Equity Markets Diverge from Fundamentals – Implications for Debt Investors

While there is a consensus amongst most economists that the impact of the upcoming recession will be worse than that of the global financial crisis of 2008 and 2009, but not as severe as the depression of the 1930s, this has not been reflected in equity markets both locally and globally.

In the US, from which most stock markets including the ASX generally take their lead, the COVID-19 death toll has now passed 115,000 and is continuing to rise by a weekly average of just under 1,000 deaths per day.  In response to a flattening of the infections curve and the lifting of lockdowns, the Dow Jones Industrial Average has rallied from its March lows back to close its all-time highs set in February this year.  

While the rate of new infections has steadied in recent months and has not risen as social distancing restrictions are eased as yet, the US is still recording new cases averaging above 20,000 per day.  In contrast, rates of infection continue to surge in Brazil, Russia and India.  The highest number of worldwide daily cases recorded since the pandemic began was 134,704 on 7 June 2020 so on a global basis the virus is clearly not controlled as yet and is still expanding its rate of spread, despite numbers steadying in the US and falling in Europe.

Economically, US corporate profitability fell by over USD 300 billion in the first quarter of 2020 (its second highest fall on record) with expectations the second quarter results will be much worse.  The US market is currently trading on a forward PE ratio of 23.75 being the highest ratio since the dot com boom of 2000 as equity prices and profitability have diverged. Credit ratings agency Standard and Poor’s currently has a record number of 1,287 companies on negative watch or outlook for downgrade despite S&P having already downgraded 700 companies since the crisis began.  Media articles are warning of an upcoming “pandemic of corporate bankruptcies” in the US so large it may overwhelm the court system. 

Geopolitical tensions between the US and China have also increased both due to accusations of the origins of COVID – 19 and China’s clampdown in Hong Kong with predictions these tensions are unlikely to abate prior to November as both Presidential candidates are expected to make a “tough on China” mantra as part of their electoral campaigns.  Stresses also remain in the global oil markets and the precise terms of Brexit still need to be negotiated.

It appears from the above high-level analysis, equity markets should be far lower than they are currently based on fundamentals.  The mainstream rationale to justify current market pricing is the predicted effectiveness of the various economic stimulus packages being implemented and commitments (backed by actions) of major central banks to do “whatever it takes” to stimulate economies.  The flaw with such a rationale is these measures are being used to ameliorate a problem that did not exist before the stimulus.

If instead of borrowing an additional USD 3 trillion, the US government borrowed an additional USD 330 trillion and gave every American citizen a cheque for USD 1 million; will that be good for the economy?   While this proposition seems outlandish, it illustrates the point that unlimited quantitative easing (printing of money) is unlikely to be a panacea. If it were, why was this not the economic policy in place before the COVID-19 pandemic and not simply the response?

The rationale for a higher stock market relies heavily on the belief the stimulus will result in a “V” shaped recovery where global economies bouncing back very quickly with little lasting damage from the very sharp, and by definition temporary, declines in GDP and increases in unemployment.

There is considerable debate as to whether the actual economic recoveries both globally and locally will be “V”, “U” or “L” shaped.  These letters representing a very sharp recovery (“V”), one which takes slightly longer to bottom out and recover (“U”), or one where there is no or a very slow recovery (“L”).  The equity markets are discounting the latter two possibilities and are pricing in a near certainty of the former.

It therefore appears as if there is far greater downside than upside risk.  If events transpire to challenge the market expectation of a “V” shaped recovery, without residual “scarring” of the economy causing long term damage, then equity markets are likely to adjust their expectations downwards.  Since a Panglossian view is already priced in, it is hard to imagine what news could cause equity markets to move significantly higher; perhaps another unexpected fall in US unemployment from a record high of 14.7% to a slightly less worse 13.4% as occurred on 5 June?  It is hard to square the announcement of the second worst unemployment rate in US history causing the Nasdaq composite index to rally to a new record high as it did earlier this month.

The acid test would seem to be that if news miraculously emerged of an immediately available vaccine or cure for COVID – 19 would a further market rally be justified?  Such an event would take equities beyond their all-time highs in late February 2020 when COVID-19 cases were less than 1,000 a day and mainly contained within China.  If such a scenario were to eventuate it would imply a better forward outlook than pre-COVID with absolutely no short- or long-term damage done by the pandemic.  This just does not seem cogent.

To accept such an argument is to ignore the parable of the Broken Window as espoused by French economist Frederic Bastiat in his 1850 essay “That Which We See and That Which We Do Not See”. Bastiat argues a broken window for a shopkeeper appears to create economic stimulus for the glazier (that which we see), but what is hidden is the alternate and better uses the shopkeeper could have put the funds paid to the glazier and the lost stimulus from them not going to the butcher or the baker (that which we do not see). 

If the COVID-19 crisis had not occurred, the stimulus funds used to offset its effects globally could have been profitably used elsewhere.  This alternate opportunity has now been lost.  As Bastiat said “society loses the value of things that are uselessly destroyed”. The starkest example of which is the over 400,000 recorded deaths from COVID-19 so far globally.  If the COVID-19 shutdown is to have no effect on future corporate earnings why not shut down the global economy for a week or a month every year and give everyone extra time at home with their families?

In Australia while the equity markets have not been as optimistic, a domestic recession is still expected with a base case fall in GDP projected by the RBA of 9% and unemployment rising above 10% from their latest Statement of Monetary Policy. If the US markets are to again turn bearish and have a “W” shaped recovery (another crash before an eventual sustainable recovery) it is unlikely Australia will be immune.

The larger question for conservative fixed interest investors is if they find the arguments above convincing how can they take advantage of the situation or shield themselves from a potential equity market crash.

We would argue the performance of equity and credit markets are very closely tied as per the theories of Robert Merton which we wrote about in an article published in April. A sharp fall in equity markets will almost certainly cause a steep rise in credit margins on all debt securities, particularly those that are longer dated and lower rated, which is precisely what was observed in March this year and in nearly all previous equity market sell-offs.

Conservative investors can guard against this risk by selling their riskiest debt securities, but this would not apply to any Amicus clients whose portfolios are already prepared for such an eventuality.

Investors looking to take advantage of these opportunities should keep their “powder dry” at this time and not make commitments to longer term investments as there is a reasonable probability better opportunities are likely to arise in the next few months when the economic reality and equity market pricing may re-align.

The cost of such a strategy is minimal in the current environment with a very flat yield curve and many at call accounts paying interest only slightly below term deposit rates regardless of term.

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