A new business cycle is starting
Global equities (as measured by the MSCI All Country World Index) rose 19% in the second quarter, the strongest rally for 11 years. Equities have now retraced 72% 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 April1.
We see three reasons 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). Moreover, Fed corporate credit facilities launched in March reduce the need for firms to decrease debt levels (further below).
And third, significant monetary and fiscal policy, coordinated between central banks and governments, provides an effective means to boost the recovery. We estimate that the combined monetary and fiscal stimulus of the major economies announced so far is worth around 26% of GDP2. 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.
Four market risks to monitor for the second half of 2020
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 any of the macro risks we list below lead to systemic risks in the financial system.
Risk #1: Jobs fail to come back after lockdowns are lifted and the recovery runs out of steam. It is still early to make a judgement on labour markets, but some of the employment data in major economies has been constructive. 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 now1.
Risk #2: Elevated level of corporate liabilities raises solvency issues. 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.
Though this comes as a cost, as accumulating credit market liabilities on the balance sheet could make it difficult for firms to make future debt payments.
Risk #3: A renewed spike in COVID-19 related deaths or hospitalisations. 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 peak4. As social distancing is relaxed and lockdowns are lifted, there has been a recent pick-up in COVID-19 cases in Beijing, Leicester in the UK 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-related deaths and hospitalizations are trending down. The risk for markets is that further waves lead to widespread lockdowns again.
Risk #4: Some US equity valuations look toppy. 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 ago1. 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%5. Lower EPS growth could crystalize investor concerns over valuations and the durability of the equity rally.
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.
- Refinitiv Datastream, data as at 30 June 2020
- BOA, IMF, OECD, data as at 29 June 2020
- Bloomberg, data as at 30 June 2020
- The future of the COVID-19 Pandemic: Lessons Learned from Pandemic Influenza
- Smith & Williamson Investment Management LLP calculation from Refinitiv data
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of publication.
Please remember investment involves risk. The value of investments and the income from them can fall as well as rise and investors may not receive back the original amount invested. Past performance is not a guide to future performance.