Investment Outlook - Market Update
After the shock onslaught and subsequent human and financial market damage caused by Covid 19 during the first quarter, the second quarter was equally dramatic and recorded one of the strongest quarterly returns for equity markets in decades, a very pleasant surprise for the value of investors’ portfolios. In contrast the global economy will record one of its worst quarters of contraction in history for the second quarter.
In the tug-of–war between the fundamentals of economic and earnings growth versus the powerful combination of central bank liquidity injections and government fiscal spend, the latter combination clearly overpowered and drove market indices in many cases back toward previous highs. The market adage of ‘Don’t fight the Fed’ once again a winning strategy.
Our baseline scenario for the coming quarter is that we are likely to see markets more confined to a trading range and to be mildly more bullish as we look towards year end and into 2021. While there is every reason to argue that the forces of liquidity can continue to dominate it is also completely reasonable to argue that fundamentals do eventually matter and are likely to have an equal say over the coming quarter with the tugof-war a less one-sided affair.
That is not to forecast that fundamentals won’t improve and indeed the most recent economic data is delivering strongly month on month and equally investors may well ignore nasty second quarter earnings on the basis they are focusing more on 2021 outlook. We must recognise that much of the bounce to date is mechanical. To be sustained over coming months, it will be crucial that fundamentals continue to catch-up. Markets indices have already built in an expectation of a vigorous rebound and anything less will be a negative. And Covid has not yet been defeated or a vaccine in sight.
An upside scenario would most likely require a combination of existing liquidity conditions and a stronger than expected recovery in fundamentals. A vaccine discovery would be icing on the cake. A downside scenario could be as a result of a much slower recovery than expected or even a double-dip. Needless-to-say, a double-dip in economic activity caused by significant Covid second waves could easily turn a downside scenario into an ugly one.
Asset class outlook:
As an asset class, equity markets in aggregate cannot be argued to be cheap nor excessively valued. We continue to highlight the extremes of valuation ‘inside’ the markets. A very small number of extremely expensive mega-cap names particularly but not solely confined to the US technology sector are dominating while leaving behind many stocks and sectors that while presently unloved present a very attractive investment opportunity to our beliefs.
The upcoming Q2 reporting season is expected to post some incredibly negative earnings numbers, minus 44% YOY for the S&P500 for example. Markets are expected to ignore and look through these numbers but for sure there will be volatility associated with the reporting season, not least outlook commentary from company management teams.
For equities, we recognise that we are at the beginning of a new economic cycle and the associated new bull market. No two bull markets are the same and each associated with new winners. Equities will once again be driven by fundamentals and not just the liquidity injections of central banks. As fundamentals improve and investor confidence increases, we remain optimistic that conditions will increasingly prevail to facilitate a sustainable rotation within equity market stocks and sectors. Value and cyclicality should prevail over growth and defensiveness and regionally Europe and Emerging Markets better positioned to deliver versus US. Looking further ahead, the US Presidential election could be a material consideration for the US stock market. Bonds
Fundamentally, government bonds remain extremely overvalued at the current negative yield levels. They are however very ‘technical’ at present and the massive government bond buying regimes globally are likely to anchor yields around current levels, irrespective of what may be otherwise dictated by fundamentals or massive increases in debt levels. Corporate debt faces real challenges of course and as an asset class will face some challenges of corporate defaults.
Longer term with renewed global economic growth we believe bond markets are particularly vulnerable to a significant sell-off given the outlook for massive new supply of debt by governments and again the possibility of renewed inflation concerns at some point.