The economy is not likely to quickly bounce back to its full strength once the coronavirus pandemic ends even if this is what the market appears to be pricing in, investment strategists have warned.
The full impact of the coronavirus crisis is only just starting to be reflected in economic data. This morning, for example, the Office for National Statistics revealed that the UK economy shrank by 2 per cent in 2020’s first quarter, despite the period only including one full week of lockdown.
These figures are likely to get much worse over the second quarter and most parts of the globe are also bracing for severe contractions, but despite this market enjoyed a strong rally in April.
But Clearbridge Investments investment strategist Jeff Schulze believes markets aren’t taking into consideration the material effects on consumer and business behaviour beyond the economic shutdown.
He thinks there is too much optimism priced into equities: the forward price to earnings ratio in the US is 21.2 times earnings, more expensive than market was in February before the coronavirus sell-off.
“Even those valuations were pretty lofty,” he said. He also highlighted that cumulative earnings are forecast to rise close to 5 per cent from the end of 2019 to 2021, according to analyst consensus, which Schulze thinks is a very optimistic outlook.
“Historically there is usually some sort of event or shock that causes that recession. This time around it was the shutdown of the economy because of Covid-19, but more importantly even as these shocks tend to fade, economic weakness tends to persist,” he explained.
“It creates a negative feedback loop where weak final demand leads to poor profits, which leads to weakness in credit and labour markets.”
Even though the cause of this recession is certainly different, Schulze believes this same dynamic is going to play out yet again and when the economy starts to reopen, “it's going to be very clear that there is going to be lingering economic weakness”.
Profit margins were already cut pre-coronavirus
The US Department of Commerce’s National Income and Product Accounts (NIPA) profit margins were revised down in July of last year by $200bn. NIPA profit margins include small to medium-sized business as well as the mega-cap companies in the S&P500.
Schulze said this measure is a better barometer of the economy and that it was “a huge revision outside of a recession”. He also pointed out that margins have been relatively flat since 2016, disproportionately hurting small- and micro-cap companies.
“Now this is really important because when we start to open up there are a lot of companies that are under margin pressure already. Even if they’re starting to see their revenues decline slightly, a lot of these companies will cut their workers because they were already under margin pressure,” he explained.
“There’s going to be a lot of excess labour. That's going to hurt consumer spending trends in the US overall.”
The strategist believes that people in the US over the age of 55 are not going to go back to a normal life until a vaccine or cure is available and, given that they make up 40 per cent of US consumer spending, this will create another drag on the economy.
US Corporate Profits relatively flat for the past 5 years after July revision
Source: ClearBridge Investments
V-shaped bottoms are the rarity, not the norm
“You need a retesting of that bottom in order to confirm a durable economic and market bottom. You’ve seen counter trend rallies in every recession,” Schulze said.
This sell-off hasn’t experienced a retest of its March lows. But since 1950, there have been 15 bear markets and the market has re-touched or broken 14 of them.
“A V-shaped recovery is not the odds-on favourite when you have a recession and to see the markets scream higher by 35 per cent from the lows, give or take, is a very interesting phenomenon,” Schulze said.
“The liquidity bridge cannot solve bankruptcy problems,” he added, referring to the Fed’s $2trn fiscal stimulus package.
“If you’re going to have a revenue stream that is maybe 60 per cent of where you were pre-virus, whether or not you were given loans by the federal government, you’re not going to be able to upgrade and survive when the economy re-opens.
“Because of that it's going to cause a bigger overhang on the US economy, which is why Q3 and Q4 when the reality comes homes to roost, it's going to be a bumpy ride for US equities.”
Schulze expects to see consumer reluctance and higher savings rates, which are typical of recessions.
“The key with recessions is there tends to be a contagion effect. It’s maybe a longer lasting recession quite frankly,” he said.
“We wouldn’t be surprised if markets moved lower as the economy started to reopen and the realities of the change of consumer and business behaviour becomes evident. It's going to directly affect earnings”.
Luca Paolini, Pictet Asset Management's chief strategist, also highlighted the correlation between equities and the unemployment rate in the US, which has always been very strong.
He said this is largely because the business cycle and the market cycle tend to coincide, yet “the market has fallen by a fraction then what you would have expected”.
In the US, over 30 million jobs have been lost in six weeks and unemployment has risen above 20 per cent, reaching levels close to those seen in the Great Depression, which saw unemployment peak at 25 per cent in 1933.
Both the Federal Reserve and the IMF have warned of deep economic recessions as a result of this crisis; however, markets are shaping in a classical V shaped recovery in economic activity, which is in Paolini’s view “questionable”.
He believes the global economy will still be well below potential for a long time and that expectations of earnings are too high, with a significant risk that they may prove to be disappointing.
“Earnings are expected to fall 30 per cent next quarter but rebound very strongly in 2021. In the US, the expectation is that earnings per share in Q2 of 2021 will be at an all-time high,” he said.
“I can obviously expect a rebound in profit in the economy, but the idea that companies will go back to the level of profitability just pre-crisis in one year, it seems to me very difficult to believe.”
After the 2008 global financial crisis it took four years before earnings came back to the previous highs. He argued that the damage to earnings from this global economic shutdown is likely to be much worse.
Anthony Rayner, multi asset fund manager at Premier Miton, said: “Much of the economic data suggests that near-term economic activity expectations are too optimistic, despite materially downgraded expectations.
“Indeed, there are more convincing signs that the rally is driven by the liquidity environment”.
He also believes the evidence is not clear cut that the market is pricing in a V-shaped recovery, citing the fact that government bond yields remain close to multi-year lows.
He also highlighted that gold, one of the other key safe-haven assets, remains close to multi-year highs. Both situations are not typically indicative of a V-shaped recovery, he explained.
The manager concluded: “Nevertheless, our pragmatic approach, and the experience of QE, remind us that liquidity can drive markets higher for extended periods.”