The call on future growth
If companies survive, they have a chance to grow in the recovery. The credit backstop has helped the chances of corporate survival in most developed markets. It is tough, no question about it. Corporate revenues have been chronically reduced. It’s made the “option on future growth” more expensive. You pay for stocks that have a higher survival rate and a higher potential growth rate. At the market level this makes equities look expensive, particularly in the US. The counter-factual would be lower equity prices and more firms going bust. Credit markets can continue to improve, and spreads narrow and while that happens, there will be a positive influence on equity markets. News about the virus – good and bad – and the veracity of the recovery will be what generates the short-term volatility. The zillion dollar question is how quickly earnings can come back.
The shock to global GDP – which is going to mean an annual decline in 2020 of between 6% and 10% for most advanced economies – will also mean a massive hit to corporate revenues. Companies have already experienced a huge decline in earnings and are extremely uncertain about how quickly they will recover, if at all. If there is less revenue, there is less profit and less to distribute to shareholders, less to retain to finance capital and potentially less to service debt. Dividend growth is likely to be strongly negative in 2020 and financial resilience has been challenged to the extent that there has been a huge number of credit rating downgrades. Earnings-per-share are down, earnings growth has been impacted and dividend payments to shareholders have been cut. Yet equity markets have re-rated higher, especially in the US. Indeed, the brief risk-off period last week did not last too long even though coronavirus infection rates in many US states continue to rise. On any traditional valuation model, equity indices should arguably be lower. According to the latest IBES data, the S&P500 is trading on a multiple of over 22x the 12-month forward estimate of EPS.
Instead of equity specific fundamentals the market appears to be driven by other factors. We know that policy is very supportive. The Federal Reserve’s policy steps have reduced government bond yields, with 10-year Treasury yields down 90 basis points since the S&Ps 19 February peak. Equally it has reduced credit spreads, where the spread of the US investment grade index has dropped 240bps since stock market bottomed on 23 March. These two factors alone explain a lot about the S&P’s increase. I did some basic regression of S&P returns since March’s nadir on changes in credit spreads and Treasury yields. The coefficients are meaningful. I added in a momentum factor – which should capture short-term sentiment and the influence of the so-called Robin Hood investors – and most of the move can be explained statistically. So, nothing really to do with equity fundamentals.
Option for growth
Conceptually this makes sense even if we can poke holes in the simple statistical analysis (correlation does not equal causation!). Central banks have kept the credit markets open, allowing companies to raise lots of liquidity and refinance their borrowings at lower yields. That improves survival rates for firms even if they are burning through cash until the economy recovers. The policy framework – the credit backstop – has provided bond holders with a put option while equity investors are essentially long a call option on future earnings. If companies are going to survive because their credit profile has been strengthened by policy, why not pay 22x times next year’s earnings with a risk that prices go down a bit? You might benefit when earnings eventually do start to rise. That’s better than paying a lower multiple but without the credit put with the risk of losing much more and with the upside option being much further out of the money. Earnings may be challenged but owning equity today gives the investor the upside potential when earnings do recover. And there is much more chance of earnings recovering if the policy framework gives the broader economy a better chance of rebounding. I am not sure everyone that buys equities goes through this thought process but in aggregate it leads to money going into stock markets because of the FOMO principle (fear of missing out).
If one sees any value in this analysis it is clear to see where the potential risks to the stock market come from. A reversal of the positive policy effects on rates and credit is an obvious one, but it is unlikely that this will materialise any time soon given the current level of central banks’ commitment. So, it comes back to trying to guess what factors effect that momentum factor – sentiment around the virus and the broader economy. The longer it takes for earnings expectations to bottom and start rising again, the more difficult it will be for that momentum to remain positive. If credit spreads continue to narrow, at some point this “credit impulse” to equities will fade. If bond yields fall towards the floor, the “rates impulse” will also fade. Then the fundamentals for equities need to do their job. There could be a bullish view. Some brokers are strongly pushing the V-shaped recovery scenario which would be associated with a pick-up in earnings forecasts. This may have already started. In its latest survey of analysts, IBES data shows a rise in the 12-month expected growth rate of earnings, for the US and Europe. The increase in multiples may just be running ahead of the pick-up in earnings – total returns could still be positive going into 2021 without much further increase in prices and, indeed, a fall in the earnings multiple.
The US is the leading candidate for a strong recovery in the economy and a strong market recovery. Last week, the Fed’s backstop of the credit markets was enhanced further when it said it had identified eligible corporate bonds that it could buy directly. There was also talk of another $1trn in fiscal stimulus, targeted at infrastructure. Perhaps more importantly for the economic outlook, there appears to be little appetite for further lock-downs (although it is not clear how rising case counts will be dealt with in those locations that have already lifted restrictions).
Still positive on credit
The positive correlation between equity returns and corporate credit returns means that if you are long equities you are also positive on credit. Our fixed income teams returned a universally positive view on credit markets at our quarterly investment committee this week with the view driven, mostly, by the technical set-up in the markets (the policy backstop). Yet the debate around the outlook was all focussed on the risk of a second wave, the extent to which economic capacity and demand has been damaged and the risk to the rebound if policy support is withdrawn at some point in the future. These are risks but not realities, but they are sufficient to influence market sentiment and that ebb-and-flow of risk appetite. In other words, the momentum can overwhelm other factors, especially over short-term horizons.
Judging whether the stock market is appropriately priced is mental torture. The returns are volatile over short-term periods. But I think my view now is that, as long as credit distress is controlled to some extent (defaults don’t rise as much as they did in previous recessions, leverage can be controlled, and interest coverage remains high), then equity value won’t be wiped out and the option on future growth will remain a valid and attractive asset. For credit, if companies have liquidity now and have and can retain access to the markets, and interest rates remain low, then the risk of credit defaults for most will remain low. That means, from an investor point of view, the additional spread on offer relative to risk-free governments is attractive. Flows into credit will drive yields lower allowing companies issuing new debt at yields and spread levels that will help them control leverage. It’s a positive cycle when it works.
But caution is warranted
None of this rules out risk-off periods because that sentiment-momentum factor is powerful. On that, I seriously don’t think that a second shock can be as bad as the first. There may be something new that comes along. Thankfully India and China agreed this week not to escalate the border spat that saw shots fired recently, but the unknown-unknowns are always out there. However, a second COVID-19 scare would be met with less fear than the first as we collectively know more about how to deal with it now, although there would be genuine questions about how much more policy help could be given. On that, authorities are never going to admit they can’t do anymore, it’s just that the costs might change. This is a long-winded way of saying that we are likely to see any renewed concerns as a buying opportunity.
And the hedge is still important
Authorities have sent a strong message – “we will fund you (society) while we try and control the virus and while you get back on your feet and start to rebuild your lives. Don’t worry about the pay-back, we will deal with that over the longer term. Just get back to making, servicing, entertaining, feeding and spending”. Forget about price-earnings ratios, if GDP growth in 2021 is positive in the range of 5% to 10% then today’s stock prices might not seem so expensive in retrospect. Oh, and by the way, remember 10-year Treasury and other core government bond yields fell most sharply in the period before the stock market bottomed. It was then that the correlation was most negative between yields and equities. Since the market recovery got underway, that parallel has been more muted. If the stock market falls again, the negative correlation will resume, and bond yields will fall further – driven by expectations that central banks will introduce negative rates in more and more places. The bond market has been doing a good job of cheapening the entry point for the duration hedge in the last couple of weeks as curves have steepened. The 30-year Treasury yield at 1.48% is a steal!
Long-term it probably pays to be optimistic
A more fundamental question hangs over the long-term outlook for equities. What we don’t know is what kind of growth environment we will be in for the next decade. Following the initial recovery in US corporate earnings in the wake of the Global Financial Crisis there followed a period between 2012 and 2017 when realised earnings growth averaged only about 4% per year. Some recovery in dividends and buy-backs and this kind of growth rate might translate into 6-8% total returns from stocks – somewhat below the long-term average. Higher debt, some eventual fiscal retrenchment, de-globalisation, demand for higher labour share of income and regulations around the environment could all impact on growth rates. It took five years for the US market to regain its pre-tech bubble level in the mid-200s and two years to recover after the credit crunch. For some indices, the pre-COVID-19 levels have already been passed. For now, the strength of policy working through the bond markets is having a positive impact on equities and the residual is encompassing the weight of money and speculation that growth will resume. History would say that it not a bad bet.
It’s coming back
As you can imagine, I am quite excited about the return of Premier League football. It’s a bit like the start of a new season or some weird summer tournament. Yes, Liverpool will win the league, but the remaining games will be important for giving clues about next season. I can’t wait to see Pogba and Fernandes together in the Man United midfield. And with Marcus Rashford (the man that can only do good) up-front, things are looking promising. Not sure I can cope with the artificial crowd sounds though (although that may become a permanent feature at some of our more atmosphere challenged stadiums going forward).