Market Update – A Turbulent Recovery

As most expected, confirmed Covid-19 cases are again rising in the US. This time in southern and south-western states which opened their economies early, rather than the original hotspots in the north-east. In response to this, markets have weakened as some plans for the relaxation of lockdowns have been put on hold. Are we about to repeat the experience of the March quarter of this year and crash back into a hard lockdown? For a variety of reasons, we don’t think so. Below, we outline what we think the next six months looks like in terms of economic growth and markets.

The current spike in cases in the US is concerning. However, daily deaths have yet to start rising again. This likely reflects the lag between infection and death – normally three to four weeks. Case growth in the US began to accelerate meaningfully again in mid-June. As a result, we expect deaths to begin increasing again from mid-July.

USA – Covid Daily Cases and Deaths

However, there is a moderate probability that there are fewer relative deaths associated with this reported spike than through March and April, reflecting:

• The average age of reported cases has fallen quite a bit, and young people are much less susceptible.

• More testing means that reported case numbers now are a better reflection of true case numbers compared to March and April, when reported cases dramatically underestimated actual cases. The number of positive test results in New York City has fallen from 70% in late March to 2% currently.
• Relative to the number of cases, fewer people appear to be being hospitalised now than in March and April and those that are have a lower probability of dying[1], although this remains to be confirmed broadly.

If the number of deaths remains relatively contained due to these factors, widespread lockdowns are unlikely. In addition, a better understanding of viral transmission means lockdowns can be better targeted at higher risk activities, such as indoor dining and drinking. Masks are also being worn by an increasing percentage of the population and, where they are being used, they are effective. This, combined with better hygiene and some physical distancing, should reduce the percentage growth in new cases relative to the initial outbreak.

So, given the above, what does the economic recovery look like? In our estimation, it looks sporadic and disjointed, but ultimately positive. Some activity, which was suppressed by government action but isn’t particularly dangerous, will rebound almost immediately. Construction and much of the manufacturing sector fit into this category. Data related to these sectors will look like a V shaped recovery. Other areas of the economy, such as food services, tourism and entertainment will remain impaired until there is an effective vaccine or treatment. Data related to these sectors will look like an L. Some activity, while dangerous, can be allowed to continue with adaptation. Professional services workers can work from home rather than in offices, university education can be delivered remotely, retail goods can be purchased in store with physical barriers or delivered. Heightened business uncertainty means investment decisions will be delayed, making a recovery in capex look like a U. We see a similar pattern in Chinese economic data (see below chart). 

From a consumer perspective, we think sectors representing around 11% of household spending will be seen as dangerous and thus directly affected. However, this 11% doesn’t account for the potential to “pivot” businesses or the extent that some sectors will be impacted less than others. Restaurants aren’t going to disappear, they will just operate at a lower capacity and with more home delivery. Overseas tourism can to some extent be replaced by domestic tourism. Some of the spending that cannot be used for services that are not operating will be redirected to goods (if you are going to be spending more time at home, why not redecorate?) or services that can still be delivered (don’t meet friends at a restaurant, meet at a park with a food truck). Regardless of this pivot, the overall level of this sort of activity will remain impaired until the virus is no longer a threat. We see some evidence of this in mobility data, where physical attendance at workplaces and retail and recreation businesses has flatlined after some recovery.

Applying this profile of recovery to the models we use to forecast earnings growth suggests earnings will not reach their previous peak in Europe until late 2021, in the USA until mid-2022 and well beyond that for Australia, Japan and emerging markets. This is consistent with previous recessions. Following the Financial Crisis, it took three years for US earnings to reach their previous peak. This is a more pessimistic earnings profile than currently forecast by consensus (see below). However, consensus tends to be structurally optimistic and then revise their expectations lower through time. As a result, the gap between our view and the markets doesn’t necessitate a price reaction.

With equity markets broadly pricing in this near-term environment, expect us to sell into strong market rallies and buy dips in order to take advantage of the ongoing volatility. We see a high chance that if deaths start rising in the USA, it will drive the S&P500 5% to 10% lower from here – back towards 2800 – 3000 which, all else equal, would provide an opportunity to increase risk exposure in the portfolios.

The key short-term risk to this outlook is the impending “fiscal cliffs” in many economies. The increase in spending by Governments to encourage and support economic growth has been unprecedented, and stopped the lockdowns triggering a global depression, rather than recession. However, it is also time limited. In the USA, on July 31, the additional $600 unemployment benefit per week included in the CARES act will run out and with unemployment benefits normally lasting 26 weeks, workers who lost their job in March will exhaust all their unemployment benefits in September. If this stimulus is not topped up, it will present a material household income shock. Australia faces a similar challenge at the end of September with the proposed end to the Job Keeper payment. If this is not addressed, it would likely be sufficient cause for us to take the portfolios back underweight equity exposure.

We think in this disjointed recovery environment, equity markets will be volatile, but should still outperform cash and bonds. In line with this view, the portfolios are still slightly overweight equity risk relative to their neutral asset allocations.  Heightened volatility presents an opportunity for us to add value through tactical asset allocation.

[1] https://twitter.com/CT_Bergstrom/status/1276695443427090432, https://www.bbc.com/news/health-53192532

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