With Q2 economic data now released, the initial impact of COVID-19 and resulting government actions has been quantified. Most developed economies have contracted by around 10% quarter on quarter, although there have been some more extreme examples, such as the UK and Spain, which have seen 20% falls. There is some disparity in the timing of lockdowns and peaks in virus cases so Q2 data is not necessarily comparable country to country.
The consensus is that there will be a sharp rebound, at least in the short term. This is already observable in the high-speed data, which shows a relative return to normality, at least for some areas of the economy. There is also the prospect of inventory restocking and catch up demand, although this is a one-off benefit. Most are expecting that it will take 1-2 years to regain the lost ground, although this is very much contingent on there not being further government action. The speed of the recovery will alleviate some fears that there will be large and permanent scars on the economy, although only time will reveal if this is the case.
We discussed in Q3 the impact of central bank and government action on the money supply. One of the observations over the quarter, as more data has become available, is that the increase in money supply has been primarily driven from the issuance of government debt rather than increases in corporate/ personal loans, although these have contributed. Given the current policy stances of central banks and governments globally, it would be reasonable to assume that this will continue to be a driving factor. Governments will be unwilling to dial back spending or make tax rises until the economy has recovered sufficiently, meaning deficit spending will be here to stay for the foreseeable future. There may be longer term problems from this, but as long as central banks effectively fund this through QE, there will be ongoing upward pressure on the money supply.
Below is the US unemployment monitor (Appendix 6) that we have included previously. The official rate of unemployment is now 8.4% (August 2020) down from 14% in April. Furthermore, there has been a marked recovery in US employment over the quarter, having reached a low in April/May. Total employment in the US is now 10% higher than it was in April, although this is from a low base and is still over 7% down from the peak. There is still a shortfall of ~4m in the total labour market, implying that inactivity is also an issue. Some have suggested that the ending of the furlough and unemployment allowances will lead this to unwind but effects such as early retirees etc. may be more persistent.
There continues to be a high level of initial jobless claims, although on a downward trend, suggesting that businesses are continuing to lay off staff, even if this may be more than compensated for with rehiring recently. Furthermore, the prospect of a second wave of infections in many states, as discussed, may mean that the desire to hire back workers begins to wane in some areas.
he upcoming US Presidential election in the US has been the political focus of markets. The vote is on 3rd November. There has been some relief that Trump’s opponent is not Bernie Sanders, who was running on a far more aggressive programme of change. However, there remains scope for disruption and surprises in the campaign. The current polling suggests that Biden will win, however, as previous votes have illustrated, nothing can be certain. Furthermore, a likely outcome is that Biden wins the presidency but Republicans control one or both Congress and the House. This scenario is probably least bullish for fiscal spending as bipartisanship will take over and debate will delay the deployment of funds. Therefore, markets are probably keen to see a clean win for one or other, as this will avoid ongoing political standoffs.
In the UK, away from the regular gaffes and U-turns, progress on Brexit negotiations (both EU and other trade agreements) appears to be moving at a slower than desired pace. This is unlikely to change the timelines of the decoupling from Europe and in the current environment, the additional disruption from a harder Brexit may well go unnoticed. Nevertheless, there are increasing headlines as the crunch point in negotiations approaches with legal changes and challenges in the quarter impacting the pound and domestic assets.
Away from Europe, a key win for the UK would be a trade deal with the US. With the upcoming presidential election, it appears that both sides are less willing to get into the weeds of a deal with the prospect that there could be a leadership change. While a deal may be quicker under Trump, there may be more scope for a more pragmatic trade agreement under Biden.
The pound has seen some more strength following the extreme weakness during the depths of the COVID selloff. As a “risk on” currency, the pound has benefitted from a generally improving sentiment in the market. However, the primary driver of the rise in Sterling has been the weakness in the dollar, which has fallen against a wide basket of currencies. We would expect the dual risks of COVID and Brexit on the pound will leave the pound under pressure over the coming quarter and the $1.20-1.40 range remains realistic.
The dollar weakness seen over the last quarter has been on the back of a long period of strength and a short period of extreme demand during the second quarter this year. Resultingly, although there have been many headlines on the dollar weakening, it remains well within the trading range of the last decade or more, albeit relatively week on a 5-year view.
To determine if this is a longer-term trend, we can first consider the rationales for the current shorter-term weakness. One of the reasons for the recent selling is the removal of the yield premium received by dollar holders, particularly from investors in Japan and Europe. While there is still a small premium it is not significant enough to carry traders/ investors to take on the risk, and will have led to some unwinding of positions.
Having already looked at this in Q3, it is likely that traditional valuation metrics such as P/E ratios are not going to be as effective in the current environment. The earnings component has taken a significant hit this year, and there is the potential for losses in many companies and sectors. This is going to make PE ratios look high as investors are rightfully looking at 2021 expected earnings. Here we can understand some of the bullishness around equities, as from the last quarter, S&P 500 2021 earnings have been upgraded by 13%, although nearer term earnings have not been revised significantly.
The note of caution here is that current expectations for the S&P are for a ~20% decline in EPS this year followed by a >40% rise, taking the index earnings to a level similar to where they were in 2018. The average level of the S&P in 2018 was around 2700, over 20% lower than the current level. However, the most at risk is that a massive rebound in earnings in 2021 may yet prove to be ambitious and it is likely that the risks are skewed to the downside.
The rebound in the market has contributed to a rise in valuations, with the combination of earnings falls and price rises pushing the prospective PE of most markets to levels not seen in many years. Global equities now trade on over 21x forward earnings, although acknowledging the points discussed above on the transitory nature of the current year earnings.
We have not looked to over interpret index level price to book data, as it is increasingly difficult to analyse, particularly for tech heavy markets such as the US. However, comparisons of recent price to book values may be another tool to assess the “cheapness” of markets. Book values should be more stable than earnings through this crisis, and in theory should provide a better indication of the long-term value of companies. Nevertheless, there is a high chance that some companies (eg. Energy sector) will be compelled to write down book values in the current environment.
Using the most basic view, the level of the index, which in the US has breached all-time highs in the quarter and is still at a level which is above the high seen before the selloff, it is easy to see why many consider the current market elevated
Overall, it is therefore very difficult not to imply from current market pricing that investors are expecting an easy exit from the pandemic and a swift return to normality. Unfortunately, there is likely to be complications and we are already seeing the economic implications of the crisis in GDP and employment data. While there may indeed be a speedy return to growth, it would be naïve to ignore the growing risks.