FAQs: Addressing renewed equity volatility

Equity market volatility returned last week as a downbeat economic assessment by the Federal Reserve and rising coronavirus infections in some US states undermined recent positive stock market sentiment. The selloff prompted the question of whether there is a disconnect between the markets and the economy. Here we answer that question and others raised by clients at our latest Livestream video event.

1. Why are markets so detached from economic reality?

Equities fell sharply on 11 June, following discouraging news regarding a second wave of COVID-19 infections in parts of the US, including large states such as California, Texas, Florida, and Arizona. The S&P 500 suffered a 6% one-day drop, after earlier in the week rallying back to the year’s starting point, while the Nasdaq reached an all-time high. This does seem at odds with the sharp economic contraction in the US and around the world.

This apparent divergence can be explained in two ways.

• First, stock markets are forward looking, and have been reacting to the outlook for the coming year and beyond, rather than to data showing the severity of the economic contraction in April and May. We are still confident that with positive medical developments and supportive stimulus measures, economies will be able to reopen sustainably without a second wave of infection overwhelming healthcare systems.
• Second, publicly listed companies in the US, for example, only represent around 25% of economic output, while smaller unlisted companies account for the remainder. The COVID-19 crisis has been tougher on smaller companies in general, so it is possible to see a divergence between US stocks and the US economy.

2. Are we headed for a second wave in virus infections?

Rising numbers of new coronavirus cases in some US states that have reopened also prompted news headlines about the potential for a broad second wave of infections.

But at present, we do not see the latest US virus developments leading to a reimposition of national, or even statewide, lockdowns. It is important to note that the increase in new infections is not broad-based, and in some cases is a continuation of the first wave that has yet to peak, rather than a second wave. In Georgia, for example, new cases have reached a plateau, despite being six weeks into reopening. Overall, US infection rates continue to fall. In the US states where infections have risen, they remain low relative to hospital capacity.

Furthermore, while news headlines may focus on fears of a second wave, markets are more likely to focus on the consumer response. So far, mobility data shows that consumers have remained active in spite of "second wave" headlines, even in those states where infections are rising. In addition, we are seeing less evidence of a significant second wave so far in European nations.

3. Is fiscal stimulus having the desired results, and how will this be paid back?

Fiscal stimulus measures have certainly cushioned the blow from COVID-19, and in particular have reduced the rise in unemployment in many parts of the world. In addition, as economies reopen, we expect consumers to spend more of their stimulus money—especially those that are confident of keeping their jobs. If there is no second wave of infections, therefore, this stimulus should help speed up the pace of the economic recovery. Of course, the stimulus will mean a more indebted world after COVID-19.

We believe that governments will deal with this in a combination of three ways—financial repression to keep interest rates low, higher taxes, and a willingness by central banks to tolerate moderately above-target inflation. All of these steps have important implications for investors.

4. Is there still value in credit?

Credit spreads have narrowed significantly since their March peaks and are closing in on our central scenario target spread levels. Scope remains for further spread tightening, but the bulk of the move is probably over. Credit remains attractive, although yield and carry are now the main drivers. Against a backdrop of central bank buying and lower for longer policy rates, the search for yield is back on. The yield-to-worst for US high yield and EMBIGD is significantly higher than for high grade bonds.

5. Why enter the market at these levels?

Global stocks are just around 5% below their all-time highs set in February, and after a 40% rally it can seem daunting to enter the market, especially with the uncertainty surrounding the coronavirus.

As noted above, we are still confident that with positive medical developments and supportive stimulus measures, economies will reopen sustainably without a second wave of infection overwhelming healthcare systems. This should leave room for stocks to run higher in both our central and upside scenarios.

On average, it's best to put all of your excess cash to work straight away.

Many investors find themselves sitting on the sidelines today, holding excess cash that they would like to put into the market. While there is a certain allure to the idea that we can enter the market at the perfect time —buying stocks at their lowest level, and reducing risk before the crowd— the unfortunate truth is that "buy low, sell high" is a dangerous fallacy, and market timing is a costly exercise.

On average, it's best to put all of your excess cash to work straight away. But for investors looking to protect against the risk of bad timing, we believe the best strategy is "dollar cost averaging" their planned allocation to riskier assets. We recommend establishing a set schedule—generally within 12 months or less—in order to reduce the cost of missing out on gains. In addition, we recommend accelerating each phase-in "tranche" if there is a market dip of at least 5% or 10%.

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