A dawn of guarded optimism 

Financial markets act as a clearing house for investor sentiment, reflecting a mix of short and longer timeframes. This week investor sentiment has been buoyed by health data showing a flattening of the Covid-19 curve. Now while this is good news, there is a danger that equity and credit markets are running way ahead of the as-yet-to-be determined economic fallout. 

Early robust gains for Wall Street, after solid gains in Europe, were erased late in New York. After a 20 per cent rally for the S&P 500 in the past two weeks, there are limits. This also reflects how within the context of a global pandemic, calculating whether share and credit valuations adequately reflect the full amount of looming economic pain is pretty much an exercise in guesswork. In the coming weeks, corporate earnings and guidance may well determine whether equities have set a bottom or if the current bounce provides an appealing selling opportunity. 

In the near term, Ian Lyngen at BMO Capital Markets believes market sentiment for equities and credit is set to enjoy more significant periods of optimism, “as opposed to bear market rallies”. Equity and credit sentiment also has support from a limited rise in government bonds yields (from very low levels) due to quantitative easing from central banks and the targeting of long-dated interest rates. 

As for flows, beaten-up areas of the equity market are leading the way. Long-term investors, with a willingness to stomach future dips, are also returning. Among the big markets in the rebound stakes, Japan and Wall Street lead, followed by Europe, with the UK’s FTSE 100 a notable laggard (hit hard by the rout in commodities and dividend cuts).

Market sentiment has a floor thanks to waves of support measures, although these contain a sting in the tail via a dramatic escalation in debt (see Quick Hits) that will weigh on long-term economic growth. 

However, chatter of another $1tn in additional stimulus from the US Congress doesn’t hurt risk sentiment while overnight Japan announced a ¥39tn ($357bn) package of public support.

Plenty of investors are looking back at previous market crashes in order to assess the likely trajectory of equities from here.

BCA Research has studied bear market recoveries since the second world war. From the median and mean profile of these periods, its analysts conclude: “The SPX will not make any fresh all-time highs until early 2022,” adding that: 

“Our equity market road map for the next few months is a drawn out consolidation phase leaving investors ample time to shift portfolios and put cash to work.”

Russ Mould at AJ Bell says that, beyond the slowdown in Covid-19 cases, evidence of a market bottom depends in part on recoveries in copper, transport stocks and junk-rated debt. Russ makes this important point:

“This is my fifth major bear market, after 1990-92, 1998, 2000-03 and 2007-09. With the benefit of hindsight, the biggest buy signal of all was the absence of people asking whether it was time to buy, as this signified total capitulation. Investors can use their own judgment as to whether we are at the point where the towels are being thrown in or not.”

Quick Hits — What’s on the markets radar

The global debt clock is in overdrive. The Institute of International Finance estimates the sale of gross government debt rose to “a record high of over $2.1tn last month, more than double the 2017-19 average of $0.9tn”. 

It adds:

“As social distancing becomes the norm across most mature economies, global recession looms: a recession which would begin with $87tn more in global debt than at the onset of the 2008 financial crisis.”

That kind of debt overhang does not bode well, as Marc Ostwald at ADM Investor Services writes:

“Interest rates have never been lower in most countries, but it is not debt servicing costs which are a problem, indeed they have not been an issue for much of the past decade, but the debt still needs to be serviced, which drains money from investment of all varieties, and is therefore a long-term headwind, whereby the debt principle (or ‘burden’) is the issue.” 

After stunning volatility in March triggered several instances of trading curbs for cash equity trading on Wall Street, here comes the stewards inquiry, writes the FT’s Phil Stafford. Ever since the flash crash of 2010, plenty of people in the industry highlighted how cash equities do not trade in their own world. Equity futures and exchange traded funds generate significant flows and in turn influence how the broader stock market functions. Creating a system-wide circuit breaker that covers all these markets is not a bad idea. Just a pity it takes a month like March to make the industry think a little more seriously about an approach that others have long advocated. Sadly, given the internecine nature of the US equity industry, I doubt this really goes anywhere. 

The pound remains a highly volatile currency and that was the case before Boris Johnson was hospitalised with the coronavirus. The languishing performance of sterling is highlighted by demand for options that protect investors from renewed weakness in the currency. Brown Brothers Harriman shows how currency risk reversals for the pound over the next three months are deeply negative, while that of the euro has recovered of late. 

Not only does plenty ride on the UK government and its lockdown-exit strategy, but also on the eventual conclusion of Brexit. 

Looking well beyond the investment horizon, Research Affiliates’ long-term forecasts calculate that “among international equities, UK equities are starting to look particularly attractive with expected returns at 8.8 per cent (versus 8.5 per cent for emerging market equities, and Europe at 6.5 per cent)”.

“UK equities were trading at much more attractive valuation multiples even before the coronavirus crisis due to the Brexit risks. Having fallen from the low-valuation multiples even further, UK equities are a bargain today.”

One brighter note for the UK economy, it now tops the rankings in terms of working from home, at least according to this UniCredit research.

The bank observes: 

“The UK economy, which is skewed towards high-value-added services, stands out for having the most flexible job composition — almost 40 per cent of work can be done from home. At the other end of the spectrum is Spain, where at most 35 per cent of work can be performed remotely.”

UniCredit adds:

“In between the Spanish and the UK economies are France, Germany and Italy — albeit the differences are rather small as we are considering high-income economies with fairly similar occupational structures. As a term of comparison, also in the US around 35 per cent of work is suitable for flexible arrangements.”