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Is it Really that Good, or that Bad?

Jul 27, 2020

• A call on the market outlook is more complex than just buy or sell
• The rolling over of good economic data was inevitable, it doesn’t mean bad news
• Too much focus on the US equity market, other assets are still down a long way
• The EU delivers a positive surprise – bonds and equities should benefit
• Asian assets to benefit from signs of solid recovery in Japan and ongoing support from China
• With a number of drugs in stage three trials it should be a matter of when, not if, we have a vaccine
• Don’t trade with emotion, it’s neither good nor bad… it’s just OK.

As investors watched the US equity market move back to where it started the year, many were left scratching their head trying to figure out the seeming disconnect with the still high and growing COVID-19 cases. We find too many commentators trying to characterise a very complicated situation within just a very black or white framework. It’s either going to be okay or it’s the end of the world; it’s a buy, or it’s a sell. The emotion is understandable given circumstances, but it doesn’t help us to take rational investment decisions.

Rather the world financial markets are a shades of grey. Some markets have run strongly but not all. Economic data may start to disappoint but perhaps not drastically. Policymakers are still heavily engaged but may on occasions disappoint. Markets should trade the range but not collapse.

Yes, some markets may have run ahead of themselves, but this is not universally true. The global equity market return of -2.8% in the year-to-date is a performance record that masks a diversity of performances by country and by sector. While the US and Asia-ex Japan are close to flat for the year to date, the Eurostoxx 50 index is still down 12% and the UK equity market down 19%. A few emerging countries such as Russia, Saudi Arabia and Brazil are also down double-digit percentages.

By sector, the global energy sector is still down 37% year-to-date, global banks down 30%, whereas infotech at a global level is up 15%. Hence the rally in equity markets has been narrow, but one must concede that in some cases it is warranted. Growth stocks derive their valuation from a combination of earnings growth and the discount factor (we use the US 10-year government bond yield as a proxy). For some tech stocks, earnings forecasts have risen since the start of the year, and the US 10-year yield is down from 1.8% to 0.58% at Friday’s close – a double positive. Also, many of those large growth stocks are capital (and employment) light businesses that have the flexibility to deal with the challenges at hand compared to the equity market leaders of the past.

The economic data has been good, but it is likely to be more mixed going forward. A near term headwind for the market is the strong likelihood that economic data will disappoint the markets in the coming weeks after such a strong showing since April. The US economic surprise index that hit an unprecedented level of 271 on July 16th can only go down. Last week’s weaker than expected US jobless claims number are maybe a taste of what is to come. In the eurozone, economic data continues to beat expectations, but with worries over a second wave of COVID-19, there must be a risk that data will weaken in coming weeks

The still-high levels of COVID-19 cases around the world are worrying. Although the level of COVID-19 cases has flattened out in the United States, it has flattened out at a very high level requiring some states to reimpose varieties of locked down. Also, the need for a country like Spain to reverse some of its reopening can only give us cause to worry that global economic activity may be about to lose momentum.

Here in Asia, in Hong Kong and the Philippines, the cases of COVID-19 have re-accelerated after a reopening. However, Asia may benefit from the ongoing relative strength of the Chinese economy and recent signs of a belated recovery in the Japanese economy. Last week’s July Japanese PMI’s showed significant increases in manufacturing output although the markets are expecting this week’s service sector report to less convincing. Data in China may suffer some moderation given the severity of recent floods in central and eastern regions.

If the markets are to remain sanguine about the high level of COVID-19 infections, they will have to stay confident that policymakers will deliver the necessary reaction to any slowdown. The EU truly delivered last week with a multi-year budget and recovery fund deal. While the numbers in the budget are not overwhelming huge, the EU has delivered significant structural reform. There is a clear transfer from North to South with grants and not just loans, and that the EU is now prepared to issue debt at an EU level puts a more cohesive backbone into policymaking.

The US policymakers, at least for the moment, are less convincing. In the US it is a worry that Capitol Hill has been unable to deliver a follow up to the income support program expiring at the end of July. In any case, we suspect that a compromise agreement will be found to inject a further around $1 trillion of income support. Markets will soon have to contend with the US November elections coming onto the horizon and the real risk that the Republican Party loses both the White House and the Senate.

We advise investors to watch the unemployment data around the world for the signs that the policymakers are not on top of the problem. An unexpected significant rise in unemployment from here, without an immediate policy reaction, could put the skids under the market. We believe the consumer discretionary sector is the most vulnerable to higher unemployment bearing in mind that the global sector is up 7.7% year today.

We are trying hard not to fuel a day traders view of the markets. Hence, it’s reminding ourselves that even if the COVID-19 is still creating problems in the global economy, through the third quarter, we will be awaiting results from four drugs that are either in or about to be going through stage three trials. In the past there has been an 85% of stage III vaccine achieving successful approval. Although the medical community caution that just because a drug is approved doesn’t mean it is ultimately the panacea needed to solve the problem.

Our advice – don’t trade with the emotion. Be prepared for volatility, because the momentum of the near-term economic news is very likely to worsen. Is there something hopelessly wrong about the valuation of assets? In our opinion, not at this stage. Policymakers have not run out of money. Most of the major central banks of the world can print more money and give every support to their respective governments to prop up their economies through further difficult times.

A significant spike in inflation is the main factor that could unravel the markets. However, at this stage, we see very little evidence on the pipeline inflation in the global economy. Inflation would mean higher bond yields, a higher cost of financing debt and an undermining of the valuation argument in favour of growth sectors such as tech.

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