There are few certainties in markets and economies and with most countries globally facing what could be the worst economic collapse in the post-war era, it is surprising to see markets and most risk assets continue their remarkable rebound. The shape of the recovery in risky assets certainly looks V-shaped today, as most markets have posted gains of around 30% since bottoming near the end of March. Is this a true reflection of what is going on in the underlying economy or is there a big disconnect?
Conventional wisdom says the market’s comparatively modest net decline since the start of the pandemic is due to the fact that the market is forward-looking, and investors have already accounted for what is likely to be a severe drop in second quarter earnings, followed by a sharp recovery. Stock prices reflect a series of expected future earnings, discounted to the present day. Hence, they don’t only reflect what is happening now, but also what is forecast for the next several years. Economic data on the other hand is backward looking and only tells us about what has happened in the past.
We should also acknowledge that the composition of the stock market and the economy is very different. Large tech firms (Microsoft, Facebook, Google, Amazon and Apple) represent around 25% of the S&P 500 index, whereas their combined revenues account for less than 10% of US GDP. These large companies also generate a large proportion of their revenues overseas. Stock indices are mostly weighted towards larger companies which may be more likely to survive the downturn and this size bias, may therefore, underplay the impact of the wider economic damage.
The level of support from governments and central banks globally has bolstered investors’ confidence that the market will not retest the March lows. Authorities have reacted with extraordinary measures both in terms of magnitude and speed. We have witnessed measures that have never been taken before such as the Fed buying sub investment grade credit (to support the ‘fallen angels’) and the UK government’s coronavirus job retention scheme (CJRS). These actions have certainly calmed the storm.
There are also other explanations for the risk asset rebound rooted in investor psychology. Market momentum and herding behaviour among investors as a result of ‘FOMO’ - the fear of missing out - is another driver behind the rise in prices. Awareness of other peoples’ success spurs investors to jump on the bandwagon.
So, what are the risks to this recovery? Markets remain vulnerable to a turn in sentiment so a second wave of Covid-19 and renewed lockdowns would likely be a major setback. Even before the pandemic, valuations were at lofty levels which might have contributed to the sharpness of the sell-off in March. Today markets are almost back to similar levels so other things being equal – which they are not – they would be sensitive to a pull back. Increasing geopolitical risks such as worsening US/China relations should not be ignored. Shorter term and more local challenges, for example in the UK when the business rates holiday period and the CJRS scheme winds down, will increase the pressure on businesses. We are less concerned over the medium to longer term outlook as this is an event driven shock and we view it as more transitory in nature; a very sharp fall in economic output but a recovery that is less drawn out than a post Global Financial Crisis.
On the back of this very strong rebound in risk assets it is prudent to pause and reflect. We remain optimistic, but we acknowledge the various risks posited above and have adjusted portfolio positioning to retain upside whilst protecting downside, balancing perceived risks and returns to ensure our investors have the highest probability of achieving their stated portfolio outcome whilst reducing shorter term pain.