The equity market recovery since the March bear market has been impressive. Investors looked through the uncertainty brought about by the COVID-19 pandemic, resulting in one of the quickest recoveries from a bear market in history. This rally was hardly expected in March, when economic forecasts were slashed, and nationwide lockdowns were being imposed to help control the spread.
The strength of the price recovery (in terms of speed and magnitude) was surprising in view of the deep economic shock. The sharp moves observed this year (up and down) are mostly explained by the driver of the bear market, in this case COVID-19, rather than a function of structural imbalances or a financial bubble. The latter would have led to a deeper bear market and a longer recovery period, like the 2008 financial crisis, with the bear market lasting for roughly 17 months (compared to one month this year).
Despite the rally in the equity market the risks to the global economy are skewed to the downside. Economists currently expect the global economy to slow down in the fourth quarter of 2020, as governments, especially in Europe, have been forced to impose regional or nationwide lockdown as hospitalisations surged.
Policy actions taken by governments and central banks have helped to minimise any scarring effects on the economy. Unemployment is still relatively low in Europe and the UK due to the furlough schemes. Across the pond, unemployment in the US was much worse, but more importantly, a huge chunk of this was temporary unemployment, which means that this will reverse once economic activity picks up. This bodes well for the global economic outlook for 2021.
The rally in the stock market has been dominated by the stay-at-home stocks and other growth stocks, which are less susceptible to changes in the economic cycle. In fact, looking below the index level, traditional value sectors and industries (generally those sectors trading on a lower Price-Earnings ratio, Price-to-Book ratio and offer a better dividend yield than the market) have been left behind in the post-March rally. This is due to investor concern around the macroeconomic backdrop due to COVID-19.
The announcement by Pfizer last week that their vaccine was “found to be more than 90 per cent effective in preventing COVID-19 in participants” led to a strong rotation into these value names. Airline and hospitality stocks rallied sharply as investors started to price in an earlier return to some sort of normality, while financial stocks (banks and insurance companies) also outperformed the index. We expect this rotation into value stocks to gain additional momentum as the impact of the vaccine on the global economy becomes clearer. The current consensus expectation is for the global economy to grow 5.2 per cent in FY21 after a 3.9 per cent contraction in 2020. The stronger expected growth, coupled by a steeper yield curve as inflation starts to pick up from a very low base, should be supportive for value stocks in the near term.
Based on current information, we could see European equities outperform their US peers
The economic outlook in Europe has deteriorated sharply in recent weeks due to the lockdown measures employed to help control the spread. Looking at country impact, we expect the German economy to perform best during this period as its economy is less exposed to the lockdown impact as opposed to the other southern European countries like Italy and Spain. The German economy is heavily reliant on global trade conditions for its exports, rather than sectors that are heavily hit by lockdowns, like tourism.
On balance, the current restrictions are lighter, so far, than those imposed earlier this year, but the risk remains that lockdowns will be imposed for longer than currently expected, which would lead to a delayed economic recovery. We expect any such development to be negative for the equity market, especially value stocks.
Government debt has risen sharply since the start of COVID-19. Governments have implemented various schemes aimed to help prop up their respective economies, mostly financed through debt. The risk exists that Europe goes through another round of sovereign debt crisis, similar to what happened eight years ago. This would potentially lead to higher political risk as these countries are required to comply with strict fiscal consolidation programmes.
The United States had to contend with an election in 2020 during a global pandemic. Our view has always been that the approval of a vaccine is more important to the equity market than the election outcome. The risk of a Biden victory was mainly his intention to reverse Trump’s 2017 tax cuts, a major catalyst for the rally in the equity market in that year.
However, the Republican-controlled Senate (which will depend on the results of two run-off Senate elections in Georgia on January 5) makes these tax hikes unlikely. Another implication of the divided Senate is the stimulus package to help reduce the impact from the pandemic. It is highly probably that the stimulus package under a Republican-controlled Senate will be lower than previously hoped for.
In our view, investors should continue to hold a diversified equity allocation in the short term given the risks to the near-term outlook. The significant premium paid for growth stocks, at a time when yields are expected to steepen and inflation to pick up (from a very low base), especially in the US, should bode well for value stocks. However, we would still recommend some exposure to growth sectors. Additionally, based on current information, we could see European equities outperform their US peers.
The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments.
Robert Ducker, Equity Analyst, Curmi and Partners Ltd