Feature Stories | Jul 10 2020
With stocks markets now pricing in a V-bounce economic recovery, while the global case-count rises unabated, what are the prospects for stock markets being right? And what further considerations of a life after covid have since developed?
-Markets pricing a V
-Further changes to expect
-Green and digital
-Slowbalisation and a multi-polar world
By Greg Peel
When FNArena published Life After Covid Parts I and II (links below), major stock markets had bounced about half way back from their “covid crash” bottoms, as forward-looking investors hunted bargains and made the assumption the economic shock would be sharp but short.
We might call it phase one of the market recovery, as investors continued to avoid clear virus losers such as airlines, bricks & mortar retailers, banks and energy companies, but jumped into stocks deemed either little affected or unaffected, and in particular, positively affected, such as the likes of Amazon and Zoom.
We have since experienced phase two, in which the aforementioned losers have also been snapped up as economies across the globe began to reopen, sooner than most had expected, while winners have powered on further. In the US, the S&P500 almost rallied back to square for the year until a more recent consolidation period, while the Nasdaq has surged on to ever new all-time highs.
Phase one was not only considered by many to be “the greatest investment opportunity of a lifetime”, in a belief stock prices had fallen too far, too fast, but also considered a bit of a no-brainer, given massive monetary and fiscal support. That support has continued to provide a base for phase two, although the wary are now looking ahead with trepidation to the expiry date of fiscal programs.
In the US, economies began to open faster than assumed largely due to worker protests in states in the south and west that were little impacted by the virus as a health threat, but greatly impacted by the lockdowns as an economic threat. Politicians bowed to the pressure. We now know the result.
It’s not a “second wave”, rather a continuation of the first wave, which began in the intensely populated north-west and has now rolled further across the country as social distancing and other measures were largely ignored.
In Australia, a far swifter and more coordinated response to the virus led to gradual re-openings – a risk taken in full knowledge that a second wave risk was high, but that the country was now much better prepared to contain it.
Victoria is yet to prove this to be so.
Part III of Life After Covid picks up where Parts I and II left off – with a stock market continuing to favour an economic V-bounce even as the global case-count rises unabated and the end of emergency fiscal measures looms.
What Has Changed?
Shocks that change the economic system are generated by the economic system itself, notes Danske Bank, by skewed incentives and institutions. The coronavirus was not a result of skewed economic or political incentives but a true random shock. Yet rather than igniting regime change, the crisis has galvanised pre-existing trends.
Workers were already migrating to home offices and groceries were being ordered online, and sovereign debt burdens were increasing as a matter of fact.
Real economic growth in developed countries was already slower than the 1950s and 60s due to a fall in labour supply because of ageing demographics and low productivity growth. Interest rates were already at historical lows and have now fallen lower still, and central banks will continue to stimulate lockdown-ravaged economies and ease the pressure on the debt burden of expansionary fiscal policy unless, Danske suggests, inflation becomes unhinged.
Danske does not believe inflation is set to ignite, despite massive stimulus and subsequent debt. One only need look to Japan in the 1990s and the US and Europe post-GFC to note negative interest rates and QE have had little or no impact on inflation.
Thus in the medium to long term, developed economies will continue to exhibit low inflation, low interest rates and low to moderate economic growth rates. The virus is unlikely to affect long term economic fundamentals and it has little effect on demographic and technological trends.
The bottom line is the virus leaves investors in the same predicament as prior to the crisis, or even more difficult than before, by compressing both equity and fixed income returns further, Danske Bank suggests. Valuation levels are at historic highs given the rapid recovery in risk asset prices and damage that will be apparent to June and September quarter earnings (elevated PEs).
Yet meaningful portfolio returns will be more dependent on taking equity risk.
What Will Change?
Morgan Stanley has offered up four near-future scenarios.
Scenario 1 is labelled “robust recovery”. It is the best-case scenario in which a vaccine arrives well before the March quarter 2021 and a reduction in risk aversion among consumers and businesses allows life to return to normal sooner than anticipated. In this case, post-covid will look little different to pre-covid.
Scenario 2 is labelled “back to normal”. A vaccine arrives in the March quarter and a second wave outbreak in the September quarter 2020 will pass with relative ease. Consumer and business risk aversion declines. Businesses remain fully open, consumer activity recovers quickly and social distancing measures are only lightly enforced.
Scenario 3 is labelled “a new normal” and is Morgan Stanley’s base case. A vaccine arrives in the March quarter but the second wave in the September quarter prior is worse than scenario 2 and leads to selective tightening up of activity once more. This leaves a more lasting imprint on risk aversion among consumers and businesses. Businesses reopen but the consumer recovery is more gradual.
Scenario 4 is labelled “deep scars”. Recurring waves of infection cause severe medium term disruptions, with no vaccine likely before two and a half years. There is a crisis of consumer confidence, permanent dislocations in the labour market and permanent damage to the economy’s growth potential.
Morgan Stanley published this report on June 21 and interestingly it appears the base case is playing out in a sense. It is not a “second wave” in the US but re-lockdowns and border restrictions have already begun. A true second wave would require another outbreak in the north-east, and as for a vaccine, well, analysts can only speculate without any level of confidence beyond hope.
Remember, a vaccine for SARS was never found.
But let’s stick with the broker’s base case, which while US-centric has implications for all developed world economies with regard new or accelerated trends that have emerged as a result of the virus.
Work From Home
US employers have largely found the enforced shift to WFH to be a success, Morgan Stanley notes. This success will likely mean a shift in worker locations well after the threat of covid is a memory.
The fallout of fewer workers in offices and fewer face-to-face meetings will be a lower “run rate” for non-residential construction, hotel occupancy, business travel and the use of corporate dining halls. Fewer commutes will mean lower public transport use, lower advertising revenues for radio aimed at commuters, and fewer morning coffees.
There will be greater demand for housing outside of city centres if commuting is not a daily imperative, impacting on construction and mortgage demand, as well as auto and parcel delivery service demand.
Internet advertising will only continue to gain share and the trend towards cloud-based computing and high-speed internet to individual homes will accelerate. Morgan Stanley has been surprised by the rise in home furnishing and home improvement spending despite the deepest recession in our lifetimes.
The same is true in Australia.
Morgan Stanley does not believe consumers will all want to return to in-store shopping as soon as possible. The “electronification of consumption” trend will only accelerate. This suggests new opportunities for the internet giants to help out with digital platforms at the small business level.
The benefits will flow on to ride-sharing firms as partners in logistics and last-mile deliveries, industrial REITs owning distribution warehouses, and payment firms.
The losers will be traditional retailers with extensive physical infrastructure, companies without the ability to scale digital offerings and landlords exposed to retail footprint rationalisation.
While the shift to online commerce has been a trend only accelerated by the virus, online services had been slower to catch on with consumers before the virus. That has now changed. Areas like telehealth, online gambling and gaming, wealth management and banking have all seen further moves towards a digital model.
The lessons learned from e-commerce suggests rewards of scale will likely drive further consolidation ahead, Morgan Stanley believes, especially in areas like hospitals, medical services and wealth management. Consumer technology, such as texting your heart rate monitor to your doctor, leaves a lot of room for cloud giants like Apple, Amazon and Google to improve the model.
Once again, real state owners and the construction sector will be the losers.
Experience & Travel
Until consumers once again feel comfortable in attending public events and places with a lot of people, pockets of the economy will need to adapt, Morgan Stanley suggests. Restaurants, for example, have been quick to adopt more to-go and delivery services and those with better digital offerings are winning.
Again, online gaming is a winner here.
Challenges will remain for those not adopting, including restaurants, which also impact on demand for agriculture and farm equipment, non-digital gaming, accommodation, cruising, theatres and concert halls, ticket sellers, conference organisers and, again, related landlords.
It’s difficult to predict just how travel will be affected, Morgan Stanley admits. Air travel is not dead, but may be impaired for the foreseeable future. Business travel is likely to be lower for longer, which flows on to hotels, restaurants, satellite-based wi-fi providers and construction of new capacity in those areas. Reduced public transport demand could impact on government budgets while increasing auto demand.
Recreational vehicle demand should see a boost. Nomads will no longer be predominantly grey.
It is no stretch from the above to suggest more industries will become increasingly digital – a trend already under way pre-virus. Software, internet and semi-conductor stocks benefit most from the increasing use of cloud-based data and analytics.
The shift into the cloud conversely impacts on providers of in-office hardware, while printers will disappear at an even faster rate than previously
“Broadly speaking,” says Morgan Stanley, “we expect that the covid-19 crisis will further catalyse an increased focus on ESG and sustainability”.
Green and Digital
PIMCO picks up this argument.
Before the virus hit, Australia was already staring down a recession, as evidenced by ongoing RBA rate cuts. Governments state and federal were already on an infrastructure push in order to boost employment, while at the same time improving transport systems. Nothing much has changed as a result of the genuine recession we’re now in, other than the focus is not purely on bricks & mortar, asphalt and rail.
China bounced itself out of the GFC by implementing unprecedented infrastructure spending, and spending continues today with the Belt & Road project, which of course not only leads to jobs but world dominance. But Beijing has said a recovery out of the virus recession will not be based on bricks & mortar, PIMCO notes.
The export powerhouse that is South Korea has designed a stimulus package focused on digitalisation and de-globalisation, which is also protective of public health and the environment.
Against this backdrop, EVs, batteries and solar energy are seen as prime candidates to benefit from government subsidies, at a time when technological advances have rendered green alternatives as more economically palatable. Governments are likely to fund such subsidies by taxing pollution-heavy processes and habits, at the same time moving further along the “green” path.
While it has not been lost on a plethora of industries as a result of the lockdowns that if you are not online you’re on death row, governments have also been jolted into reality. This will lead to targeted efforts to support an economy’s ability to compete in an increasingly digital world in building “new infrastructure” around 5G, wi-fi, cloud services and data centres, artificial intelligence, big data and smart cities.
PIMCO notes that moving to a 5G network from 4G increases demand for semi-conductors by 200-300%.
Another virus wake-up call for industry were the flaws made apparent in reliance on offshore supply chains and “just in time” inventories. Companies are now incentivised, both economically and politically, to bring production back home.
The reason supply chains were “offshored” in the first place was to exploit lower wages and lower employer obligations in other countries, thus “onshoring” will need to be met by reduced labour costs. Factory automation was already well underway pre-virus, and post-virus this trend will be another to accelerate.
After covid, says PIMCO, it’s chips, not bricks, that matter.
Not All Rosy
It’s all well and good to anticipate shifts in the economic landscape post-virus with regard developed economies (and here we can also include China, as it is by now foolish to still rope China in with emerging markets), but not all economies have such capacity.
Despite the efforts of central banks and governments, unemployment will rise, and some of that increase will create permanent joblessness, Brandywine Global warns. This leads Brandywine to “wonder” whether or not governments will come under pressure from citizens straining under lockdowns, who have lost jobs, and found it increasingly difficult to feed their families.
The virus does not pre-ordain the onset of social unrest, the analysts suggest, but it can create a fertile environment for unrest. Countries most at risk would be those with the weakest healthcare capacity and, in the end, how governments address the crisis and the subsistence needs of its citizens will determine how susceptible a country is to civil unrest and even changes in government.
One point here to note is that while the likes of Johns Hopkins maintain seemingly accurate global case-counts and mortality rates, it is clear not every single case or death in the world has been, or even could be, accurately counted. Even the UK initially only counted cases in hospital.
Apparently not a soul has coughed or died in North Korea, despite heavy trading activity via the Chinese border. Leaders such as those of Brazil and Russia have continually sought to play down the virus, which leads one to wonder whether all cases are being counted. Could India even count all its cases out of that many people? The Middle East is another area in which one might have cause to question accuracy, and while it makes sense more isolated areas of Africa would also be more isolated from a virus originating in China, do we really know?
The strength of institutions in developed countries will allow for a peaceful resolution of lockdown dissents, Brandywine suggests, but the same peaceful resolution of conflict in emerging markets may be different, where the strength and stability of institutions and government responses to the crisis may prevent a resolution of protests or civil disorder.
Health capacity aside, emerging market governments generally have not provided the same type of income support to their citizens as have developed countries. Further economic deterioration, warns Brandywine, could cause protests to boil over, despite government curfew efforts. The global economy is expected to decline, and sharply. Economic deterioration will worsen unemployment rates and negatively affect incomes, which disproportionately falls on the citizens that are least able to manage it: the poor and lowly paid.
The virus will only serve to worsen existing inequality in the world, Brandywine believes, but especially in emerging markets. Widening inequality raises the risks of civil unrest, populist uprisings and political instability, particularly in those countries facing scarce food supplies.
Regime change is certainly a possible outcome from this environment.
To V or not to V
When considering the shape of a recovery in terms of the alphabet and other characters, one must acknowledge there are two recoveries under analysis here – the stock market and the economy. The former is supposedly a predictor of the latter, such that a V-bounce in the stock market implies the assumption of a V-bounce in the economy.
But only the assumption. The stock market may predict a sharp V, but the economy ultimately tracks out a more gradual U, which could then cause the stock market to W before getting back on track.
So far stock markets have tracked a V, although not clearly symmetrical, leading commentators to suggest it’s more of a “tick” or “check” as Americans would say. But it’s still a form of V, noting that the global bellwether S&P500 has recovered to be only -6% below its all-time high in February (as at July 7), or to put it another way, requires only a 7.5% rally to return to that high having been down -40% at its nadir.
A V-shaped recovery is taking on increasing credence by economists, Citi Research notes, and has already been embraced by financial markets. Admittedly, recent economic data have suggested a V-shape, although this is the “arithmetic consequence” of the policy of lockdown and open up, Citi warns. Data levels still remain dramatically lower than pre-covid days.
Much has been made of a surprising bounce in US job numbers in the last two months, smashing all monthly records. Hurray, said Wall Street. But the reality is the re-openings have only resulted in one third of lost US jobs being reinstated, and re-closures have already begun in virus-stricken states.
In April, the US manufacturing PMI fell to 41.5 and in May ticked back up 43.1. Despite the tick up, May’s result still implies ongoing significant contraction, just at a slightly slower pace. In June the PMI bounced up to 52.6 – back into expansion. Hurray, said Wall Street, but the result only implies that having fallen that far, activity has only just rebounded slightly from that low level.
Many factors point to a quarter to quarter V that does not have staying power, Citi suggests. Covid is not vanquished, trade remains in contraction, business investment is collapsing, financial conditions may be supported by the Fed but are no means “loose”, and equity markets are disconnected from the real economy, potentially contributing to uncertainty that will enhance financial turbulence.
These are all “bumps” along the way that may cause the recovery to veer off track or slow down, such that the trajectory looks more U than V, Citi warns. Trade and business is a bellwether for employment and consumption. Consumption is a bellwether for “normalcy”.
Clearly the virus has not been vanquished. We all watch the news.
It’s no surprise global trade has contracted as a result, but trade tensions are being exacerbated by national security concerns ranging from technology to PPE and food. Trump is even talking about more tariffs at this time. China is either unable or unwilling to fulfil its phase one trade agreement with the US, and has turned on Australia. The US has bought up almost the entire global supply of remdesivir.
Firms are not expecting a V-shaped recovery in trade. Ongoing weakness in trade will show up in weaker unemployment, Citi notes.
As the US entered 2020, business investment was expected to be flat, and we might suggest weaker in Australia, with significant declines in machinery and equipment investment in favour of technology products. In response to be virus, the pullback has been “fierce”, Citi notes, with projected investment in advanced economies contracting some -20% in the June quarter and continued contraction expected through the second half. Weak investment also impacts on employment, and on productivity growth.
Despite stock market exuberance, uncertainty measures are very high, Citi reports, including with regard economic policy, financial conditions and the real economy – about as high as the GFC peak. Uncertainty begets uncertainty, leading tighter financial conditions (capacity to borrow) and lower investment, as well as lower business confidence, manufacturing PMIs, trade and real investment.
It’s a negative feedback loop. Were the stock market to correct as a result, uncertainty would increase and a negative spiral would result, causing the recovery to veer off track.
Despite many countries reopening their economies sooner than had been first anticipated, none of Citi’s economists across eleven countries has correspondingly brought forward expectations for when economies will return to pre-virus levels. Indeed many have shifted back to later quarters in 2021, or 2022, or even 2023.
Much depends on the US and China, which together account for over half of global GDP growth. China’s swift rebound from its March quarter shock had economists assuming a return to pre-virus levels by the December quarter, while for the US expectations were for the June quarter 2021. China has managed, apparently, to quash a second wave scare, but in the US…
Were either of these economies to veer off the V-bounce track, warns Citi, global growth prospects would be significantly altered.
Then there’s the matter of a vaccine. Financial markets are acting as if a vaccine will be swiftly found. The private sector is not, as evidenced by weak business investment and consumption. Governments have taken fiscal action but this is not “stimulative”, notes Citi, merely supportive. A V-bounce in the economy assumes robust private sector activity. If there are bumps in the road, additional fiscal measures may be needed.
Note that the US fiscal support package expires at the end of this month, and in September for Australia. Congress is already preparing a further US$1trn package, but the White House has insisted it is capped at that level, suggesting little appetite for keeping the pumps open for longer.
The Australian government was grappling with just how to proceed after the September expiry before the Melbourne second wave flared up.
Citi had upgraded to a smaller contraction than previously forecast in Australia’s GDP, thanks to the swift moves to contain the virus and pump in the monetary and fiscal support, but the analysts published before the Melbourne flare-up became serious. Either way, Citi had expected an “air pocket” in the recovery in the December quarter, after the September fiscal support expiry.
The “bumpy road” concept is not Citi’s alone.
Critical to Wall Street’s V-rebound has been “whatever it takes” monetary support from the Fed, alongside fiscal measures. Not only does guaranteed liquidity underpin equity market sentiment, it reinforces the TINA trade that was already apparent pre-virus, given interest rates were already historically low. With little return available in fixed income, there is no alternative but to invest in equities.
This reality has only been reinforced by covid. As Amundi Asset Management puts it:
“In the “day after” scenario, the expectation of low bond yields and massive central bank buying also works in favour of a relative preference for equities vs. bonds as dividend yields outstrip bond yields. It’s true that earnings growth expectations are still too high, but if we think the worst is over, that there’s no juice in bonds and liquidity abounds, we have no choice other than to look at equities to try to grasp opportunities in areas that haven’t fully recovered their pre-crisis valuations.”
However, warns Amundi, the road along the recovery path could be bumpy.
In terms of equity yields versus bond yields, RBC Capital Markets points out that the virus has produced a spike in US companies cutting their dividends. Even the big US banks have now had their dividends capped by the Fed, and in some cases cuts must follow. Australia has seen a similar pattern.
In both markets, earnings expectations for FY20/2020 have begun to be upgraded by analysts from the low levels assumed when lockdowns were enforced. Not back to previous levels by any means, but not falling further, yet.
Let’s face it. A vast number of companies simply withdrew earnings guidance for the June quarter and beyond, and who could blame them? The virus was, and still is, a great unknown. Analysts themselves have admitted to be really only guessing, and again, who can blame them for such a caveat?
Much talk has been of stock markets now being overvalued on a price/earnings basis (PE), specifically against historical measures. Note that this opinion was held even before the virus. But if you’ve really little idea what E will be, then PE is rather meaningless.
At the very least, suggests RBC, if there is to be a V-shaped economic recovery, it appears to be priced in already.
US June quarter earnings season is about to begin, and presumably much will be revealed, at least about the June quarter. Any changes to dividend policy will be disclosed. As to whether specific guidance will be provided regarding quarters beyond is unclear at this stage, given the virus impact has far from subsided in the US.
Australia has to wait until August for updated earnings numbers, notwithstanding the usual “confession season” or profit warnings that typically precede. Presumably a lot more will be revealed than is currently known, but as to reinstating guidance, or dividends that have been deferred, companies may have been more confident a month ago, but the Melbourne situation casts a renewed uncertainty pall.
Amundi notes that so far, only those US companies most directly affected by the lockdown measures have gone bankrupt. But the race against time between solvency and liquidity continues. If expectations of an end to the pandemic are too optimistic, any slip-up could heat markets up again. The risk of policy mistakes can’t be underestimated, says Amundi.
Moreover, geopolitics will increasingly take centre stage as the US election moves closer.
Which leads us back to the wider, post-covid world view.
Post-covid, the US and China will increasingly compete in multiple spheres, suggest Morgan Stanley, from technology to security, health policy, financial markets and corporate governance. In between, the Rest of the World will need to attempt a balancing act, vying for economic influence and economic opportunity. Morgan Stanley singles out Europe, Brazil and India in particular, but we can also include Australia.
As the corporate sector adjusts, one key outcome is the rising importance of what Morgan Stanley calls “Slowbalisation” – a slowdown or even partial reversal of globalisation in revenue mix, supply chains and operational risk/reward as some industries shift towards localisation.
US-China tensions will of course endure. The trade war is by no means over, and now Washington’s decertification of Hong Kong’s special status further draws barriers around certain types of commerce, Morgan Stanley suggests. Europe (and Australia) is stuck between a “two-track” relationship, with both markets as key customers and competitors.
Improved Sino-Russian relations, China’s Belt & Road, the launch of the Asian Infrastructure Development Bank, and the New Development (formerly BRICs) Bank are a clear sign of a shift to a multi-polar world, setting up competition for influence between China and the US.
The pandemic, notes Morgan Stanley, has triggered global debates about economic self-sufficiency versus efficiency, beyond just that of healthcare. National policy responses are still emerging, but at the corporate level companies are already looking to at least diversify their supply chains, more so than outright “onshoring”.
The outlook for Life After Covid remains to a large extent unclear.
And much of the above hinges entirely on if, and thus when, a vaccine is found.
Life After Covid Part I (https://www.fnarena.com/index.php/2020/06/02/life-after-covid-part-i/)
Life After Covid Part II (https://www.fnarena.com/index.php/2020/06/10/life-after-covid-part-ii/)
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