A new business cycle is starting | July 2020



In this episode we discuss the new business cycle that is starting.

[0.30] What has been happening in markets now that COVID-19 loft downs are gradually being lifted?

  • Global equities (as measured by the MSCI All Country World Index) are up 17% so far in the second quarter, the strongest rally for 11 years. Equities have now retraced around two-thirds of the prior falls since the COVID-19 outbreak led policy makers to lock down whole economies earlier this year1.
  • markets are optimistic that a new business cycle has started after a short, sharp recession. There is some evidence of this happening with consumers spending in the shops again following the easing of restrictions, for instance, UK underlying real retail sales (excluding auto fuel) rebounded by a record +10% in the month of May, after a -15% collapse in April, which means that shops have recouped 45% of revenue lost during COVID-192.

[1.30] Is this a limited economic recovery – or the start of something bigger?

  • We see three reason to believe that this business cycle could be extended beyond an initial bounce in growth
  • first, the pandemic was an exogenous event, rather than a domestic shock triggered by economic imbalances, even if revenues in selected sectors, such as travel, could take years to recover to pre-COVID-19 levels
  • second, deleveraging pressures are likely to be moderate given that the share of global household liabilities in the economy has been lowered since the 2008 Global Financial Crisis (GFC)
  • also, the Fed corporate credit facilitates launched in March reduce the need for firms to reduce debt levels
  • third, significant monetary and fiscal policy, coordinated between central banks and governments, provides an effective means to boost the recovery
  • this policy largesse increases the likelihood that consensus global real GDP expectations of +5.0% in 2021 are met, following a -3.7% contraction this year3.

[2.43] Could that debt bring a nasty hangover? Does that dent the prospects for the global economy?

  • Yes, governments around the world are adding accumulating public debt at record rates
  • this creates a large debt burden for future generations and is creating imbalances in the economy, for example, high levels of US unemployment insurance payments if extended may encourage workers not to return to their jobs, as some workers are paid more to stay on the doll
  • or non-viable companies are being bailed out by government loans and grants
  • in the long-term, government policies could lead to less productivity growth and a lower standard of living. Such a backdrop may not be beneficial for equities.

[3.38] What do you think will influence markets in the second half of the year?

  • While we recognize that the sharp equity rally may overshoot still weak underlying macroeconomic fundamentals, the broad success of central banks in suppressing market volatility since the end of March has shown a Pavlovian willingness in investors to follow monetary and fiscal stimulus
  • from here, the upward trajectory of stocks will likely depend on the ebb and flow of news and crucially whether macro risks lead to systemic risks in the financial system.

[4.16] Is there a risk that jobs fail to come back after lockdowns are lifted and the recovery runs out of steam?

  • It’s still early to make a judgement on labour markets, but some of the jobs data has been constructive, for example, the US May payroll report beat market expectations of a -7.5 million employment fall with a +2.5 million increase4. Surprisingly, around half of the hiring was in leisure and hospitality, a sector that was been heavily exposed to the brunt of the COVID-19 outbreak. Though it remains to be seen if the bulk of workers return to jobs, enhanced unemployment benefit and stimulus cheques have given a significant boost to personal income
  • how fast these are phased out will be important. In May, US real take home pay grew by more than 8.3% from a year ago, the 3rd highest reading from available data that goes back to 1960, giving consumers the financial wherewithal to shop for now5.

[5.22] We’re already seen a number of big names file for bankruptcy protection, to what extent are you worried about corporate bankruptcies?

  • As we discussed in the May Investment Outlook, the Fed’s explicit backstop of the US corporate credit market has enabled companies to issue record levels of bonds to meet immediate financing needs
  • this comes as a cost, as accumulating credit market liabilities on company balance sheets could make it difficult for firms to make future debt payments
  • by enhancing its secondary market credit facility in mid-June to include purchases of individual corporate bond purchases (including riskier high yielding securities), the Fed has effectively become a regular market participant
  • this should lower the risk of near-term debt refinancing issues in credit markets but at the expense of raising long-term solvency issues
  • in the near term, we think the risk will be reduced, but for the long term, this will be a concern.

[6.30] Does a renewed spike in Covid-19 related deaths or hospitalisations pose a risk?

  • History shows that there have been eight major pandemics since the early 1700s, of which seven had a significant peak around 6 months after the first peak6
  • as social distancing is relaxed and lockdowns are lifted, there has been a recent pick-up in COVID-19 cases in Beijing and major US states, such as Texas, Florida and California. Though additional COVID-19 cases should probably be expected as more testing is conducted, global coronavirus virus-related deaths and hospitalizations are trending down. The risk for markets is that further waves lead to widespread lockdowns again.

[7.28] What are your views on valuations today?

  • The US S&P 500 stock market index is currently trading on a 12-month forward Price-to-Earnings ratio of 22x, not too far off the peak of 24x during the “dot com” bubble two decades ago7
  • valuations could become even more extreme should company earnings fail to recover. If Joe Biden wins the keys to the White House on 3 November his agenda is to reverse much of the Trump tax cuts, which we estimate could halve consensus 2021 Earnings Per Share (EPS) growth expectations of now around 30% in 20218
  • lower EPS growth could crystalize investor concerns over valuations and the durability of the equity rally.

[8.25] And, just finally, what is your overall view? Are you generally optimistic or pessimistic?

  • Given the disproportionate impact of COVID-19 on lower-income households, combined with high unemployment rates, continued accommodative policy support is likely to be necessary
  • with so much economic uncertainty, including a host of political and geopolitical risks, the recovery is unlikely to be smooth sailing
  • however, on balance, we believe ongoing central bank and government support should mitigate macro risks in the second half of 2020 to provide uplift for equities, so we remain generally optimistic on the equity outlook.


1Refinitiv Datastream, data as at 30 June 2020
2 Refinitiv Datastream, data as at 30 June 2020
Bloomberg, data as at 30 June 2020
4 Refinitiv Datastream, data as at 30 June 2020
5 Refinitiv Datastream, data as at 30 June 2020
6 The future of the COVID-19 Pandemic: Lessons Learned from Pandemic Influenza
7 Refinitiv Datastream, data as at 30 June 2020
8 Smith & Williamson Investment Management LLP calculation from Refinitiv data


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This episode was recorded on  29/06/2020

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The Pulse from Smith & Williamson

Investment Show: A new business cycle is starting

Episode 11

Broadcast on Smith & Williamson at 09:00, 6th of JULY 2020

Available online from 10:00 on the same day .

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