What a difference a month makes. Global equity markets (MSCI All Country World Index) have rallied by 27% from their March lows. Last month we recommended investors stay invested in equities and not to sell at the bottom.
April’s dramatic turnaround has not altered our positive view of equities on a 12- to 24-month basis, especially relative to government bonds. However, the odds of near-term profit-taking is significant, which could lead to a renewed market correction.
Risk assets have rallied thanks to a healthy dose of economic stimulus and mounting evidence that the number of new COVID-19 cases has peaked. Unfortunately, the odds of a second wave of infections remain high. In the absence of a vaccine or effective treatment, only mass testing can keep the virus at bay.
Such testing will become available, but probably not for a few more months. Meanwhile, the global economy remains depressed. As earnings estimates are revised lower, stocks could give up some of their recent gains.
The Economy Is In Freefall
The global economy is on track to suffer its worst contraction since the 1930s. However, the combination of aggressive monetary and fiscal stimulus will prevent a rising wave of defaults from swelling to a crippling tsunami that permanently curtails household income. Given that banks and households have stronger balance sheets than in 2008, when governments ease lockdowns, the economy will recover quicker than it did following the Global Financial Crisis (GFC).
The economic lockdowns and the collapse in consumer confidence continue to take their toll on the U.S. and global economies. The eventual end of the stay-at-home orders and the progressive re-opening of the economy will halt this trend. The rapid monetary and fiscal easing worldwide will allow growth to recover smartly in the second half of the year, but only after authorities loosen extreme social distancing measures.
First-quarter U.S. growth is already as weak as it was at the depth of the recession that followed the GFC. The second quarter will be even worse.
U.S. industrial production is falling at a 21% quarterly annualized rate and the weakness in the Purchaser Manager’s Index (PMI) manufacturing survey warns that the worst is yet to come. In March, retail sales contracted by 8.7% compared with February, which was the poorest reading on record, and year-on-year comparisons will only deteriorate further. Annual Gross Domestic Product (GDP) growth could fall below -11% next quarter with both the industrial and consumer sectors in shock, according to the New York Fed Weekly Economic Index.
The International Monetary Fund (IMF) expects the recession to eclipse the recession that followed the GFC. Under the IMF’s base case, the resulting output loss will total $9 trillion in the coming 3 years.
The IMF’s forecast indicates that growth will suffer substantial downside relative to its baseline scenario if the second wave is strong and forces renewed lockdowns. In this scenario, the current package of stimulus must be increased even further to avoid a depression-like outcome.
If a second wave of infections forces renewed lockdowns in the fall, then 2020 growth could be even lower, and this would be very negative for equity markets.
The Good News
The good news is the economy will recover quicker than it did following the GFC. The deep recession engulfing the world should not evolve into a prolonged depression because banks and household balance sheets are in a better shape than in 2008.
While the recovery will be chaotic, the economy will not remain as depressed for as long as it stayed after 2008, which will allow nominal GDP to recover faster than after the GFC.
Consumers are also in better shape than in 2008. Last December, U.S. household debt stood at 99.7% of disposable income compared with a peak of 136% in 2008. More importantly, financial obligations represented only 15.1% of disposable income, a near-record low.
As long as governments help households weather the current period of temporary unemployment, consumer bankruptcies should remain manageable. The collapse in the consumption of durable goods (for example cars) has created pent-up demand, but not a permanent downshift in the demand curve.
Despite short-term risks, we continue to favor equities on a 12- to 24-month investment horizon, especially in an environment where a second wave of lockdown can be avoided.
Stock valuations have deteriorated, but they remain broadly attractive. While multiples are not particularly cheap, the equity risk premium remains very high. In other words, stocks are attractive because bond yields are low.
Low inflation for the next 18 months will allow monetary conditions to stay extremely accommodative. Growth will recover in the second half of 2020, so the window to own risk assets remains fully open if we can avoid a second wave of complete lockdowns. Ample market liquidity also continues to underpin equity prices.
The Structural Outlook For Inflation… And Bond Yields
Looking further out, the outlook for inflation will depend on whether the structural forces that have suppressed the rise in consumer prices over the past few decades intensify or weaken.
On the one hand, it is possible that the pandemic will cast a shadow over consumer and business sentiment for years to come. If households and firms restrain spending, this would exacerbate deflationary pressures. Likewise, if governments tighten fiscal policy in order to pay off the debts incurred during the pandemic, this could weigh on growth.
On the other hand, high government debt levels may increase the political pressure on central banks to keep rates low, even once the labour market recovers. This could eventually lead to economic overheating in two-to-three years.
A partial roll back in globalization could also cause consumer prices to rise. Global trade was already stagnant even before the trade war flared up. The pandemic may further inflame nationalist sentiment.
On balance, we suspect that inflation will rise more than expected over the long haul. This is not a particularly high bar to clear. Investors currently expect US inflation to average only 1.2% over the next decade based on Treasury Inflated Protected Securities (TIPS) break even yields. Market-based inflation expectations are even more subdued in most other western economies.
If inflation does surprise to the upside, long-term bond yields are likely to increase by more than expected. Therefore, government bonds offer an increasingly poor cyclical risk-reward ratio. However, investment grade credit, emerging market debt and private credit might offer interesting opportunities in the next few years.
We think the coming months will remain volatile and a negative development in the pandemic trajectory could set off another equity market correction.
However, for long-term investors there are opportunities to add to their risk assets in both equities and fixed income.
DISCLAIMER: The views expressed in this economic update are those of the author and do not necessarily reflect those of BFT. This update contains “forward-looking statements” that relate to future events, including future economic performance and plans. These forward-looking statements can be identified by the use of such words as “believe,” “think,” “intend,” “may,” “will,” “should,” ”expect,” ”anticipate,” “estimate,” or “could,” or variations of these terms or the use of other comparable terms. There are certain risks and uncertainties that could cause actual results to differ from those predicted in the forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this update.
Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices does not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.
The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value. The Nasdaq Composite Index is an unmanaged group of securities representative of the market capitalization-weighted index of over 2,500 common equities listed on the Nasdaq stock exchange.
The MSCI World is a market cap weighted stock market index of 1,644 stocks from companies throughout the world. The components can be found here. It is maintained by MSCI, formerly Morgan Stanley Capital International, and is used as a common benchmark for ‘world’ or ‘global’ stock funds intended to represent a broad cross-section of global markets.