Short and Sharp: The weeks when decades happened

Although the second quarter of 2020 will mark the worst quarter for United States and global growth since World War II, market uncertainty and peak fear have passed and, dare I say it, potentially the equity market trough too. With new coronavirus cases peaking, although not yet declining, countries are eager to lift national lockdown measures sooner rather than later, judging the economic pain wreaked by COVID-19 containment measures to be worse than the infection itself.

Market dynamics have been brutal. While the scale of the public health emergency helps to explain some of the extreme downward market movements in March, the intense de-risking by investors also sharply contributed to the drastic falls as soaring volatility forced risk-focused investors to sell.

But now, as a result of these actions, investors have built up meaningful cash positions suggesting that, not only is indiscriminate selling behind us, but investors have sufficient dry powder to take advantage of attractively valued risk assets. In other words, market positioning may now work to propel markets higher. What’s more, decisive policymaker intervention has short circuited extreme volatility, sending a strong buy signal for many risk conscious investors.

Central bank action has also directly provided very strong positive technical signals for financial markets. For example, the U.S. Federal Reserve’s (Fed) recent announcement that it will purchase the “fallen angels” segment of high yield has spurred a record weekly inflow into the sector and prompted a sharp tightening in high yield credit spreads.

Yet, while Fed corporate asset purchase are certainly powerful from a market sentiment standpoint, they cannot offset the weakness of high yield balance sheets. Unless there are fundamental improvements in the underlying economy, defaults and bankruptcies will still rise—even if recent market movements suggest the opposite.

Timely and sizeable loan programs from the government and central bank should certainly help to limit insolvencies. Unfortunately, however, the news isn’t quite as positive as it should be. The Fed’s Main Street Business Lending program is clearly promising. However, there are significant concerns about the ability of companies to access those loans, perhaps due to banks’ reluctance to lend to struggling businesses.

Until this is resolved, there will be the obvious negative implications for small business bankruptcies, prolonged unemployment and consumer credit defaults which, in turn, will further suppress demand, suggesting a slower economic recovery. Already, nearly all the U.S. job gains since the financial crisis have been erased in the space of just four weeks and further losses are likely, with the unemployment rate in the United States potentially hitting 15% by mid-year, if not higher.

Recent GDP data in China were better than expected, filling many investors with hope about the U.S. and European outlooks. Yet, its retail sales figures suggest a very different prospect. Reports indicate that although businesses have re-opened, consumers are simply not returning due to either caution about household finances or fear of catching coronavirus.

This should provide some insights for rest of the world: reopening will be hard. Any return of daily routine and economic activity will take time, a prospect reinforced by secondary waves of infection now cropping up in parts of Asia. Sharp testing may help to reassure people that resuming normal activity is safe. But rushing the re-opening process, before sufficient hospital capacity, testing kits and contact tracing technology are in place—as some governments appear keen to do—will only end up injecting more uncertainty and fear, risking the potential economic recovery.

Investors should, therefore, brace themselves for prolonged economic weakness. Although governments are looking to lift lockdowns, the re-opening of economies will be only gradual, compounding financial strains for businesses and households.

So, with all this in mind, is the recent bull market currently underway sustainable? History suggests it’s unlikely—in almost all pullbacks, equity indices retest their lows from the initial wave of selling.

It’s worth noting too that the impressive bounce in the S&P 500 index from its March trough has been narrowly focused on big tech. In fact, some commentators have suggested that four out of every five stocks are still in a bear market. Indeed, while the S&P 500 is indicating good times ahead, European benchmark equity indices and the U.S. small-cap index are very much still in bear market territory, throwing severe doubts on the impression that investors are optimistic about the outlook.

Certainly, the combination of unprecedented policy support and a flattening viral curve has dramatically reduced downside risk for the global economy and financial markets. A lifting of lockdowns—how ever gradual and stilting they may be—will result in a rise in economic activity from a very low base, so quarter-on-quarter GDP growth is likely to be positive in Q3. Yet, markets appear to be over-optimistic about the likely recovery.

Of course, further policymaker stimulus will be forthcoming if the economy fails to recover and markets find themselves struggling again. Fed President Powell’s most recent statement was extremely powerful, suggesting that the response of fiscal and monetary authorities will continue to grow as needed. Yet while this undoubtedly sends strong positive technical signals, these optics are unlikely to fully hold back a wave of defaults and bankruptcies, nor prevent cautious consumer behaviour as they continue to fear the coronavirus.

It seems then, with financial markets signalling a narrative that appears to be very detached from the likely jilted and slow economic recovery, equities are likely to retrace some of their recent gains. At least investors can take comfort from the fact that the worst of the pandemic is likely behind us, the market bottoming process is underway, and with markets typically leading the economy, we are—plausibly—clear of the market lows.