False Dawn? A market wrap of April

Equity markets saw a sharp bounce back in April, supported by the continued roll out of support packages and programs from governments and central banks; and the slowing of new COVID-19 infections (net of recoveries) and related deaths in many countries.

By month end, the S&P 500 in the US was up more than 30% from its March lows and losses for the year had been trimmed to less than 10%. As shown in the chart below, the US has fared considerably better than its developed market peers, in particular those in Europe. In Italian (FTSE MIB) and Spanish (Ibex 35) equity indices, losses for the year at month end were still 24.4% and 26.8%, respectively, on an equivalent total return basis. In major equity markets, only China which is further down the track in its COVID-19 experience, has proved more resilient than the US.

Part of the answer for such huge differences lies in the structure of the market in these different countries, in particular the dominance of tech in the US. This is further compounded by the concentration or lack of breadth in the US, with the 5 largest companies (Microsoft, Apple, Amazon, Alphabet, Facebook) representing 20% of the S&P 500 index, the same as the bottom 350 companies. The chart below highlights that this is even narrower than at the height of the tech bubble.

Highlighting the distortion caused by the largest stocks is the year to date total return of the median stock in the index at -15.7% total return, compared to -9.3% total return for the actual weighted index.

As noted by Peter Oppenheimer of Goldman Sachs in a recent strategy note, unusually for this stage in the market recovery, the rally has been led by quality and growth names and the outperformance of cyclicals has not been as marked as normal. He argues that this perhaps supports the view that it is the policy support referred to earlier that has driven the rally, by reducing tail risks, rather than a strong increase in growth expectations. Taking a step back from the monthly data, the chart below shows that this has been not only the quickest decline into a bear market, but also the sharpest recovery, at least so far.

In terms of how other asset classes fared, Fixed Income had a fairly calm month, after all the attention lavished from central banks to reduce stress and ease liquidity. In US Treasuries, the 2 Year yield barely diverged from 0.2% all month, whilst the US 10 Year yield stuck mostly close to around 0.6%. Credit spreads also indicated relative calm, falling into mid-month and then remaining stable: for US investment grade spreads then stayed below 200bps and for high yield below 775bps. LIBOR also eased off, having been initially stubborn, falling from 1.45% to below 0.7% for the 3 month benchmark rate.

For US High Yield, the performance was fairly modest (compared to equities) with the Bank of America High Yield index gaining 3.8%. High yield is likely to see highly bifurcated returns in coming months. Whilst one of the Fed’s many programs will support new ‘fallen angels’ at the higher quality end of the sector, there is no policy support at the lower end for CCC rated bonds and default rates are still expected to increase with the downturn in the economy.

The big story in Commodities in April came from oil. A lack of storage capacity and forecasted 'shut ins' had been flagged for some time, as there was very weak demand for existing production levels, but the price reaction was more violent than forecast. The problem was greatest for the US WTI benchmark contract that requires physical delivery in (landlocked) Cushing, Oklahoma. As the ‘front month’ contract for May expired (in April) and many ETFs and other exchange linked products had already ‘rolled’ into the next contract, there was no demand to take delivery at any (positive) price and price briefly fell to -$37, before expiring at $10. Volatility continued, but by month end prices had recovered to almost $19, helped by the agreed production cuts commencing on May 1st and some very gentle signs of increased US demand. The supply/demand imbalance and lack of storage is still likely to persist for a few more weeks and possibly longer, depending on how well/quickly economies get back closer to normal, so things may yet get worse before they get better for oil.

Gold had a good month, although still fairly volatile. A monthly gain of 7% took the annual gain to above 11%, but the path has certainly not been as steady as might have been hoped with the headwind from margin selling pressure having abated. After a high of $1,743 in mid-month, gold closed the month at $1,686. Still, going forward, the combination of negative real rates, risk aversion and returning emerging market consumer demand offer support for further gains. Overall for commodities, as they are spot assets and not anticipatory assets, they cannot be as forward looking as, say, equities. So whilst the rebalancing process has started, it may take a further 1-2 months to reach a bottom.

OUTLOOK

Considering the economic outlook first, before turning to the markets, in terms of economic output (real GDP growth), consensus forecasts for developed economies are -4% for 2020 followed by +3.5% in 2021, so the previous level of output therefore not being re-attained before 2022. In emerging markets expectations are better, helped by China, and the 2020 forecast is +1%, followed by +5.5% next year. It is of course early days in understanding the path to follow and these remain low confidence numbers.

The sensitivity of these forecasts was perhaps highlighted this week by the European Central Bank, who see their best case for the euro zone this year as -5% and the worst case as -12%. Arguably most telling though was their estimate that each month of lockdown takes between 2.0% and 2.5% of GDP away. Given that we cannot know how successful attempted re-opening of economies will be, this produces a huge error range of several standard deviations around the forecasts, with a massive skew to the downside.

One of the more reliable indicators in the short term remains US initial weekly jobless claims, for which the picture is shown in the Bloomberg chart below and getting gradually less bad week on week. It’s interesting that this week the market was disappointed that the figure was higher than the estimate of 3.5m new claims, even though the absolute number is falling – whereas in earlier weeks when the outcome was much higher and twice as bad as the estimate, the market rallied. Possibly a sign that a little more faith is being put in the estimates now whereas before no one had any idea what to expect so ignored the forecasts anyway. Also possibly just a sign of fading enthusiasm, given how far the rebound has gone.

Record Monthly Payroll data

Monthly non-farm payroll data certainly has the potential to be market moving next week. Expectations are currently for a monthly decline of 22 million and for the unemployment rate to go up from 4.5% to 15%. As much as its easy to make the rational argument that it should be about outcomes versus expectations, sometime with a change of this order (circa 30x worst GFC week) it might not be believed until it happens.

Earnings Outlook

Earnings results so far have been mixed and the month ended with some sobering comments from Amazon about a possible Q2 loss, despite surging sales, given new safety measures required. In any event, as with most quarterly data it’s a little too noisy to be that useful of itself as well as being a little early to draw any conclusions. The outlook is also made cloudier by many companies understandably withdrawing from providing guidance. Prior to COVID-19, around 50% of US companies provided 2020 EPS guidance, whereas this is now expected to fall to only 1 in 6. Forecasts from most brokers indicate that earnings are unlikely to re-attain their pre-pandemic path before 2022. Credit Suisse research shows that in the 13 recessions since 1935, its taken 2.5 years on average to regain the prior peak in trailing 12 months earnings; and taken roughly twice as long for earnings to recover as GDP. In ‘favour’ of the current situation though may be that ‘event driven’ recessions (which is how this one will be classified) tend to be shorter than average.

Equity Market Outlook

Equity markets in April seem to have been in somewhat of a honeymoon period before the direction of travel becomes clear. On the one hand they have the support of government and central banks and have a tailwind from net new infections in general being on a falling path. On the other hand it is too early to know whether or not what is currently baked in (if that can even be quantified) is too optimistic or not. As alluded to in the prior note from quarter end, the economic consensus appears to be that normality will start to resume in Q3, which is predicated on a hope/expectation that the mitigation measures taken will be successful; and that on starting to re-open economies there will not be significant relapses requiring further shutdowns.

As such the base case outlined only really has outcomes in the short term that are neutral or negative. If countries are successful and do not experience a significant second wave, we might expect markets to remain volatile and rangebound for a few months and consolidate until there is greater confidence that the worst has passed allowing progress later in the year. Pullbacks will doubtless occur along the way, particularly given that we have possibly already run a little too far ahead, but markets should hopefully remain well above previous lows in this scenario. If on the other hand shutdowns need to persist longer or follow a stop/start pattern, we can expect to see economic projections worsen beyond current base case expectations and markets follow a downward trend, with April proving to have been a bear market rally. In the meantime, economic data will start to become gradually more meaningful, which will also play a role in comparing it to expectations.

In considering any cash that may be available to deploy, whilst it’s easy to see the argument for better entry levels, which may well occur, it also needs to be borne in mind that there is no guarantee this will transpire. So a phased policy of continuing to average in would remain sensible. Back to the Oppenheimer strategy note referred to earlier, he believes that in the current environment with scarce growth and scarce income, growth companies and sustainable dividend payers are likely to prosper. As will those with strong balance sheets, given higher debt levels.

All data/charts not separately attributed above from Bloomberg.