By Seema Shah, Chief Strategist, Principal Global Investors
While the extraordinary COVID-19 economic hit has caused the U.S. unemployment rate to swing from its lowest level in half a century to a peak unseen since World War II, financial markets are dancing to their own tune. Broad U.S. equity indices are rapidly ascending the upward slope of the V, powered along by unprecedented central bank and government stimulus. April marked the biggest monthly rise in the S&P 500 index since 1987. Yet, this also implies that, even though the tremendous market performance looks good, it just doesn’t feel good.
Data vs. the markets
The impact of COVID-19 has been ruthless to companies and consumers, seen in earnings per share downward revisions (most negative on record) and economic data (equally awful). Yet, with high frequency data such as motor gasoline demand and phone mobility tracking enjoying an uptrend in recent weeks, April likely marked the nadir for economy activity. Are financial markets rallying in anticipation of the recovery?
Even the abysmal U.S. employment report for April seemed to ring a note of positivity, with more than 70% of jobs lost last month marked as being temporarily laid off. While that may offer some grounds for hope that many will re-enter the workforce as soon as lockdown is lifted, with economic activity facing the twin weights of lingering COVID-19 fear and elevated precautionary savings, how many businesses will truly be in a sufficiently strong position to re-hire their employees, facilitating a smooth economic recovery?
Once the recovery begins, prolonged weakness
There are some sectors which may be facing a prolonged period of weakness. Aviation being perhaps the most obvious example. In recent weeks, several airlines have announced that they do not expect to resume normal operations until 2022 and Boeing, the aviation bell weather, expects it to take five years and anticipates the failure of at least one major airline.
Similarly, with retail having to comply with social distancing measures for the foreseeable future, this sector also faces serious challenges. In the UK, an Ipsos Mori survey found that almost 50% of Britons would feel uncomfortable shopping, other than in supermarkets, and the British Independent Retailers Association has forecast that up to 20% of smaller shops may not even reopen once government support schemes begin to fade. Even after lockdowns are lifted, market participants should anticipate a wave of business failures across many sectors and across countries.
Unfortunately, the fallout from struggling businesses does not just stop there. Bankruptcies create negative feedback loops, particularly for the labour market. Consider this: as we hear of more and more businesses contemplating closure, there are potentially millions of currently furloughed people who will not be reemployed. A second wave of job losses is perhaps in the cards.
And therein lies the problem. Markets may be right to look through Q2 numbers and look forward to a Q3 recovery. But it is entirely possible that there will be a Q4 reckoning, where a second wave of job losses & prolonged period of business failures tests equity sentiment.
A solution? Ongoing government support
The bountiful government support packages around the world were initially considered temporary financing, but it seems that policy support will be here to stay for a while.
In the UK, government support to pay 85% of workers’ wages was initially introduced as a three-month package, hoping to keep businesses going until the re-opening of economies released pent-up demand and a rapid normalisation of economic activity could take place. Instead, that stimulus has now been extended until at least October of 2020. What’s becoming increasingly obvious is that global fiscal support will need to be sustained so as to prevent a surge in bankruptcies and subsequent economic strife.
Similarly, sustained liquidity provisions and asset purchases from central banks will be required to support the economy. While this may take the sting off corporate and household weakness—and investor disappointment—it is still an outlook that inspires caution.
Until a vaccine, what is the risk?
Investors need to be wary of a second virus wave. As lockdowns are being relaxed, attention is turning to whether new infection rates will remain suppressed even as mobility increases.
Until a vaccine is made available, we are almost certain to see more cases and, indeed, a number of countries such as China, South Korea, Singapore and Germany are already facing new clusters of cases. But from an economic and market perspective, the key question is whether or not a second wave is severe enough to prompt governments to reintroduce lockdowns?
Inevitably, governments will be extremely reluctant to close economies again given the economic damage already inflicted. Hopefully, now that more is known about the virus, countries will be better prepared, with enough testing kits, contact tracing and PPE equipment at the ready, in order to manage the outbreak and avoid a full shutdown.
If a second surge were to take place, overwhelming health infrastructure, governments may find themselves with little choice but to reintroduce lockdowns. While the psychological impact on society cannot be exaggerated, the economic impact would also be devastating, with lingering long-term effects. Household caution would likely remain elevated for an even more prolonged period, and business failures and surging unemployment would be inevitable. In that worst-case scenario, even the most monstrous policy stimulus could not support continued equity market gains.
Looking ahead, implications for investors
With the worst of the pandemic likely behind us, central bank supported equity markets are unlikely to re-test their lows. Yet, while reopening momentum may well carry risk assets a bit higher over the near term, the tepid economic recovery and deep uncertainty over the virus outlook argue against a pivot to more risk-on positioning. Certainly, defensives are already expensive, but as long as the very significant clouds are hanging over investment sentiment, market leadership will likely continue to be concentrated in that market segment.
By no mean are all businesses in cyclical sectors destined to fail. Many will pivot to take advantage of the emerging trends. Already we have seen retailers and food providers potentially benefiting from the opportunity to reduce prime real estate costs (typically their greatest fixed cost) as they focus on shifting their merchandise aggressively from physical channels to digital channels, and thereby sidestepping many social distancing challenges.
If things go well in in the remainder of 2020 and into 2021, a stronger economic outlook may involve broad rotation away from defensives into cyclicals, from large cap to small cap, and from growth to value. For the time being, however, investors should only selectively add cyclicals to their portfolios, focusing on companies with strong balance sheets, positive cash flow, less leverage, and those that have a vision to benefit from new secular growth trends.
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