Sentiment in financial markets remains focused on a rising tide of viral outbreaks in the US. Rather than fret about localised quarantines that clip economic activity, investors should welcome efforts to stem the spread of infections.
George Saravelos at Deutsche Bank argues:
“The trade-off between economic and human cost is a false one. It is the virus itself that causes economic harm, and without putting a strategy in place to contain it, growth will be hit lockdown or no lockdown.”
He refers to a paper from economists at the Becker Friedman Institute at the University of Chicago that looked at mobile phone records of more than 2m US businesses, and concludes lockdowns were only responsible for a fifth of the recent decline in economic activity. The main driver was a shift in consumer behaviour.
George says a “key takeaway . . . is that the market should now reward measures that bring the virus back in control, so any state action that reduces diseases transmission (including lockdowns) are likely to be a market positive, not negative”.
Nicholas Colas at DataTrek weighs in on this topic after enduring the recent lockdown in Manhattan:
“It’s scary to watch, but we also know there are simple things local populations can do to mitigate Covid spread. Every region seeing rising case counts will do them. It’s not an ‘if’; it’s a ‘when’.”
The price action suggests sentiment is looking on the brighter side, with modest gains in Europe followed by a late afternoon rally for Wall Street, led by banks. Regulatory relief for banks is a tonic, although the final cost of defaults and failed business awaits.
So where does this leave equities and other risk assets, after a big quarter of gains now has them looking vulnerable to further economic setbacks over the summer?
DataTrek has been applying the play book from the March 2009 recovery and at this stage of the 2020 rebound, history suggests “25-ish more trading days where the S&P will wander in the wilderness”, and adds:
“Bottom line is that during this period in 2009 it was very tempting to see this volatility as a sign stocks were about to roll over again. But they did not.”
One interesting point of difference between the financial crisis and today — among many — is how shares in the technology sector are viewed by most investors through the lens of being a haven from broader market stress. During the financial crisis, tech was a cyclical and lower government bond yields reflected a poor economic outlook, which spurred selling of the sector along with many other equity groups.
Dhaval Joshi at BCA Research says tech’s “haven” or defensive qualities reflect in part how the composition of the group ‘‘has flipped from hardware dominance to software dominance. In 2008, the sector market cap had a 65:35 tilt to technology hardware. But today, it is the mirror-image: a 65:35 tilt to computer and software services.’’
Now computer and software services certainly rank highly in having plenty of cash — a very defensive quality — while the pandemic has heightened their role in an economy that involves both working and being educated at home. (Junior detests Microsoft Teams, by the way, and misses the social interaction of the schoolroom and, I suspect, the lunch menu.)
The rush for all things tech naturally arouses questions about a bubble and sky-high valuations.
Over at Bank of America, its latest research investment committee note highlights how a basket of tech-favoured exchange traded funds that engage in hefty research and development has outperformed the broad market this year and sits near a record high. The ETFs in the following chart track companies in medical devices, biotech, aerospace and defence, autonomous tech and robotics, artificial intelligence and semi conductors:
What links these groups and explains their already impressive performance is the prospect of a US government-mandated shift toward more R&D and industrial policy, reckons BofA and it adds:
‘‘Policymaker priorities have already begun to shift; in recent months >20 new bills from both political parties have been introduced to spur R&D, boost capex, strengthen supply chains, protect intellectual property from theft by foreign governments and protect the US energy grid from cyber attacks.’’
That’s a powerful tailwind and BofA reminds us that:
‘‘Federal funding in 1971 for the war on cancer is still giving us new drugs today; more recently, every key component of the smartphone exists because of funding to government agencies, universities and non-profit [groups].’’
Still, a broader question for investors is one of sticking with tech for an extended journey.
BCA’s Dhaval for one thinks:
‘‘The recent run-up in growth defensives such as tech and healthcare does make sense. Their valuations have moved in near-perfect lockstep with the bond yield, implying that the rally is based on fundamentals.’’
True, as shown by this BCA chart, the gap between the tech and healthcare forward earnings yield and the bond yield has gone up this year and is much larger than in 2018:
‘‘In a longer-term perspective the current gap between the tech and healthcare forward earnings yield and the bond yield, at +4 per cent, hardly indicates a mania. In the true mania of 2000, the gap stood at -4 per cent!’’
Another interesting observation comes via DataTrek’s Nick about the dominance of a select group of companies within the US equity market:
‘‘Big Tech is sucking up ever more US equity market cap, but a long run look at the top 10 stocks back to the 1920s shows that dominant names usually make up 15-35 per cent of the whole market. We’re not even at 25 per cent just now.’’
Quick Hits — What’s on the markets radar?
Among major currencies, the British pound sits near the bottom of the performance rankings for the current quarter and one marked by a weaker US dollar. Only Brazil’s real has fared worse and some analysts believe sterling exhibits the characteristics of an emerging market currency.
Stephen Gallo at BMO Capital Markets weighs in on the pound and says traders view it as a “risk-on/risk-off” currency for now:
“Put differently, it's very difficult to judge which way global risk assets are going to lurch next, and the GBP’s positive relationship with those variables is still reasonably strong.”
A new record low of -0.06 per cent in the five-year gilt yield is enough for some currency traders to retain a bearish outlook on the pound which is below $1.25.
Stephen thinks the UK fiscal approach and trade deal negotiations with the EU are key factors. A rise in long-term gilt yields in response to a lot more fiscal spending would narrow the gap with US Treasury yields and possibly support the currency. But for now, holding above $1.25 looks tough for the pound.
A cheap pound does not make owning UK equities any more attractive in a global context. Many look at UK shares trading at a significant discount versus global rivals as reflecting the economic and political uncertainty from Brexit.
The UK share market cyclically adjusted price-to-earnings ratio “sits at a decade low relative to both the eurozone and the US”, notes Oxford Economics and it also highlights this important reason for such a decline:
“Lower UK valuation multiples also reflect a structural decline in UK corporates’ profitability relative to other markets, with domestic costs having risen against a backdrop of weak global demand.”
Worrying for domestic investors, Oxford Economics thinks:
“The Covid crisis is likely to have exacerbated this longer-term trend” for UK profitability.
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