OCBC OneWealth App– Mind the potholes

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Covid-19 global pandemic

Mind the potholes

30 July 2020

Entering the recovery phase

After a grueling second quarter which saw economic activity dramatically plummet as governments around the world imposed harsh mandatory lockdowns to contain the first wave of Covid-19, the global economy has only started to recover as countries slowly emerge from a quarter of unprecedented disruption. Manufacturing and services Purchasing Managers’ Indices (PMIs) have recovered somewhat while high frequency indicators including mobility data from Apple and Google and restaurant reservations from OpenTable point to a recovery in economic activity. For the most part, the second quarter will likely mark the nadir of the current economic crisis and we are likely heading into the recovery phase of the current cycle.

The recovery phase of an economic cycle is typically conducive for risk assets as the outlook for the operating environment improves and earnings recover. In this case, the longer-term risk-reward for equities remain sound, but we need to remain vigilant of the risks on the horizon. Put simply, we are not in the clear just yet.

Covid-19 remains a clear and present danger

The virus remains a clear and present danger. We have observed a resurgence of Covid-19 infections globally in countries that have reopened including Hong Kong, Australia, Spain, the US, Israel and so on. Several states in the US have rolled back reopening efforts including banning indoor dining and shuttering bars, casinos and cinemas to curtail the spread of the virus. Australia imposed strict movement restrictions in the Victoria state while Hong Kong banned indoor dining and imposed strict crowd control. Prolonged imposition of strict social distancing measures could very well stall the ongoing economic recovery. At the same time, the prospect of a fiscal cliff where government fiscal stimulus or support schemes expire could potentially exacerbate the problem.

The good news is countries have not resorted to the types of crippling mandatory lock downs that we saw being imposed in March and April. With the benefit of experience, governments are better prepared to contain virus outbreaks. Localised containment measures, widespread testing and rapid contact tracing will be key moving forward. Investments have also been made to expand the capacity of healthcare systems to deal with another wave of cases. So far, for most countries facing a resurgence of Covid-19 infections, hospitals have not been overwhelmed by new cases which has allowed governments to avoid another costly lockdown.

The general sense is that for most countries, there is palpable lockdown fatigue. The political will to re-impose another state-wide or nation-wide lockdown seems weak in the wake of intense public disapproval and the heavy economic costs it entails, both on the economy and the government’s budget. In the absence of these drastic measures, the economic impact from containment efforts of subsequent surges in Covid-19 cases would be less severe than in March and April.

Elections await

A second risk to look out for is the US Presidential elections in November. An election year typically heralds more market volatility as investors anticipate a potential shift in policy authority. The possibility of a Democratic sweep of both the executive and legislative branches of government on the back of the Trump administration’s poor virus response, a struggling economy and rising social activism is a key risk for markets. Already, betting markets and polls are increasingly reflecting a rising probability of an outright Democratic sweep.

While the Trump administration’s foreign and trade policies have been problematic, their business-friendly domestic economic policies have been a boon for stock markets, particularly their commitment to deregulation and cutting corporate taxes. A Democratic sweep with strong majorities in both the lower and upper chambers of Congress effectively hands the Democratic party a blank cheque to reverse Trump era rules and pass legislations that are closely aligned to their policy platform. This includes rolling back Trump-era tax cuts and raising taxes on the wealthy, adding teeth to environmental regulations and enforcing anti-trust laws, with their sights set on big technology firms in the US. Onerous regulations and tax increases are certainly bad news for equity markets and might trigger a negative response among the investor class.

The best case scenario for the market would be a Biden win with a divided Congress in the from of a Republican Senate and Democratic House, as we would see a more measured approach from the White House towards US-China relations while a potential reversal of Trump’s tax cuts will likely to be blocked by a Republican Senate.

US-China tensions: Here we go again

Related to the elections is a third risk for the market: US-China tensions. As things stand, the US-China relationship remains deeply fraught and has deteriorated markedly, with tensions broadening beyond trade to issues of technology access, healthcare, investments, and geopolitics. Hong Kong has become a political football in the tussle between these two economic superpowers. And it seems highly improbable that the Trump administration would let up on the political attacks heading into the elections in November. After all, some would argue that President Trump’s harsh attitude towards trade, and particularly trade with China, endeared him to voters in the Sun Belt states whose support eventually won him the 270 electoral votes he needed to win the 2016 elections.

It is therefore unsurprising that President Trump sought a more adversarial relationship with China even amidst a global pandemic, consistently labelling Covid-19 the “China virus,” supporting conspiracy theories about China’s influence over the World Health Organisation and accusing China of hiding information about the virus.

It is also important to note that a majority of Americans hold an unfavourable opinion of China and that adopting a hard stance against the country has broad bipartisan support. Against this backdrop, it is highly unlikely that Joe Biden would willingly flout popular sentiment. Indeed, he has openly supported taking on China but through a less disruptive, multi-lateral approach.

The noise from persistently belligerent US-China rhetoric may inject a great deal of volatility in financial markets as we head into November.

Looking expensive

There seems to be little appreciation of these risks in a market that has exhibited an impressive ability to shrug off any non-bullish narrative thus far, explaining it away as if it were some temporary inconvenience. As it stands, the global stocks as proxied by the MSCI All Country World Index has already priced in a great deal of optimism, having recovered most of its year-to-date losses.

Consequently, valuations across many regional markets are looking quite stretched, partly reflecting the effect of sharp downward earnings revisions. On a 12-month blended forward basis, price-to-earnings ratios of the major regional markets are trading about 2 to 3 standard deviations above their past 10-year historical averages. Looking at valuations using forecasted earnings for 2021, on the assumption of a normalised business environment, valuations do not appear as steep, but are certainly not cheap.

Extended valuations should be seen in the context of a very different market environment, one that is flushed with liquidity and central bank support on the scale that we’ve never quite experienced before. The Federal Reserve has expanded its balance sheet by more than US$2.8 trillion dollars in just a few months. Much of the money created has been used to buy US Treasuries and mortgage-backed securities. The central bank has also effectively back stopped US corporate bonds, having set up a separate facility to purchase individual paper. They have also expanded liquidity support to at risk businesses via the issuance of trillions of dollars in emergency loans. Save for buying equities outright, the Fed has essentially backstopped a long list of risk assets.

The explosion of M2 money stock suggests that equity markets might continue to stay elevated as these funds search for a home. Where better than stocks to park cash where returns are uncapped on the upside. With long-term US Treasury yields trading at about 60 basis points and inflation-protected bond yields trading in the negative, there are admittedly limited options for investors seeking to grow their stash of cash besides equities.

Stay invested and engage risk prudently

Extended valuations underscore the need to be judicious and selective when thinking about engaging risk particularly because the margin for error is compressed. We are not working off a low base and the bar for further upside is admittedly higher. We can take comfort in the flood of liquidity but at some point, we will reach a “show me the money” moment in which economic fundamentals and company earnings must somehow validate the high price being paid for a discounted stream of future earnings.

We are in the midst of an economic recovery, but as we have seen thus far, the pace of that recovery will likely be gradual and uneven until and unless the threat of the virus is permanently removed. So, while investors continue to participate in financial markets, they should do so carefully and also ensure that they are well-diversified and are exposed to quality assets that are able to ride out a more volatile market environment ahead.

It is easy to get distracted by the bright lights and exuberance of the market. But for long-term investors, they should always keep their eyes firmly on the risks ahead. Unexpected potholes may mean a bumpy ride.

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