Mind the Gap
With September set to be the first negative month for most risk asset markets since March, it is worth analysing what has been driving the reversal.
First, profit taking. After a virtually straight line rally for months, some market participants will of course be tempted to lock in their gains. Second, we have a US presidential election looming and historically markets have tended to take something of a wait-and-see approach in the weeks preceding these. Third, Brexit negotiations have delivered a string of pessimistic headlines in recent weeks, with positions hardening at the beginning of September but apparently becoming more conciliatory in recent days. Fourth, the new fiscal stimulus plan in the US is still being discussed, with plenty of reasons to be bearish about the probability of a favourable outcome. Last and certainly not least, COVID-19 infection numbers in Europe and other parts of the world have surged in recent weeks, prompting governments to take measures to contain the ‘second wave’.
As a result, the S&P 500 and the NASDAQ are down 4.7% and 5.86% month-to-date, respectively, while in fixed income US high yield, euro high yield and the Coco index are down 1.36%, 0.67% and 2.07% respectively.
At the same time, broadly speaking economic data continues to improve at different paces in different parts of the world. PMI Manufacturing numbers are comfortably above the 50.0 threshold virtually everywhere, and the trend for September has generally been flat versus August or slightly better. PMI Services figures have retreated in the Eurozone to close to 50.0, while in the UK, the US and China they are flatter but still well above 50. We eagerly await the monthly report from the Bureau of Labor Statistics in the US, due in the first week of October, to assess whether the steep decline in unemployment continues at the same pace. In addition, numerous vaccines continue to make good progress, meaning the probability of success is increasing with every month that passes. Anecdotally this has resulted in a few corporate CEOs and CFOs sounding a bit more bullish in earnings calls, and with some revising their estimations for year-end higher as the economic recovery has turned out to be stronger than initially expected.
In our opinion, and taking all of these factors into account, it seems the gap between risk asset prices and economic fundamentals continues to close. We do not think the global economy is out of the woods, but it is hard to deny that the economic recovery has been faster than many expected. This means many investors will find it easier to ‘buy the dip’ than they would if economic data was deteriorating. Our sense is that there is still a lot of cash on the side-lines, and we are in the early stages of a new cycle, so at the moment we can’t see markets falling too far before participants are tempted to put a bid out there.
That said, this view relies on a few assumptions. The most important one is that governments will not decide to close down their economies again, as they did in March. The second wave has been uneven across countries but mortality rates have not increased dramatically thus far. We therefore believe that the bar for a repeat of the March national lockdowns is quite high, with governments so far preferring to focus on more localised restrictions to contain the spread of the virus. We are also assuming vaccine development keeps progressing, which again seems to be the case judging by comments from governments and manufacturers. On the political side of things, markets would like to see a final Brexit outcome and an agreement on US fiscal stimulus to deliver some good news. Though uncertainty is high, it does seem that over the last few days both of these are moving in the right direction. Negative headlines on any of these fronts would mean that market participants would need to adjust their growth expectations downwards, which would widen the gap between market prices and economic fundamentals. On balance we believe it is more likely we have positive news than negative news on these issues given expectations.
One final point. In the early stages of the cycle there is usually a gap between economic fundamentals and market prices that might look optically large. As the cycle progresses and uncertainty clears, this gap typically starts to close and expected returns and expected volatility both tend to decline. This recession has been unusual for many reasons, but in this respect we expect it to be more typical.
