River FOURcast: May 2020
Welcome to our monthly macro update, giving greater insight into our outlook for investment markets and the investment ideas that currently interest us.
We make our internal views more accessible using our four-phase framework, the River FOURcast. Much like a weather forecast, it provides a guide to what we think may be coming, and how we should position portfolios to prepare for the climate to come.
- April saw positive market moves as investors anticipated economies moving towards gradual reopening. In addition, substantial global fiscal and monetary stimulus provided support and most major equity markets rose 5-10% in local terms. The US continued to outperform others, up 13% for the month and down only 9% year to date as at April 30.
- The US Federal Reserve increased its stimulus further in April, including a program to buy investment grade and certain sub-investment grade corporate bonds.
- However, corporate profit visibility is still extremely low. Many reporting companies have withdrawn earnings guidance amid continued uncertainty of the length and depth of economic downturn we will experience.
- Pressure on the energy sector continued and oil futures prices briefly turned negative, which highlighted that there is too much oil supply chasing too little storage capacity as end-use demand has dropped significantly.
- Various countries are over the peak of new daily cases and are preparing to ease lockdown measures, albeit gradually. Any exit without mass testing, an effective therapeutic, or a vaccine brings a high risk of resurgence and a second round of shutdowns.
We believe we are still in the Downturn phase of the market, but recognize vigilance is required when using this framework in these unprecedented times. The economic damage taking place has direct implications for future recovery. Eventual levels of unemployment, financial leverage, investment spending and consumer confidence will determine how quickly economies can recover. Improving coronavirus trends, reopening plans, treatment hopes, and the massive policy response are all positives. But we remain cautious at the present time. A significant amount of economic activity has been permanently destroyed. We expect this to have a lasting impact, which is not necessarily fully reflected in markets.
- Credit conditions remain very weak, despite a slight improvement in the cost of borrowing for both investment grade and high yield companies from levels seen in March, helped by the Fed’s intervention. Although the Fed can help support the price of corporate bonds, it isn’t creating cash for companies to pay coupons or repayments, and so we expect to see an increase in the level of defaults, perhaps concentrated in the most affected sectors such as energy, leisure and retail.
- Economic expectations are weak with GDP growth numbers extremely negative across the globe. For example, US real GDP contracted 4.8% in the first quarter of 2020. With the level of stimulus we have seen, we would usually expect an improvement on the horizon. But economic trends remain uncertain as the potential for easing lockdowns too soon may cause multiple stop-start cycles. In addition, consumer and corporate behavior will likely change. This could dampen both demand and productivity. One thing the consensus appears to agree on is that things are likely to get considerably worse over Q2 2020 and that we are likely in the deepest recession since the Great Depression in 1929.
- Global equity valuations appear fair to expensive following the April market rally. Valuations must be considered in the context of current economic conditions – limited business activity and low earnings visibility. The main question is whether markets are correctly looking beyond 2020 to a recovery in earnings in 2021 (which can support the current price), or whether markets are being too optimistic about the length of the recession we are experiencing and the likely earnings that will emerge from the crisis.
The massive fiscal and monetary stimulus underway is projected to be up to 22% of Global GDP, with U.S. stimulus up to 38% of U.S. GDP. This extreme support from governments and central banks helped equity markets to move higher in April. The biggest development in April was the Fed’s announcement expanding its asset purchases to include investment grade and some sub-investment grade corporate bonds. Particular focus is on “fallen angels” (corporate bonds downgraded from the lowest notch in investment grade to the highest notch of high yield) and buying exchange-traded funds in the broader high yield market. This announcement provided significant support for credit markets. High yield bond spreads reduced significantly, although they are still at almost 8% above government bonds, compared to a long-term average of c. 4-5%.
At recent meetings held by the Fed and the European Central Bank (“ECB”), both central banks indicated that they could deploy more stimulus if required but withheld from introducing anything further while they wait for more information to emerge. Markets were a little disappointed the ECB didn’t follow in the Fed’s footsteps and also start buying sub investment grade bonds as rumours had indicated they might.
Given the extent of the stimulus, central banks will see their balance sheets rise by 17% of GDP in this year alone. This prompts debate about to the future direction of inflation. The damage to capacity caused by the virus means impact on inflation and unemployment will be long-lasting. It will take a sustained pick up in money growth, rapid nominal GDP growth, and perhaps accelerating unit labor costs, to create a stronger inflation outlook. We are far from that now as the rise in the US jobless numbers passes 30 million in the 6 weeks since shut down.
As much as stimulus is positive, we must remember the virus caused the crisis and will be the deciding factor on the speed and sustainability of the recovery. Strategies to contain the virus and shorten its duration appear to be working. But the economy and corporate earnings are still vulnerable to a prolonged shutdown, or a shutdown that eases too quickly and causes a second wave of the virus. We are also likely to witness changes in people’s behaviors once lockdowns are lifted.
It may be the case that the economy can only improve significantly once we have access to effective treatments or a vaccine. Recent news flow has been encouraging. Gilead Sciences, a US biotech firm, showed positive trial results with their antiviral drug remdesivir. Longer-term hope comes from the announcement that global giants GSK and Sanofi are bringing together their leadership, manufacturing muscle and expertise to develop a vaccine. Yet, these still don’t amount to a “miracle cure”. Much testing is still underway, with a widely available vaccine unlikely until next year.
In April the Q1 2020 corporate earnings season began. Coming into this, analyst predictions for earnings seemed a little high but have gradually been reducing. Even with that, estimate revisions declined to a record low. Only 8% of the S&P 500 index, (just 42 stocks) reported positive earnings revisions, with technology companies such as Alphabet (Google) standing out. Other results from US tech giants have not been as good. Amazon announced Q1 profits below market estimates while Apple’s decision to withhold guidance for the first time in a decade hit sentiment in the stock.
Over April analysts have continued to slash forward earnings estimates and many companies have withdrawn guidance for 2020. Even so, expectations of the speed and magnitude of earnings recovery look too soon and too high, especially given social distancing restrains household and corporate activity. As analysts update their models post the current earnings season, we expect increased downward revisions adding vulnerability to market valuations.
Implications For Portfolios
Investing now is about treading a fine line between the significant support from central banks, the continued uncertainty for corporates and the global economy. At an overall level we are moderately underweight risk assets.
While monetary and fiscal actions are supportive, there could still be more bad news to come. The positive moves in credit and equity markets in April appear premature, leaving markets vulnerable. We are waiting for a better opportunity to re-risk portfolios – either driven by a further price fall, or by greater certainty about the future.
We are researching several favorable opportunities; including the Term Asset Backed Loan Facility (TALF) being launched next month which is backed by the Fed, and the use of structured equity, to protect from market falls while accessing equity market upside.
Please speak to your usual River and Mercantile contact if you would like further information on these opportunities.
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