Thoughts on the Markets:
June 10, 2020
This summer will be an important time to give us clues regarding how the economic recovery will progress. Two important two reasons, one, unemployment insurance payments will fall off and two, temporary stimulus measures will run off as well at the end of July. This is when we should see to what extent there will be re-hiring from the temporary layoff pool. From this point the employment data will take a more important meaning for the future.
Thus far the extra income (from MMT) has gone mostly into savings (U.S. savings rate up to +13%), this extra income will disappear in August, question: will the renewed consumer confidence turn into real demand?
August will also be important in terms of COVID-19 developments. While all the experts are anticipating a second wave, how big it will be is an unknown. For those countries being the first impacted by COVID-19 we are seeing a second wave, thankfully thus far it has been manageable. Let’s see how the U.S. manages.
GDP estimates have been slashed significantly, below are current estimates:
U.S. GDP in 2019 was $21.44 Trillion, base case for 2020 is: Q1 -5.0%, Q2 estimates are in the -30%—50% range.
IMF estimates for year 2020 are -3% GDP worldwide, with advanced economies at -6.1% and emerging economies at -1%.
IMF estimates for 2021 are +5.8% GDP worldwide, with advanced economies at +4.5% and emerging economies at 6.6%.
World Bank estimates for 2020 -5.2% GDP (deepest recession since WWII), and +4.2% for 2021 Globally
World Bank estimate for USA in 2020 is at -6.1% for 2020, and +4.0% for 2021
Simple math tells us that we will not be back to 2019 GDP levels before sometime during 2022.
More importantly what will happen to Corporate profit growth?
Current earnings estimates (consensus) are as follows:
2020 SP500 125.48
2021 SP500 164.48 (reference 2019 was 162.93)
2020 STOXX600 15.977
2021 STOXX600 20.458 (reference 2019 was 23.05)
(Earnings estimates from REFINITIV aggregated data)
The $100 question is are these estimates reasonable?
On the surface these estimates may look reasonable BUT I cannot see profitability growth exceeding revenue growth as forecasted for the SP500. COVID-19 will certainly make the cost of doing business go up in so many ways and I don’t see any business being immune from this. Some will be more insulated (tech) others will be deeply impacted (services). My thought is that while 2020 estimates may be closer to reality, 2021 could easily be a BIG miss!
With both the SP500 and STOXX600 trading on 25X 2020 estimates there is no room for error. The key factor here has been the importance of MMT in supporting the market. Mr. Market is telling us that he has effectively written off 2020 earnings.
The SP500 is trading on 19.6X 2021 estimates which leaves little margin for error. Bear in mind my model is based on 10Y at 0.81% and shows the SP500 11% over fair value (normally + or -10% not a big deal longer term), but it should be noted that the model’s sensitivity to rates is huge. The more rates move up the more expensive the market will become. Therefore, watch out for inflation risk as MMT takes hold as this will at some point cause multiple compression.
I think we continue to be in a sweet spot for equities, but this is unlikely to last much longer. I did not anticipate such a strong recovery in equity markets (my bad) and have remained more defensively positioned. However, we are seeing more and more signs of irrational exuberance. The day traders are all geniuses today…hmm reminds me of another time (a la 1999). The August-September data (as mentioned above) will be critical to see what kind of recovery we will have and how sustainable it will be.
Key things to watch:
1. Rates: where the 10 year is going? Portfolio no longer exposed to long end of the curve. Prefer TIPS as easy money has been made on the long end. Rates may go lower but how much? Never been a believer in squeezing out the last nickel of profit from a trade.
2. USD: I would expect weakness in the USD to continue. This will be bullish for Emerging Markets, though I have not added emerging markets as yet. What is holding me back is COVID-19, as some large emerging economies very exposed (Brazil), and questions around the sustainability of the recovery.
3. Stay long Gold and gold equities. There will be volatility particularly with the equities but for me a core long term holding.
4. Equities: Prefer value/slow steady growth. While the FANGS have been the place to be, I expect this to change moving forward.
5. Portfolio Risk: portfolio is not positioned for an extended deflationary period. I recognize the risk of deflation (a consensus view, by the way) but I believe MMT will insure it is short lived. I am more concerned about being correctly positioned for inflation down the road. Refer back to my rates argument, the big money has been made with falling rates, time to move on.
Final thought: In 30 years I have never seen market moves like we are seeing today. The market appears to be discounting a full and quick recovery. From my experience this never happens, there will be setbacks. We need to be prepared for this as these setbacks will provide great opportunities for the long term investor. The good news is that, for better or worse, central banks have taken care of the liquidity concerns with their swift heavy intervention. The question remains how quickly will the demand side recover?
Be safe and good trading!
Alan