Market report June 2020
Global stock markets surged in the second quarter, fueled by stimulus measures and progress in fighting the virus. Investors face new threats in the third quarter, businesses and individual countries are counting the costs of the pandemic and preparing for the second wave of the virus.
Following the crash in the first quarter, stock prices rose in April, May and June as many economies opened up and business resumed. At the end of the second quarter, the rates of return on stocks slightly decreased. Increased volatility continued, the MSCI World index rose 18.5% in the second quarter, remaining 5.3% below its level at the beginning of the year. US equities led the way in developed markets, while Japanese and British equities underperformed.
Chart: Growth in global stock markets due to reactivation of the global economy
Global Markets vs Lockdown*
Regional Returns: Q2 2020 (local currency,%)
Historical results and ongoing analysis do not guarantee future results. As of June 30, 2020.
* Ease of lockdown vs stock markets, based on the severity index published by the University of Oxford (chart left). Global equities represented by MSCI World (USD) US small cap represented by Russell 2000, US large capitalization companies S&P 500, Australia by S&P/ ASX 300, emerging markets by MSCI Emerging Markets. China – MSCI China A, Europe – without Great Britain – MSCI Europe – without Great Britain. Japan by TOPIX and Great Britain by FTSE All-Share.
Source: Bloomberg, FactSet, FTSE, MSCI, Russell Investments, S&P, Tokyo Stock Exchange. University of Oxford and AllianceBernstein
Extreme emotions among investors
This reflection caused mixed emotions. Investors most likely believed that the 20% drop in global equity prices in the first quarter proved to be temporary. It was also an investing lesson in how to stay calm during a market panic. By selling in the midst of a crash, investors risk locking in losses and sacrificing the recovery potential as pinpointing turning points in the market is difficult. The risk is high. Market results at the end of the quarter indicate that rising COVID-19 cases could trigger another wave of sell-off (which we expect in the autumn). Despite the improvement in macroeconomic data, the global economy is undergoing the greatest recession in modern history.
To a large extent the growth reflects the fact that investors’ worst fears have been allayed. The road to a lasting recovery will be difficult, a total global crash or a prolonged depression seem unlikely at the moment, given the financial and monetary obligations to stimulate governments and central banks. In fact, interest rates are expected to remain historically low for several years, which will further reduce the attractiveness of government bonds. It also compresses the discount rates used by investors to measure the present value of companies’ future cash flows, making those cash flows more valuable today. Market gains also resulted from the sharp increase in retail volumes. And with record amounts of cash being invested in money-market funds, there is plenty of pent-up purchasing power to use when confidence rises.
The market is not growing widely, but taking into account individual sectors
Market confidence varies by sector. Many tech companies continued to climb in the second quarter as investors rewarded businesses that enable remote work, shopping and other home related activities (stay at home stocks). Cyclical sectors surpassed defensive sectors. However, financial funds continued to struggle with low interest rates and an increased risk of default. Value stocks, which include a large proportion of banks, continued to underperform with respect to the growth stocks. The extreme case is the Russell 1000 Growth Index, where five companies now account for a record 36.9% of the overall benchmark. In general global benchmarks, the same names (Microsoft, Apple, Amazon, Alphabet, Facebook) have more combined weight than the market of any country other than the US. As a result, US equities now account for 66% of MSCI World, up from just 30% three decades ago.
Chart: Cyclical sectors and growth stocks led to uneven growth
Historical results and ongoing analysis do not guarantee future results. As of June 30, 2020. All index returns are in local currency.
Based on GICS sectors. The defensive sector includes consumer basic products, healthcare, communication services and tools; resources consist of energy and materials; cyclical consists of the discretionary activity of consumers, industry and technology.
Source: FactSet, MSCI
What awaits us
Investors should be prepared for more surprises, as the risk of the virus persists. Many firms have suspended their earnings forecasts in their first quarter reports, which led to a very wide dispersion in earnings forecasts. Investors should be clearer about which companies are better able to deal with the effects of the pandemic and which are not, as the second-quarter earnings season starts this month. In such an environment, investors whose research process has its source in deep industry and company knowledge will have an advantage.
Investing in the wake of the COVID-19 crisis requires developing long-term cash flow projections that reflect a highly uncertain environment. Sectors and industries will be redefined, as weaker firms will collapse and stronger firms will grow. This requires examining balance sheets and working with management boards to determine which companies are making sound strategic decisions, to distinguish winners from losers in the current crisis.
We should get used to volatility as the defining feature of today’s markets, not allowing for sudden fluctuations in any direction that can thwart strategic goals. Revising your risk tolerance in an unstable world and appropriately diversified exposure will help. There are now many ways to leverage your capital’s long-term potential with varying levels of downside protection. It’s also worth looking at regional and style exposures to make sure the allocation is not overly prone to elevated valuations or country concentrations that could change rapidly.
It is possible that equity markets could rise above a major exogenous shock if they receive enough outside help. But the performance patterns were not uniform. As the crisis unfolds, avoiding the most vulnerable companies and identifying companies that will survive will be necessary to generate long-term positive returns in a market that, as a result of recession and recovery, may still reflect a wide dispersion of results.
Stock prices vs fundamentals
The rise in prices in the US stock market that began on March 23 has surprised and often confused many professional investors. Among the most important, would mention four of the most important explanations for the current decoupling of US stock market prices from economic fundamentals:
- Divergent expectations of economic recovery and the consensus of economists.
- Divergent earnings expectations across sectors or stocks (FAANG).
- Pavlovian markets, responding to announcements of an expansionary monetary and / or fiscal policy.
- A technical rally whose dynamism comes from new investors and is reinforced by systematic investment strategies.
Find the last two arguments the most convincing. New retail investors’ expectations are different from those of professional or seasoned retail investors: it is not financial media, but social media (lifestyle networks) that dominate. The investment behavior of “new retailers” shows an alarming degree of risk taking (knowingly or due to a lack of financial literacy), also through the extensive use of derivatives. In some market segments, “new retailers” have already achieved a great deal of importance. Current conditions in the US stock market appear to be fragile due to decoupling from fundamental factors and the highly speculative rationale for investment, as well as regulatory and operational risks.
Divergent earnings expectations across sectors or stocks (FAANG)
We are dealing with divergent expectations of investors operating in the stock markets, bonds and international organizations as well as decision makers, about the shape of the economic recovery in the US. As of today, the stock market is pricing in a rapid recovery in the entire US economy, with the S&P 500 expected to return to the pre-crisis level of EPS in Q1 2021. Meanwhile, international organizations (IMF, OECD) and economists’ consensus say that the economic recovery will be much slower and the pre-crisis level will only be reached a year later, in mid-2022. This most likely means that investors expect large US listed companies to grow much faster than the rest of the US economy, which in turn causes US equity indices to rise.
The second plausible explanation is that the US stock markets do not reflect expectations for the growth of the economy as a whole, but only present very high profit expectations for certain sectors, especially technology stocks (FAANG). Due to their important weightings in major US stock indices, as explained in this explanation, the entire market was pulled up by this pro-technological rotation of the sector. Periods of high dispersion have historically been associated with volatile market conditions and have been a reliable lead indicator for future corrections. This means that for this technology-driven growth to be sustainable, the sector’s revenues would need to become largely independent of the real economy or built on sustainable economic rent.
The third explanation is that market movements are no longer based on core valuation indicators, but only respond to announcements of expansionary monetary and/or fiscal policy measures, with the result that the response time between the announcement and the rise in the stock market has become increasingly shorter. During the Covid-19 crisis, the response to the huge fiscal and monetary stimulus package was almost immediate, if not premature. As a consequence, the stock market has integrated the effectiveness of these policy measures and no longer requires any hard evidence (e.g. whether the Fed is really buying what it says it will buy). It can be said that policymakers have become so credible in the minds of the capital markets, that they can trigger a Pavlovian conditional “buy” reaction with a simple announcement. Paradoxically, this credibility of the policy-making process may have become a new source of a structural gap as policymakers now have to fully meet market expectations that may have become and persistently exorbitant.
Retail sales dynamics
The fourth explanation is that it is a technical growth whose dynamics comes from the retail sector and is reinforced by systematic strategies such as risk parity and the CTA trend.
Institutional investors did not drive the latest rally. On the contrary, their holdings in money market funds have grown significantly since the beginning of the year. The much lower liquidity in the futures market indicates that there are few active institutional investors participating in this market. With 34% of domestic equity, US households have the critical mass to move the market. However, in the past, they tended to use buy and hold strategies, and their arrival in the market was often a signal that the rally was over. NEO brokers such as Robinhood and Citadel Securities have lowered the barrier to entry into the stock market. They also widened the range of available products (split shares, options, leveraged certificates) and reduced the transaction cost to almost zero. This may explain the strong increase in daily volume of transactions on US online brokerage platforms. It could be said that neo-brokers moved the toolkit from Wall Street to Main Street. So, even if only a small fraction of retail investors got active on these new platforms and only a small fraction of the huge extra savings (savings rate from 8.2% in February to 33% in April) and the government stimulus was directed to these platforms, it is big the chance that due to the high turnover, retail investors are now exercising a significant influence in setting prices in the equity markets.
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The views expressed in this document are not research, investment or commercial advice, and do not necessarily reflect the views of all management teams. They change over time.