Sentiment in markets has been positively impacted by signs of increased activity where lock-downs are starting to be lifted. This could continue as more restrictions are eased and consumers emerge from the darkness of isolation. But there are risks. Sentiment can change quickly if news turns negative. Policy will remain supportive and it needs to. Politics, however, might prove to become a major threat to investor sentiment.
In the Derbyshire village where I lived during my youth, 29 May is known as Garland Day. It is when the villagers host a celebration marked by a procession through the streets of a – king - on horseback covered with a garland of flowers. Although I am not sure that this was part of the original ceremony this cavalcade also stops outside each of the six pubs in the town where children perform a traditional dance and adults partake of a glass of beer. The procession ends up at the village green (while the adults end up quite merry), the garland of flowers is hoisted to the top of the church tower and the children dance around the May pole. Like most things, the event embodies a number of ancient and more modern traditions, including May pole dancing (originally a pagan celebration of Spring) and the pub crawl (a 20th century tradition sadly lost to us in recent months). The event is cancelled this year, which is a shame given how amazing the weather has been and that the symbolism of re-birth might well be important as the world starts to emerge from the worst days of the coronavirus pandemic.
Darling markets of May
Markets are certainly seeing reasons to be optimistic. The month has seen strong returns from risky assets with sentiment driven by signs of improving activity as lock-downs are lifted. This should not be a surprise but it is encouraging to see economic activity starting to get off its knees. We are in the early stages but so far there is only limited evidence that removing social distancing restrictions is leading to any increase in infection rates (watch some of the US states though were the return to normality might have been somewhat rushed). The market rally has been led by the higher beta equity markets, cyclicals over defensives and high yield over investment grade in the fixed income world.
To repeat some of the themes of recent weeks – the worst is now behind us, the momentum of activity is turning positive and will continue to be so in coming weeks. There continues to be a focus on the development of vaccines and cures, while macro-economic policy continues to be massively support. Moreover, investors appear to have discounted the year in terms of GDP growth (large negatives everywhere) and the hit to corporate earnings (looking to the recovery in 2021).
In our MVST – Macro, Valuations, Sentiment and Technicals – approach to assessing drivers of investment returns, we would certainly ascribe an important role to Sentiment. However, there is a risk of relying too much on a sentiment driven rally given that markets can be quite fickle. The escalation of tensions between the United States and China over Hong Kong and other issues could reverse some of the good feeling generated by the removal of lockdowns. So could any evidence of increases in infection rates or disappointments from clinical trialling of drugs.
Sentiment and Valuation are linked. Sentiment can be both a momentum and a contrary indicator. Over the last month it has certainly reflected positive momentum allowing a bullish view on cheap assets like credit and cyclical sectors in the equity market. A clear example is the airline sector which has been one of the best performing in the S&P500 over the last week or so. It is on a price-earnings multiple of 6.5x according to Bloomberg – so it is cheap. There is some support for the industry from governments yet the fundamentals remain challenged and little evidence to suggest that airline bookings are starting to recover quickly. Without the Macro, Sentiment and attractive Valuations will only take market so far. Some investors might see Sentiment as a contrary indicator – one could certainly put forward the argument that the recent rally in markets is based on little more than the uplift to activity that was guaranteed once social distancing started to be relaxed. If activity plateaus because consumers and businesses will need to remain cautious in the way they operate, the sentiment rally will peter out.
The macro outlook is complex
Over the medium term the Macro factor is the key driver. The performance of many asset prices is driven by where we are in the economic cycle. Obviously, this is not a normal cycle. We have a very abrupt recession and face an uncertain recovery. There are several layers to the Macro situation. One is the first order recovery in activity levels. A second is the level of policy support for markets. Beyond that it becomes more nuanced. How sustainable is the policy support? What are the longer-term implications of rising government debt and central bank balance sheets? Will there be a permanent loss of capacity and employment? How can emerging market economies recover with limited resources? Will there be changes to global supply networks and trade flows? For now, the Macro factor deserves to be positive but longer-lasting reductions in credit risk premiums in fixed income and genuine earnings based gains in equities markets are some way off.
Still like credit
Yet we have to make investment decisions. On balance some risk needs to be taken to get returns that are positive and above the rate of inflation. Corporate credit remains a favoured asset class. Credit generally is a beneficiary of quantitative easing through the portfolio balance effect. It is also discretely supported by the emergency credit backstops that have been put in place. The fact that there has been $1trn of investment grade corporate bonds issued in the US market already this year tells me that the positive view of the asset class is widely shared. Along with government bonds, investment grade credit is the asset class where the Technical situation is most helpful. In other words, there is strong demand and central banks have countered the deterioration in fundamentals with increased technical support for the functioning of credit markets. This is true in Europe as well as in the US. The growing support within the EU for the establishment of a large Recovery Fund is a positive for European credit as it reduces debt strains in certain sovereign and banking markets.
Perhaps markets are metaphorically drunkenly following a flower-covered man on horseback. Dancing around the May pole after a drinking a few beers has been known to have some negative effects. We have to keep reminding ourselves that we are still in the middle of a global pandemic and the worst (but perhaps quickest) recession ever. The sentiment led rally is looking vulnerable and we should expect some set-backs. Yet I keep coming back to the policy support and the massive boost to global liquidity that is being provided by central banks. The Congressional Budget Office in the United States currently estimates that the Federal deficit will be $3.7trn this year, a lot of the borrowing to finance that will be bank reserves created by the Fed that flow into deposits and broader money growth. This will ultimately be the key driver of both the recovery and market performance.
Restoration and retribution
There is something else about May 29. It also used to be known as Restoration Day which celebrated the restoration of the British monarchy, the ascent of Charles II and the overthrow of Oliver Cromwell’s Commonwealth. It marked a significant break in England’s political history. An event triggered by the loss of consent of the citizenship in the ruling elite. This should resonate today. I am not suggesting that Britain’s current Cromwellian Prime Minister is about to be toppled, but the coronavirus crisis does threaten to have longer-term political implications. Some governments have handled things better than others either in terms of levels of preparedness or in the management of the crisis. Others have been ill-equipped in terms of public resources and decision making. Others still appear to have bounced from denial to blaming others. New Zealand and Germany are two of the winners. Political leadership could well be questioned critically in places like Brazil, Russia, the UK and the US – all countries with high levels of infection and death rates. The Global Financial Crisis had profound political consequences and led to a backlash against political and financial elites through the rise in populism. The coronavirus crisis could have similar effects but it may be the populists that suffer this time. There is a risk to markets that in order to deflect from domestic criticism, some will be tempted to garner support through refocussing on international conflict.
There are big political challenges ahead. Post-mortems on the management of the crisis will be uncomfortable for some political leaders and, in the case of the US election, could ramp up policy uncertainty. More general policy management going forward will be challenging. Populists may try to blame globalisation for the pandemic but voters will want active government to buttress health care, employment and incomes. My colleague, Gilles Moec, AXA’s Group Chief Economist, has begun talking about the “socialisation of our economies” arguing that higher levels of government intervention are here to stay. This will impact on policy but also on the environment for companies. Being supported by government through the crisis might require companies to change the way they operate in terms of social and environmental policies.
Nothing is certain in politics. Winston Churchill lost the election after leading Britain through the second world war. Angela Merkel and Emmanuel Macron may have just put Europe on a better political trajectory with their proposals for the Recovery Fund, while the leaders of the US and UK are unlikely to come out of the crisis well. We know that the current level of fiscal support is not sustainable but Europe has the capacity – it has only been held back by the reluctance to use the savings in the north to the mutual benefit of all in the Union. It has that upside potential right now. The US and UK are arguably “all-in” and face high debt burdens and difficult choices on policy in the coming years. I have been a dollar bull for ages but I am starting to see the case for a long-term reversal of the Euro’s exchange rate against the dollar if the European elite get it right this time.