable future and earnings are going to recover later this year or next.
We remain cautious. Bear markets have a precedent for luring investors back in too early. The world is amid a sharp slowdown and the full drawdown on corporate earnings has yet to be established. Further, the equity market rally that started in late March has been driven by liquidity rather than fundamentals.
On a positive note, at the time of writing, lockdown measures are starting to be eased to varying degrees around the world, which is a first step towards recovery. Yet, it is too early to know whether the quarantine measures enacted thus far will prove sufficient to suppress the spread of the virus, or whether further periods of containment will be required until a vaccine becomes available.
Even once the lockdown has been eased, global growth could remain subdued for a while and we anticipate a more moderate return towards normality than the V-shaped recovery currently being priced-in by equity markets.
[i] Financial Times, “Global economy to suffer worst blow since the 1930s, warns IMF”, 14th April 2020
[ii] TwentyFour Asset Management, “The Beginning of The End For Government Bonds, 27th April 2020
[iii] Barclays, “Result Snapshot – Not bad enough”, 30th April 2020
[iv] Financial Times, “US stocks close out best month since 1987 in global rebound”, 30th April 2020
[v] Microsoft.com “2 years of digital transformation in 2 months”, 30th April 2020