Recovery prospects outweigh the negatives

Prospects of economic recovery have certainly registered across global equity markets during May. European equities are pushing higher and the S&P 500 is established above 3,000 points. Whether the trend is sustainable is very much a topic of debate at the moment.

Analysts at Goldman Sachs acknowledge that “a shift towards positive cyclical growth momentum is usually very supportive for risky assets” but they also flag a list of concerns. There is the risk of a second wave of Covid-19, while the bigger issues potentially looming down the road are “the potential second-round effects from the lockdown, such as a pick-up in bankruptcies, defaults and a continued weak labour market”.

Other risks involve a dramatic escalation in the dispute between the US and China, with a weaker renminbi and deflationary wave likely to hit emerging market economies harder. So far, strains in EM economies have been absorbed by hefty easing and stimulus, with the Federal Reserve’s infusion of dollars also playing an important role.

Pushing back against the current optimistic equity sentiment (or perhaps relief that lockdowns are easing) requires a profound shock.

Alan Ruskin at Deutsche Bank argues that for the economy, this would entail signs that the “policy band-aid is not working” with unemployment rising after a brief drop in the next few months.

A persistently weak consumer is not what recent buyers of cyclical equity sectors such as banks, industrials and materials want to see. In this respect, lacklustre consumer demand in China after lockdowns have eased, is one indicator for investors to keep watching. Downward pressure on incomes and higher unemployment are the main consequences of economic shutdowns and may prove tough to remedy.

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Oxford Economics says after an initial jump, a full recovery in US employment may take time:

“While many workers will probably be recalled once lockdowns are relaxed, depressed income and spending, lingering virus fear, and mandated capacity restrictions will probably mean half of all ‘temporary’ lay-offs could become permanent.”

That will rightfully worry the Fed, but the big challenge for central banks remains the risk of financial contagion and that’s why plenty are watching the commercial real estate sector and whether this lengthens the eventual journey out of the Covid-19 slump.

For now the likelihood of these scenarios loiter some way off. Christopher Smart at Barings Investment Institute cautions that investors in the autumn may well face, “a much messier picture as further waves of damage crystallise, the political consensus turns into gridlock and the path out of recession starts to lengthen”.

So where does this leave equity sectors as June beckons?

Over at Société Générale they think an eventual recovery in the short to medium term will facilitate a sustained rally in cyclicals, “reflecting both the prospect of economic growth and their historically depressed valuations”.

But it adds:

“It remains to be seen whether the post-holiday rally in cyclicals marks that beginning.”

Goldman think, “with continued uncertainty and after an already strong recovery, we only position selectively in reflationary, procyclical trade ideas across assets”.

Plenty rests on the direction of bond yields, and expectations of a sustained pick-up in the economy is usually signalled by higher long-dated interest rates. For now, bond markets are not pushing hard in that direction, capped by central bank buying and — reflecting longer-term uncertainties — still hefty demand from investors for such paper.

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Dhaval Joshi at BCA Research highlights the importance of low government bond yields in determining the performance of equity sectors. Low yields resonate for companies that have strong growth prospects as the value of their future cash flows rise. In contrast, low yields do not help offset a Covid-19 slump in sales for sectors that rely on a fully functioning economy.

Dhaval argues:

“For many cyclicals — such as airlines, hotels, and restaurants — the hit to sales, profits, and employment will be long-lasting, as consumer and business behaviour adapts to the post Covid-19 world.”

This only heightens the importance of central banks and in this regard, the mood music remains one of keeping bond yields stuck near zero for some time to come. That of course nurtures risk appetite and fans the upbeat mood for cyclicals and an eventual recovery in the economy.

But this can cut both ways and a wobbly recovery in the economy later this year means the chatter around negative interest rates from the Fed will become a lot louder. As it stands, the UK may well jump first given the dovish soundings coming from policy officials at the Bank of England.

Not a good story for banks, a sector that has led the way lately. Over at Citi, their latest global macro strategy outlook notes the Fed will not want a stronger US dollar during the next bout of risk aversion and they add:

“More liquidity will be forthcoming, as will the hint of negative rates.”

It may well be the case that market sentiment reflects policy stimulus and has yet to fully appreciate the risk of a more limited recovery in broader economic growth prospects beyond a bounce in the summer.

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Dhaval argues that “ultra-low bond yields are here to stay” and beyond tactical counter-trend plays:

“Long-term investors should structurally own the good stock market — growth defensives — and structurally avoid the bad stock market — value cyclicals.”

The debate rumbles along and certainly provides investors with plenty to think about as the economy reopens.

Quick Hits — What’s on the markets radar?

European markets are on a EU recovery fund roll and the euro has pushed through $1.10, it’s best level versus the dollar since April. Deutsche Bank thinks this may just be the start as recent euro weakness “has been driven by Europe’s slow and uncoordinated response to the crisis”.

Much depends on how the proposed European budget and recovery fund fares over the coming weeks.

The latest weekly US jobless data delivered some good news. Continuing claims figures dropped to 21.05m from a previous 24.91m and below a forecast 25.68m.

HFE noted:

“The decline in continuing claims is encouraging, signalling at least some people are finding jobs or are being rehired as the economy is reopening. Even so, labour market conditions remain weak and lay-offs are ongoing.”

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