No V in earnings
Social distancing seems to be affecting the ability of Premier League defenders to defend. Governments are closing bars and restaurants. Infection rates remain high. The US election circus is becoming even more unpredictable. These remain very, very unusual times. I remain of the view that we are not ready for higher bond yields and a strong cyclical recovery. The equally weighted S&P500 index is down 2% in price terms year-to-date, compared to the market cap weighted index being up 5.8%. The difference is a handful of long-duration growth stocks that have outperformed everything. What that also tells us is that we are not yet seeing a true cyclical earnings driven market. An uncertain short-term outlook suggests it will be well into 2021 before we do.
There has been a clear recovery in global economic activity over the last six months and if you choose the right set of data it can be made to look like a V-shape. The recovery, helped in no short measure by monetary and fiscal policy stimulus, is a major reason for the strong performance of equity and credit markets over the period. However, it is equally clear that it is going to take a long-time to get back to where we were before the crisis in terms of levels of GDP and employment. It will take even longer to get back to where we should have been if growth had not been so aggressively curtailed at the end of Q1. This will mean higher unemployment than would otherwise have been the case and, when government income support schemes eventually run out, a lower level of household income and spending.
More restrictions amid still high infection rates
In the short term the risks are clear, and it is easy to take a more bearish outlook on growth in the next couple of quarters given the escalation of new lock-down measures across many countries. According to the data from the Johns Hopkins University, confirmed new daily cases of coronavirus are currently running at over 320,000 globally and there has been a steady rise in the moving average since the early summer. The run rate in the US is lower than at its peak in July but it not materially falling below around 50,000 per day. Russia is seeing a re-acceleration and other emerging economies are having to deal with rising infection rates (see the data for Argentina, for example). This obviously reflects more widespread testing and may even be suggesting that herd immunity might soon be reached in some sectors of society (looks like amongst the student population in the UK, for example). In turn, this may be good news as the infection growth rate should slow at a time there could be good news on a vaccine. However, governments are cautious, mindful of protecting health systems when hospitalisation rates are climbing again (albeit from low levels). Economic activity is being restricted again as a result. The net effect is a more clouded outlook in the short-term which in turn will lead investors to ask whether more stimulus can come from central banks and governments.
Long term losses
Growth may resume at a healthier pace in 2021 on the assumption that we will be closer to the end of the pandemic and that there will be more economic stimulus (post-election in the US, the deployment of fiscal help in Europe). However, sadly, there will be businesses and jobs that don’t survive, especially in the travel, leisure and hospitality sectors. There is also a read across to ongoing problems for commercial real estate and bank balance sheets. The legacy of the pandemic will be higher output gaps and higher levels of debt. It is hard to see interest rates rising for many years as a result. I was struck by the news that a major cinema operator was closing all its theatres this week. Who knows, that may turn out to be a permanent decision. But people will want to go to see films again, won’t they? We will want to eat out in restaurants and go on holiday. If lots of providers of those services are gone, how do we once again redress the supply-demand imbalance? There will be investment opportunities but the cost of capital for resurrecting those businesses might be prohibitive. Hence the ongoing need for an increased level of intervention in the private sector from the state. Maybe some phoenix funds emerge to take advantage of the potential resurgence in those activities once the all-clear on the virus is sounded.
My basic Looking through the near term, the important thing for markets remains the rate outlook and the earnings outlook. If other central banks follow the US Federal Reserve (Fed) in terms of nuancing their inflation targeting model towards an “average inflation” target, then the logic is that rates have to remain on hold for a very long-time. Despite my love of a good chart I rarely include them in this weekly note. However, this week is an exception. Chart 1 plots consumer price index levels for the US, UK and Euro area over the last five years (re-based to 100) against what they should look like if we did have a 2% inflation rate. The clear observation is that consumer price levels have been below target over the entire period (and going back longer by the way). The only slight exception is that the UK’s price level tracked a 2% target for a while but recently inflation has been lower and the “inflation gap” has widened again. A confrontational interpretation of Jerome Powell’s new inflation averaging policy would be that for all the time inflation has been below 2%, it needs to be above it for the average to be sufficient to force higher interest rates. Rates on hold for at least five years then?
No rise in expectations
Of course, inflation may rise. That is not being priced in though. The implied 10-year/10-year forward inflation break-even rate from the structure of US Treasury and TIPS markets is just 1.82%. The 5-year/5-year forward inflation swap rate is 2.15%, in the bottom half of its historical range. It’s a similar picture for the Euro Area and the UK. Now I still like inflation linked bonds in a diversified portfolio, given their low level of correlation to other assets and the optionality that is provided by break-evens still being quite low. However, I’m not convinced that we see inflation high enough to force interest rate hikes for a very long-time.
Some equity investors are concerned that real yields, which are very low, will rise and this will undermine multiples in the equity market. It’s true that since the Global Financial Crisis, real yields have fallen consistently while equity valuations have risen. However, I tend to think that it has been QE and financial repression that has driven valuations higher as real yields had been falling for many years before the financial crash and the S&P500 PE ratio actually fell on balance during the noughties. I do concede that a rise in real yields from their current -1% (on 10-year maturity) would probably be negative for equities, especially if it came about through even lower inflation prints. Such a scenario might accelerate the need for the Fed to be even more aggressive, pushing nominal yields lower still to ensure real yields remain supportive. The current gap between the S&P500 earnings yield (the inverse of the PE) and the real 10-year bond yield is around 5.7%, in line with the average for the last 10-years or so. On that basis and in this current policy environment, it suggests that the market is not particularly stretched in relative valuation terms. Having said that, the market average is totally distorted by the performance and ratings of a handful of large-cap growth stocks. The equally weighted S&P index is still down on the year.
More evidence needed for cyclical tilt
So, inflation stays low or only rises slowly, rates stay low until that has happened enough to raise inflation average, and as a result real rates remain low. Yield curves may steepen if the recovery strengthens but policy on hold and a strong global bid for duration might restrict how far that can go for now. Typically, the curve should steepen with policy on hold and the last time the Fed held rates at 0.25%, the gap between 10-year and 2-year bonds rose to as high as 280bps (it’s just 61bps at the moment). However, I just don’t see things being lined up sufficiently to allow that to happen just yet. Looking at the equity market, the most recent consensus forecasts for earnings per share in 2021 are not suggesting a huge amount of confidence in the cyclical recovery. The consensus EPS forecast for the S&P500 for 2021 is currently $160. The first published 2021 forecast was $192 per share. Forecasts were slashed and have yet to recover from the lows, even with some steepening of the yield curve over the period. For the most cyclical sectors, estimates are still well down on initial expectations (basic materials down 13%, consumer services down 23%, industrials down 17%). The downgrades are much lower for healthcare, IT and utilities. At the moment the “steeper yield curve, rising inflation, cyclical recovery, value over-growth” story just does not hang together strongly.
There is a value trap risk in that investment strategy in the short-term. However, with patience it is a more compelling medium-term story. Over time longer-term yields should rise and we will get upward revisions to cyclical earnings forecasts. The hurdles at the moment come from the uncertainty around the US election and the uncertainty about the timing and effectiveness of a vaccine. There is a bullish scenario for next year if and when both those hurdles are mounted. At the moment, opinion polls are starting to suggest more confidence in a Biden win and a potential Democratic sweep of Congress. If that transpires and Trump’s threats to contest the election result don’t materialise, I suspect there will be a surge of confidence in the outlook even if it means having to price in a shift towards higher corporate taxes and more regulation. The first priority for a new Administration would be combating the health and economic impact of the pandemic, meaning more fiscal help. Getting there, however, is going to be bumpy and should there be a contested result I wouldn’t be surprised to see a significant correction in risk assets and a rally in rates. Perhaps the best approach for now is to just “standby”.
It's so quiet
Anyone that went “long goals” in their Premier League betting will be feeling quite smug at the moment. The crazy (and for some of us very depressing) results from last weekend made for very good TV highlights and have added to the unpredictability of this strange season. Being played under COVID-19 restrictions and in empty stadiums is clearly having an impact on the ability of defenders to defend. There have only been 4 games and already Manchester City have conceded 5 in a game, United 6 and Liverpool 7. Perhaps the lack of a crowd is making defenders too relaxed or unaware of the dangers of leaving attackers unmarked – taking social distancing too literally. Hopefully, as a support of Manchester United, things can’t get worse than last Sunday. Hopefully.