Feature Stories | Apr 29 2020
Following a halving of peak losses for stock markets here and in the US, analysts weigh up the expected economic shock from here and whether the rebound can be justified.
-Markets looking ahead to recovery
-U-shaped recovery more likely than V
-Earnings recession will determine direction
-Uncertainty reigns over all
By Greg Peel
On February 21, the ASX200 hit a new all-time intraday high at 7197, with China in lockdown in an effort to contain the spread of Covid-19. Up to that point it was assumed it was just a Chinese problem.
Until it became apparent it wasn't. From late February to mid-March, the ASX200 fell -11% to register a "correction". While fear was elevated, it was widely assumed the virus was something that could be overcome fairly quickly, and that share prices would be able to swiftly V-bounce back to their highs. There were clearly bargains to be had.
Pimco calls this the "hope & hedge" phase of the virus-driven bear market. Investors uncertain about what might happen held on to risky assets but hedged, just in case, by buying bonds and gold.
In late March, Australia, too, went into lockdown. No more holding on to risky assets. Sell everything. Pimco calls this the "De-risk, De-lever, Liquify" phase, which took the ASX200 into a "bear market", down -39% by late in the month. Investors were not just selling voluntarily, margin calls came into play. Even gold and bonds were thus sold.
On March 23 a bottom was put in place, and the ASX200 rallied 25% to mid-April, to be down -24% from February. The trigger was massive central bank stimulus, including "whatever it takes" measures from the US Federal Reserve and the Reserve Bank of Australia, followed up by massive fiscal stimulus packages. Pimco calls this the "Opportunistic Offence" phase, with bargain hunting running amok.
The ASX200 has since drifted back slightly and appears to be consolidating in what we might call the beginning of a "What Now?" phase.
Adding to hope has been movement towards the lifting of lockdown restrictions. But that may yet prove to be a very slow process.
Meanwhile, economic data shock has begun. To date we've only seen relatively early indications of what the impact will be, and things can only get worse from here as data catches up to the virus, yet the market remains forward-looking, taking weak data in its stride and attempting to anticipate just what the ultimate fallout might be.
It is a given Australia, and the rest of the world, has now fallen into recession. The question is as to how quickly we can come out of it.
V, U, W or L?
An economic "V" shape implies a swift recovery out of what will be an historically shocking June quarter. A "U" implies a slower turnaround into recovery, maybe lingering through to 2021. A "W" implies things might get worse again before they get better, and and an obvious trigger for that would be a feared "second wave" of the virus. An "L" implies things don't get any better for a long time.
In the case of stock markets, we've already had the anticipatory "V". The question is whether this will turn into a "W" on a second leg down, not necessarily because of a second wave of the virus, but because the initial "V" proved to be overly optimistic.
This game of numbers and letters underscores a simple reality. As MFS Investment Management puts it (perhaps with apologies to Donald Rumsfeld), there are "known knowns" and "known unknowns".
It's What You Know
MFS suggests that for the next several weeks investors are unlikely to be surprised by "horrendous" macroeconomic data. Evidence to date backs up that claim. The past four weeks have seen more US workers apply for unemployment benefits than there were jobs created in the entirety of the economic bull market from the 2009 GFC low, yet the US stock market has regained half its losses in that time.
We all know it's going to be bad. This is a "known known". We also appreciate the resultant corporate "earnings recession" will be bad.
What we also otherwise appreciate is that we don't know what the pace of economic recovery will be nor the path of post-recession earnings growth. These are two "known unknowns".
Yet the S&P500, in the face of the worst recession in our lifetimes, has taken equity valuations back to a level last seen only in June last year. (Not so effusive for the ASX200, which is back in 2016.) Over the past few weeks, notes MFS, investors have increasingly assigned a higher probability to a shorter-than-anticipated recession and a stronger acceleration in profits.
Yet another market known unknown is that of earnings dilution as a result of raising new capital. In Australia we have already seen a mad rush in particularly affected sectors, and some not so obviously affected, to bolster capital with new shares. Over the past decade, notes MFS, working capital has been the priority for most US CEOs, and lower balance sheet quality has been the lever. More share buybacks have been implemented in the recent past than any other time in recent history, peaking in 2019.
MFS reminds that 2008, in the heat of the GFC, saw an historically high level of capital raising, leading to substantial shareholder dilution, and this recession is expected to be even deeper.
Today US companies are scrambling to secure liquidity. Profit maximisation is no longer the priority, MFS declares — mere survival is the goal. We are reminded the GFC was exacerbated by an over-leveraged financial sector. This time around the banks and real estate investment trusts are well capitalised. It is every other sector that is not. Capital raisings have just begun.
"None of us can guess what the duration of this recession will be, nor can we tell how strong the recovery will be," warns MFS. "Yet many seem to believe they have sufficient visibility into any such recovery's many known unknowns to make the high-conviction call that the recovery will be strong. We wish we had such conviction, but we don't, and we don't think you should either."
Earnings Trump All
In the short run, markets are driven by liquidity, fear and greed, suggests Longview Economics Research. The 30% rebound rally in the S&P500 is a prime example. Unprecedented policy action, both in size and speed, and specifically the provision of unlimited Fed liquidity, have helped to squeeze the shorts out of the market and underpin a sharp relief rally.
In the long run, however, markets are driven by earnings and valuations (price/equity ratios). Given PEs always revert to the mean over time, in the very long run, says Longview, "it's only about earnings".
Currently the S&P500 is trading on its highest forward PE multiple since the dotcom bubble of 1999-2000. The latest (April 21) PE is 19.7x, just above the 19.0x reached at the February all-time high. This implies the consensus earnings forecast has fallen more than the index suggests.
And that implies the market is looking through the short term earnings impact of a recession, to a relatively swift recovery.
Longview calculates a fair value for the S&P500 using long term forward PE ratios and applying those to an estimate of what the analysts expect will be the trough in forward earnings consensus. That estimate is based on a range of factors, but primarily on the relationship between US industrial production and consensus earnings growth, and on the experience of prior recessions.
Naturally there are significant levels of uncertainty surrounding just how severe the global contraction will be, Longview notes, and whether it proves to be worse than the -3% IMF forecast for 2020 is unclear and unforecastable. What experience does tell us is the size of the S&P500 correction is always greater than the size of the earnings contraction.
Generally the contraction in earnings is greater than the contraction in industrial production, on an average multiple of 1.2x. Longview suggests a sensible central case forecast for industrial production contraction is -15-30% peak to trough. Multiply that by 1.2x and S&P earnings should contract by -18-36%.
The next step is to multiply earnings by an assumed PE ratio (E x P/E = P). High levels of monetary and fiscal support argue for a higher PE than in previous recessions, and it is not implausible that massive liquidity drives the S&P's forward PE to even higher levels over the next twelve months, Longview surmises.
Markets always cycle out of recessions from at or below average PEs (not the case currently), uncertainty is high with respect to the degree of global economic downside, uncertainty is high with respect to the path of the virus (second wave?), uncertainty is high with respect to the effectiveness of monetary and fiscal support, record high unemployment is inconsistent with record high PEs and it is possible that the "cheap money" bubble built up in the past decade will burst, triggering a cascade of negative shocks.
Given such levels of uncertainty, Longview assumes an "arguably conservative" forward PE of 14.3x, which when applied to the -18-36% earnings contraction assumption, implies an S&P500 -27% to -43% below current levels (1633 to 2093 at the time of analysis publication, last 2863, March low 2191).
It's a risky business to attempt such forecasts, Longview admits, and economies could indeed bounce back sharply if the virus fades, potentially if treatments/vaccines are rapidly finalised.
Pimco is another research house expecting a phased recovery, transitioning from intense near-term pain to gradual healing over the next six to twelve months. Pimco also acknowledges substantial risks to forecasting at this time, but has settled on the assumption of a U-shaped global economic recovery.
Unless there is a second wave, in which case the recovery will be W-shaped. Given the damage a second wave would wreak, Pimco is stress-testing and managing against W risk.
The Fed's extended QE program has stabilised US credit markets for now, but they are by no means back to normal and the financial system remains fragile and dependent upon central bank support, Pimco warns. Given the size and scope of economic and financial market disruptions, it will take time to fully restore financial market functioning, and the Fed may not be able to prevent stress in riskier segments of the market.
To that end Citi notes it expects US$5.5trn of central bank asset purchases over the next twelve months on the one hand, versus an assumed -50% fall in global earnings over 2020. The central banks have won the battle in recent weeks, but Citi suspects earnings concerns have not yet been seen off completely.
"We suspect the S&P500 may be ahead of itself."
Shaw & Partners forecasts that were the hit to global GDP to last for a full three months, across the June quarter, growth would be cut by -8.5%. Given the US reports GDP as a change on the prior quarter at an annualised rate, this would equate to a -30% plus drop.
Many houses are already forecasting such a number for the US June quarter.
Shaw notes that economic shocks over the past forty years have typically started in the financial markets but this one didn't. There are fewer past examples to draw upon.
On balance, Shaw is also among the U-shaped recovery cohort, seeing a large economic contraction in the June quarter, levelling off in the September quarter, and bouncing back in the December quarter. As demand is falling off faster than supply, inflationary pressure will remain weak, and the oil price already provides an example.
Financial markets are always forward-looking, Shaw notes, but the clarity of vision is unlikely to be high in coming months.
Aviva Investors expects the global economy to contract by -8-14% in the first half of 2020 compared to where it might otherwise have been. That would be a similar decline to that last seen in 1930. While this might sound severe, "such is the uncertainty about the impact on activity of the crisis, and the offset that fiscal and monetary policy may provide, that it could plausibly be much worse".
One difference is nevertheless that the Great Depression was never going to be overcome with a cure. A recovery will begin, suggests Aviva, stating the obvious, as a viral treatment is found, improved data on immunity can be utilised and, ultimately, a vaccine is developed. Many sectors should recover quickly, as economic contraction is not the result of declines in capital or productivity, rather a case of lockdowns. That said, it remains to be seen how well small and medium sized enterprises can survive a prolonged shutdown.
Aviva is considering three scenarios.
The first is a recovery beginning in the second half of 2020. The second is also of a recovery beginning in the second half, but from a greater depth, and the third is for a greater depth and slower recovery. These scenarios do not see the level of activity back to the previous trend until between late 2021 and late 2022.
Fiscal and monetary support will undoubtedly cushion the blow, Aviva suggests, but will not provide an offset to a near term decline in activity. Given uncertainty, both on the health and financial fronts, it may be that much of the support provided to households is saved rather than spent. Perhaps the best we can hope for is policy support helping to ensure a quick recovery once uncertainty has past.
We recall that in 2009, the Rudd government provided direct cash handouts to eligible households, sparking a rush to acquire that household's first ever flat screen TV, and helping to ensure Australia only suffered one quarter of economic contraction.
Aside from everyone now owning at least one flat screen TV, Morrison's fiscal measures are not so much a cash handout to be spent indulgently but a subsistence stipend to help pay for food and rent, be one a JobKeeper or Seeker. It is not a "stimulus" package, as Rudd's was, but a relief package.
Morgan Stanley foresees what is shaping up to be, globally, "one of the deepest but potentially shortest recessions in recent history".
Massive policy actions provide a backstop for risk assets but the outlook over the next few months is highly uncertain, Morgan Stanley warns, alongside everyone else. While markets may be tempted to rally on a sign of virus cases peaking, macro data will likely come in at depressed levels for some months.
The pace of recovery is "highly ambiguous". Normalisation will likely take a long time and second-round effects, such as corporate defaults, will slow it down. Volatility will remain, thus Morgan Stanley retains a defensive approach to protect against renewed volatility.
That said, the broker's strategists are looking to position to take advantage of normalisation of market conditions over time.
Morgan Stanley is another expecting a phased recovery.
The first phase will be that of some easing of lockdown measures in industries that can comply with social distancing, and based on the testing, tracing and medical capacity of the government. This phase is expected to begin in mid-May, but only a third of lost output will be recovered by the September quarter.
The second phase will be slower, balancing medical capacity and output expansion until a more permanent medical solution is available, which is estimated as mid-2021.
The third, post-virus stage will be helped by more traditional policy stimulus and reform but also challenged by the structural adjustments that face the economy.
Morgan Stanley forecasts a -5.2% fall in Australian GDP in 2020 and expects only a partial recovery in 2021, with output by next year-end still below 2019 levels. Unemployment is forecast to rise to 9.5%, gradually improving to 7.2% by end-2021.
Australia is performing relatively well in the near term compared with other advanced economies, the broker believes, given a lighter level of lockdown by comparison, a positive case trajectory and strong policy support. However, three issues will weigh on a recovery.
The first is Australia's reliance on migration to drive growth. The second is the housing market wealth effect, which could drive sustained household deleveraging and a softer spending path, and the third is weak inflation, which is not likely to see upside till further down the track.
T.RowePrice notes Australia entered this environment in a very strong fiscal position (remember the word "surplus"?) and with low levels of government debt which has provided the firepower to support the economy. Australia has taken significant strides so far to limit downside pressures.
T.RowePrice expects fiscal and monetary support will continue to be ample until the situation appears under control.
Turning to the real numbers, UBS notes that since the market peak in February, consensus 2020 earnings estimates have fallen -18% and dividend estimates by -22% (to April 23).
The experience of FNArena over this time is that brokers are still working through their forecast changes and every day brings downgrades to stocks a broker hasn't yet had the chance to fully analyse, in the absence of company guidance, and given the virus impact on every stock under coverage, one way or the other. A mammoth task.
UBS' own forecasts are more severe, expecting a -23% fall in 2020 earnings and -30% for dividends, implying the assumption of a greater virus impact than consensus currently suggests. The fact that both consensus and UBS have dividends falling by more than earnings implies either earnings forecasts must yet fall further or dividend payout ratios will be reduced to preserve capital.
Which, in the latter case, we're already seeing.
UBS nevertheless counters its below-consensus 2020 forecasts with a larger growth recovery forecast for 2021. The broker expects earnings will not return to FY19 levels before FY23, and dividends won't return to FY19 levels until "well after" FY23.
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