10 May 2020

Every day one hears the grim news regarding the global economic outlook. Nevertheless, financial markets continue to rebound relentlessly. What’s up? The markets are working through various phases in coming to grips with the Covid-19 emergency. In the first phase, investors panicked as the Coronavirus spread world-wide, lockdowns were intensified, and fears of global depression escalated. In the current second stage, financial markets have been buoyed by the assertive global monetary and fiscal policy response, early indications that the spread of the virus is slowing, and positive signals that the development of a vaccine is progressing.

I believe markets may now be transitioning into a more uncertain interval. To be sure, the prospect of an easing in lockdown conditions is reassuring. However, I suspect we will soon discover that before an effective vaccine emerges and is distributed world-wide, the reality of living alongside the Coronavirus will prove to be highly complicated.

In this third phase, investors should heed the warning heard on the London underground to “mind the gap”. Of course, I am not referring to the space between the train and the platform; but rather, the chasm separating rebounding markets and economic fundamentals. I am not turning bearish, although the S&P 500 has already hit my 12-month target. As we begin to encounter the challenges involved with ending economic lockdown, I suspect financial markets will again become more volatile. Another 10% slump in the equity prices would not be surprising at some stage in the months ahead. And, this is before we begin considering the implications of Stage 4: a post-Covid world with high debt and globalisation under threat.

Gazing Beyond the Abyss

In an earlier blog entitled “Covid Forecasts: Don’t Lack Imagination”, I warned the coming recession would be more severe than following the Global Financial Crisis (GFC). I optimistically suggested, however, the recovery would be stronger than the previous downturn, and the pre-Covid level of GDP would be restored around the end of 2021. This outlook is now widely accepted. The IMF’s recent global forecast revision projects that after slumping 6.1% in 2020, the world’s advanced economies will rebound 4.5% next year. The ECB’s Survey of Professional Forecasters reaches similar conclusions.

Financial markets have been willing to look past the abyss, and to focus on the 2021 recovery, largely reflecting a positive appraisal of the implementation of aggressive monetary and fiscal policy measures. Indeed, the Chart above illustrates that the global fiscal stimulus is larger and earlier than during the GFC.

Likewise, a sobering reassessment of the outlook for corporate EPS prospects has taken place. The chart above illustrates that analysts now expect an 18% decline in S&P 500 earnings this year, compared to only -4% just a month ago. I could quibble, as I expect a 25% decline, but the reappraisal is welcome. Furthermore, reflecting the prompt economic recovery, the following Chart indicates forecasters expect a 25% EPS rebound in 2021. This V-shaped earnings recovery would leave 2021 earnings above the 2019 level. Again, I do not dispute these conclusions, as I forecast a 35% EPS rebound next year.

Phase 3: What Could Go Wrong?

As optimistic financial markets enter Phase 3 — re-opening the economy prior to the availability of proven treatment and a vaccine — it’s worth considering what could go wrong. Where to begin. A key reason for the market’s rebound has been positive signs mitigation efforts are working. Thankfully, the following Chart does indicate the “infection curve is flattening”. However, it’s worth noting that the number of new cases world-wide is not yet on a decisively downward trend.

Fortunately, Europe does appear to have turned the corner at last, and the death and case count is now declining consistently. However, there are still potential hot-spots. The following Chart indicates that while the number of daily deaths in the USA may have peaked, the level remains high, and has not yet begun to decline. Even though the mortality rate should slow further, the Trump Administration’s push to re-open may prove to be hasty.

Likewise, new problem areas could still emerge. For example, while the Covid-19 death count in Russia remains low, the recent acceleration in new cases is worrying. A similar pattern is appearing in Brazil. Other developing countries, especially those with weak health care systems, could be vulnerable, especially as summer ends in the southern hemisphere.

Even in developed countries, it is universally accepted that an aggressive test-track-and trace strategy must be implemented to quickly identify and isolate emerging hot-spots. Experts indicate this is quite feasible, but will require vastly higher testing capabilities than now exist. The UK and USA, amongst others, already appear to be struggling with this logistical challenge. If on-again, off-again lockdowns become necessary to prevent a new spike in infections, economic recovery will be impeded. Maintaining the necessary high degree of public compliance would be challenging.

How will social-distancing be maintained in the workplace? Who will monitor compliance? What will be the complaint procedure for workers? Who would be willing to complain as massive layoffs are still occurring? Answers to these practical questions are necessary for employees to feel safe returning to work.

The success of lockdown mitigation efforts have relied heavily on the public’s belief that “we are all in this together”. How will this solidarity be maintained if distinctions are made by geography, age, health, ethnicity, etc.?

And, perhaps most importantly, there are huge practical, specific challenges confronting each sector of the economy. For example, airport and aviation executives already suggest that maintaining social distancing is impossible. The same is likely true in urban transport systems.

We could all add to the list. However, the implication is that economic activity may not snap back in the way financial markets now appear to be anticipating. The Chart above compares previous economic cycles. Even though the Covid downturn is projected to be deeper than following the GFC, the level of pre-recession GDP is recouped within 8 quarters (two years) from the previous peak. The GFC recovery took nearly 3 years to restore lost output. However, the chart also illustrates if mitigation measures need to be re-introduced, e.g. following a second round of infection next winter, the pre-emergency level of GDP may not be restored for up to four years (nearly twice as long as following the severe 1982 slump)!

Has Valuation Become Irrelevant?

Financial markets can only price one possibility at a time. Investors, however, must consider numerous outcomes, and manage risk accordingly. The markets are now priced for a perfectly reasonable outlook: economic re-opening leading to a recovery recouping GDP and EPS losses by the end of 2021. Indeed, I outlined precisely this scenario last month in establishing a 12-month S&P 500 price target of 2,900.

However plausible, this is not the only possible outcome; indeed, the degree in forecasting uncertainty has rarely been greater. One hears the suggestion that valuation is irrelevant in such unclear conditions. I disagree. Furthermore, I believe valuation metrics must reflect the currenct lack of clarity. Following the recent rebound, the Chart above (provided by Morgan Stanley) suggests this is not the case. The S&P 500 Earnings Yield Ratio (EYR) is now in line with the past five years, despite the uncertain outlook. Using an EYR of 5 and my $170 EPS projection for 2021 translates into a 2,900 market level. As this scenario is now priced in the market, meaningful setbacks (10%) are quite possible if the projected economic recovery falters.

The Chart above illustrates that European markets trade at an historic discount to the USA. As Europe’s mitigation efforts appear to be working, it is quite possible the region’s economic recovery may begin earlier than in the USA (although Europe’s recession is likely to be deeper). This may contribute to market outperformance, althought I would not bet the house on it yet.

As I outlined in a recent blog “Emerging Markets: Bracing for Bad News”, I do not think the EM discount to developed markets sufficiently reflects the risks facing the global economy.

Strategic Implications

• Financial markets are entering Phase 3 of the Covid cycle. Optimism about the prospect of economic re-opening must be balanced by a more sober evaluation of the complications, and possible setbacks, that lie ahead.
• Markets are priced for a realistic, albiet optimistic (under the circumstances), economic scenario. Renewed volatility is likely, if investors consider other pathways for the economy or if the eventual recovery falters.
• I stick with my 2,900 12-month S&P 500 target. Higher market levels would require a PE expansion beyond my 17X 2021 EPS forecast, or a much stronger-than-expected earnings recovery. Of course, development of a vaccine this year would be a game-changer, propelling the market towards 3,400.
• Europe looks cheap, but it’s not for the faint-hearted.
• EM’s discount is not likely to be enough to tempt investors this year.