The first half of 2020, marred by the Covid-19 pandemic, will go down in the history of the financial markets as one of the most uncertain and volatile eras where a decade’s worth of economic progress was undone in days, and the next decade’s destiny was written. It will be remembered for one of the steepest market crashes and the most impressive rally, for record loss in demand matched with record amounts of stimulus, for the worst recession ever and the quickest recovery ever, for the worsening of US-China relations, and also for social and wealth inequalities coming to the limelight. 2020 will perhaps be the most significant economic year in our lives, and it’s pity we will probably never see it as such.
Markets were surprised by the volume and speed at which central banks threw cash at the problem
The global economy wasn’t exactly strong going into the crisis with PMI in decline since 2017, coinciding with the beginning of the US-China trade conflict. Another major component was that we were reaching the end of the credit cycle, and a downturn could very well have been expected. Valuations, particularly those in the US markets, were very high, and investors felt the need to start moving away from growth-heavy portfolios to value. However, cyclical and value stocks like banks were perhaps the hardest hit in the coronavirus crash in March. What followed was an unprecedented rally, unlike the slow toil back in 2008 and 1929, recovering most of the losses on the S&P 500 largely due to the steep rise in tech companies.
The rally in equities in the US made investors question whether the markets were pricing in the full scale of damage the virus could cause. But there is a good reason why the markets were bullish: Central Banks. The virus has been expected to cause a loss in demand equivalent to $30 trillion, but markets were surprised by the volume and speed at which central banks threw cash at the problem with nearly $10 trillion in monetary and another $8 trillion in fiscal support. Moreover, unlike in 2008 when banks needed capital infusion to support the economy, most of the cash this time, directly or through banks lending, went right to the bottom of the economy where the velocity of money is far higher.
The economy will wake up from its “hibernation” and deliver a V-shaped recovery
Currently, the market believes that the stimulus will probably outweigh the loss as it flows through the economy and that central banks will do “whatever it takes” to prop-up the economy through this period. Most investors also do believe that, unlike in 2008, there will be a recovery, and it will be very quick. The presumption that the economy will wake up from its “hibernation” and deliver a V-shaped recovery is rather rampant and supported by outperforming data. However, risks still remain. A second wave in the autumn could impede the party. Markets could face a reality check come earnings season. Recovery could slow down, or stimulus could altogether stop working like in Japan.
US stocks in particular are at extreme valuations, equivalent to the time right before the dot-com crash. Valuations tend to be rather high coming out of a recession, working under the assumption that corporate earnings will rebound, but that might not happen for American companies this time. Corporate profits are arguably the best predictors of the stock price and move in unison in the long run. The disconnect between the two has been growing in recent years, signalling a correction soon. Since low interest rates and easing can be expected to hold equities stable, it is more likely for the market to remain stuck at its current level as earnings catch-up.
US stocks in particular are at extreme valuations, equivalent to the time right before the dot-com crash
It is also important to note that not all of the US market is overpriced. Most of the recent gains have come from the tech giants that account for nearly a quarter of the S&P 500 now, and banks and industrials actually maintain pockets of value. Even as tech companies have had a good crisis, there still needs to be reckoning that their valuations are too high. A threat of oversight, regulations, taxes, or any disappointment in tech will crush the S&P. Come November, a Democratic presidency that will be harsh on Silicon Valley can be expected to cause a big correction. A Democratic presidency will also be hugely damaging to the healthcare industry in its current position in the US.
US corporation taxes are at the lowest they have ever been, and these could be raised to pay for the crisis. The 2017 tax cuts and simplification were a big achievement, bringing America in line with the rest of the world in its taxation model. If this is now reversed, alongside the current restrictions on dividends and buy-backs, equities could get absolutely hammered. On the other hand, the Robinhood bubble, where millennials are buying stocks of bankrupt businesses hoping for a revival, will disappoint as well. Even if many of these companies come out of Chapter-11, equity holders will be wiped out by debtors and vulture investment funds. The participation of new retail traders is at a record high, signalling the peak of the market.
Even if many companies come out of Chapter-11, equity holders will be wiped out by debtors.
Turning to Europe is where many buying opportunities remain. The recovery in the STOXX 600 and the FTSE have been more balanced, and there remains significant room to go north. Much of the make-up of these index is industrials, utilities, banks, and automobile, which have not necessarily rallied like the tech sector. The market also seems to be more connected to reality as most of the EU and the UK have emerged from lockdown and handled the crisis better. Plentiful stimulus, better finance, and general political stability are beginning to draw investors to Europe after a decade of lacklustre prospects. Another reason is to ground oneself in value, and cyclicals as investors think growth may surprise on a positive end.
This market shift was marked by several important factors like extreme valuations and change in sentiment in growth, value and income investing. Heavyweights, including Buffet and investors with a cult-like following, were caught off guard and failed to move nearly as quickly as the Central banks and policymakers. The 60/40 portfolio which has consistently delivered returns faltered for the first time since the 80s in the age of extremely low interest rates, and commodity markets are where a lot of the action is now expected to be. But, all said and done, the recession playbook remains intact, and there is a glimmer of hope of normalcy in the markets with better growth and more inflation. From gold to bonds, the markets have had a rather rocky ride in H1 2020, a year that the financial markets will perhaps never forget.