Closing the book on a tumultuous quarter

Global equities ended the quarter mixed, with Wall Street unable to extend its recent string of advances, and another policy initiative from the world’s central bank, the US Federal Reserve.

The calendar matters for many investors and given the sharp divergence between risk assets versus government bonds so far this year, the quarterly and monthly rebalancing of portfolios has spurred buying in equities and credit. So we will get a clearer sense of market sentiment once April gets rolling. 

The recovery trade for risk assets over the past week has lessened the blow to stocks, but as the first quarter ends the MSCI All-World index (developed and emerging market equities) has still lost a fifth of its value over the past three months, it largest slump since 2008. Also, measures of smaller companies such as the S&P 600, have lagged the recovery seen in blue-chips. That suggests tougher times ahead for what is seen as a barometer of the broader economy.

Column chart of % change, by quarter  showing MSCI All World index has worst quarter since 2008

While some laud the dramatic bounce seen in the latest manufacturing activity data from China (see Quick Hits for why a dollop of caution is required), a hard road awaits for Europe and North America and that is not good news for the global economy and will test sentiment for equities and credit.

Analysts at Unigestion note that while fiscal and monetary policy support is a trigger for buying equities, the other two elements required to seal that deal — such as improving health conditions and pricing of a significant recession in markets — “are still missing”. This leads them to stick with a defensive approach, or what they advocate: 

“Look for only the most appealing of opportunities that would directly benefit from fiscal and monetary support (eg, US investment-grade credit on the back of the Fed’s corporate bond-purchasing programme).”

They are not alone in that camp. Lazard Asset Management notes its preference for companies with strong balance sheets and sources of funding, but it’s also concerned that the pandemic “will persist longer than many investors suspect and that the economic damage will be deeper and potentially longer-lasting”.

Much of the recovery rally in equities has been led by strong companies, hardly a surprising development and shown here via Citi Private Bank:

Now many of you have probably heard a number of companies announcing cuts in their dividends. This helps explain why the dividend factor has been lagging much of the market. Economic crunches spur a dash for cash, something that will typify consumer behaviour and clip the recovery.

For the UK’s FTSE 100, 13 blue-chip companies are withholding £2.7bn of payments for either 2019 or 2020, according to Russ Mould at AJ Bell.

Before the pandemic arrived, the FTSE 100 was expected to generate £89bn in dividends in 2019 and £91bn in 2020 so, as Russ puts, it: “The damage is still relatively light.”

Plenty now rests on big payers, led by Shell, BP, BAT, HSBC, Rio Tinto, GlaxoSmithKline and AstraZeneca holding the line for the ranks of income seekers. In that respect, some such as Shell, tapping a massive line of credit, appear intent on maintaining their dividends. But the pressure on UK lenders to suspend their payouts is very intense in the wake of a warning from the Bank of England as the FT reports on Tuesday.

Over at Citi, its analysts note that dividends per share don’t usually fall to the extent seen for earnings per share, but in the case of Europe there is scope for quite a shock for income seekers. The bank expects European EPS will fall 50 per cent and observe:

“High payout ratios, combined with company prioritisation of balance sheets and employees, mean that EPS could also halve. Big exposure to energy and financials suggest the UK dividend base looks especially vulnerable. Income investors should currently favour utilities, telecoms and health care.”

Looking at the S&P 500 and dividend futures from BNY Mellon, the scale of the “income” evaporation across the market is chilling. This is hardly good news for retail investor sentiment in a world of rock-bottom yields.

As John Velis at BNY Mellon explains:

“By 2021, the market expects dividends per share for the S&P 500 to be down to under $38 per share (a staggering 41 per cent drop from recent highs of approximately $63 per share) and then to start slowly rising again. Going out 10 years to 2030, the expectation is that dividends will just about recover to pre-Covid-19 levels.”

This reflects how many companies are under pressure to stockpile cash, while the recent US support measures mean any company taking government loans is unable to pay a dividend or buy back its shares for up to 12 months once the debt is paid.

Looking back in time presents a mixed outlook. 

“The recession after the first world war (and coinciding with the 1918 Spanish Flu epidemic) brought dividends down 33 per cent between the end of 1917 and 1922, taking nearly seven years to recover to pre-1918 levels, while the Global Financial Crisis saw a 24 per cent decline. The bounce back was quicker, and dividend levels pre-GFC were reattained just three years later.”

Restoring dividends depends greatly on the economy attaining a V-shaped trajectory and generating a sharp rise in earnings.

As a deeply traumatic quarter ends, the resilience of equities reflects a view that normal life will soon prevail, followed by the restoration of earnings. 

At the start of the year, analyst expectations for S&P 500 earnings growth during 2020 stood at 9.2 per cent. That has since been cut to one of minus 1.2 per cent, as plotted here by FactSet.

But these earnings estimates have the capacity to change a great deal from here, particularly when US companies start reporting their first-quarter earnings and provide guidance in the coming weeks.

DataTrek notes that the resilience of the S&P 500 around the 2,500 level reflects the view of there being little long-term damage to the earnings prowess of US blue-chips once the pandemic abates. Its strategists note:

“We’re trading at 20x the trailing 10-year average S&P earnings of $122/share, not the 10x we saw in 2009.”

Equity sentiment may well focus on an earnings growth restoration in 2021 and thus place a floor under large-caps. The question of whether equity markets have indeed hit their lows will probably be settled over the coming quarter. 

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Quick Hits — What’s on the markets radar

The US repurchase, or repo market, has been supersized. The Fed will now take collateral in the form of US Treasuries from foreign and international monetary authorities (other central banks) and lend them dollars for a short period. Flooding the global financial system with dollars is designed to allay any leap in demand over the end of the month and quarter. The new repo facility expands the current swap lines, as not all central banks have access via that route with the Fed. 

George Goncalves, a longtime US bond market strategist, also highlights how the new repo facility can reduce the need among central banks “to sell their US Treasuries to raise cash (which would put further stress on the bond market). Also, by extension, the Fed can dial back on QE-infinity, for now.”

Whether this marks the top for the US dollar is the topic of some debate. The Fed’s fire hose will help, but further bouts of market turmoil will probably push the dollar higher. 

The latest purchasing managers’ index data from China duly sparked chatter of a V-shaped recovery in some quarters, but this is a diffusion index and big swings in activity create a misleading picture. It will take three months of improving data to determine whether this is a sustainable trend. Even China’s National Bureau of Statistics noted: “It does not mean that China’s economic operation has returned to normal.” 

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