Wealth Management: Market Perspective – Looking across the valley
Kevin Gardiner, Global Investment Strategist, Wealth Management
The elusive Mr Market
We talk of markets panicking, or being exuberant. There is no doubt stock prices often o reflect emotions. But those emotions are ours, not Mr Market's.
When investors do collectively panic - or cheer - they focus narrowly on the things that matte most to their investments: corporate income and interest rates.
Sometimes, that investment focus may align with wider concerns. Often it doesn't, and markets seem callous, as when (for example) natural disasters, oppressive regimes, civil unrest (sadly topical on both sides of the world as we write), or the plight of refugees leave them unmoved.
Investors' current mood seems pretty impersonal. Stock markets have surged by a third since 23rd March, but virus casualties are still rising and economies are still weak. In fact, stocks and human interest may not be as
divergent as they seem. The discrepancy largely reflects timing, not indifference. The decision to suppress the virus by closing part of the global economy had big ramifications for business, as well as for people. Profits have slumped along with jobs and incomes - we are still waiting to find out exactly how far (data are lagging). In this case, what was bad for people - the virus and the cost of suppressing it - was bad for stocks too.
But markets - investors - look forward, not back, and stock prices fell as soon as it became clear that profits were going to - and before they actually did. Between 19th February and 23rd March, global stock prices fell by a third.
The backward-looking economic data published over that period showed little deterioration.
At those lower levels, stock prices seemed to be suggesting - particularly with interest rates so low - that profits would not just slump, but would stay at depressed levels for years. Growth is the norm, however. You need very good reasons (other than fanciful op-ed articles) for expecting it not to resume.
When investors do collectively panic - or cheer - they focus narrowly on the things that matter most to their investments: corporate income and interest rates. Sometimes, that investment focus may align with wider concerns. Often it doesn't, and markets seem callous, as when (for example) natural disasters, oppressive regimes, civil unrest (sadly topical on both sides of the world as we write), or the plight of refugees leave them unmoved.
As we noted in April, this is a special downturn in many ways. It is the most sudden; probably the deepest; the least contentious; the first to be led by services; it has broken financial records (the fastest bear and bull markets); it has led to the biggest and fastest policy response; and, most importantly, it has been the first deliberate downturn.
That latter point is important. There are few excesses needing to be corrected before recovery can begin - no speculative boom, lending binges or surging inflations to be unwound. Just as we chose to close part of the economy, we can reopen it.
Sudden, deep - and short?
Following China's earlier timeline, and the costs of suppression have become clearer, lockdowns have indeed begun to ease. As a result, this may yet be one of the shortest downturns. The contraction of the global economy was likely concentrated in the six weeks or so from mid-March - most economies are probably growing again now. The remarkable US jobs report for May is the most visible indication to date.
Profitability will bounce with growth. Countless columns have debated the speed and extent of the rebound, but to a stock market that fell by one-third the most important thing may be that it is there.
So, at the risk of overanalysing short-term market moves - an occupational hazard - we suspect investors initially overreacted.
Stocks usually "look across the valley"
On this reading, markets/investors have not been especially callous or disconnected from reality. Just as forward-looking market prices fell before economies did, they may have started to recover before them too. Stock prices usually "look across the valley" in this way (figures 1 and 2). But don't expect this to cheer the sub-editors
as they headline those second-quarter GDP and earnings data in July and August
Of course, lower interest rates are also encouraging investors to look across the valley, and they are not so closely aligned with human welfare as business conditions. One of the reasons people were sceptical about rising stock
prices after 2008 was that they were widely attributed to low rates - investors seemed to be gaining while economies were languishing.
However, we saw the post-2008 rebound in profits as the main driver of stocks, and saw healthy jobs growth as suggesting output was being under-recorded. Similarly, stocks' latest rebound likely owes more to the realisation that profits can revive, with the latest (small) reductions in interest rates and bond yields playing a subsidiary role.
Time horizons are long
In fact, we don't think stock valuations have ever fully reflected recent levels of interest rates. But even at higher rates than today's, prices would still implicitly be looking a long way ahead. Losing this year's cashflow might eliminate a small portion only of market value (figure 3). Of course, this is textbook theory. In practice, if it became clear that a full year's earnings were going to disappear, prices would doubtless temporarily dive as investors panicked anew.
In 2001 and 2008, earnings did indeed disappear. But rebounds were predictable - balance sheets (telecom, media and technology goodwill in 2001, bank assets in 2008) could only be written off once. A rebound is predictable now - lockdowns are easing.
That said, cyclically adjusted estimates suggest stocks are now neither especially cheap nor dear. We have been happy to hold and top-up positions throughout, but those positions are no smaller or bigger than usual.
Amid such seismic upheaval, it is hard to imagine “business as usual”. There will be many changed working arrangements and spending patterns. But we continue to think that the future will resemble the past more closely than many commentators are so confidently asserting.
Memories can be short. People's tastes may not change much. International comparative advantage still exists. Not everyone can afford to abandon materialism. When it comes to the really big questions - such as how best to organise economies - there are fewer available alternatives than people imagine anyway.
So we advise continuing to keep “big picture” analyses at arm's length, and to focus on pre-existing trends, such as an increasingly online, virtual and contactless economy; the gradual end of the oil age; and sustainable and responsible investing.
And prepare to return to an investment world in which US-China trade tensions, China's sovereignty in Hong Kong, the EU's approximating federalism, the presidential election (US corporate tax increases if Biden wins?) and Brexit once again feature prominently alongside economic indicators that (eventually) lose their sensational edge.
Click here to continue: Market Perspective: The bill
In this Market Perspective:
Download the full Market Perspective in PDF format (PDF 1.4 MB)