Markets have been unsettled for some time about the prospect of a second Covid wave and they finally capitulated this week. The market collapse on Wednesday, which saw the S&P500 fall more than 3.5% and the DAX fall more than 4%, came on the day that Germany introduced a stringent set of national lockdown restrictions involving a one-month shutdown of bars and restaurants which is due to come into effect on Monday. France also announced a national lockdown which came into effect today. It may not be quite as stringent as that enforced earlier in the year but it is still pretty drastic. As President Macron said in his TV address, “the virus is circulating in France at a speed that even the most pessimistic forecast didn’t foresee … The measures we’ve taken have turned out to be insufficient to counter a wave that’s affecting all Europe.” Given the renewed spread of the disease, it seems only a matter of time before the UK is forced to follow suit.
What does a second wave mean for the global economy? Throughout this year, most reputable forecast institutions have presented a range of alternative scenarios around the baseline and it is worth digging into some of the details of the IMF’s forecast released last week. The IMF baseline looks for a 4.4% contraction in global GDP this year followed by a rebound of 5.2% in 2021 (in my humble opinion this sounds like a stretch since it implies that all the damage done to output in 2020 will be recouped next year). However, whilst the downside scenario garnered rather fewer headlines it was nonetheless illustrative. It is based on the assumption that Covid proves difficult to contain, with a significant drag on activity in the second half of 2020 extending into 2021. In addition, the IMF assumes that progress on finding effective treatment is rather slower than currently assumed, with a delay in the process of finding a vaccine and the requirement that social distancing measures have to remain in place for a long time to come.
Under these circumstances the global growth rate next year could come in as low as 0.9% versus the baseline projection of 5.2% and it takes until 2025 before output is back on the path implied by the baseline (chart 1). It is also notable that in this scenario emerging markets take a larger than proportional hit. This accords with my long held view that since EMs are acutely dependent on a recovery in their main export markets, the IMF is too optimistic on how quickly output in Asia will rebound in the baseline projection.
As far as markets are concerned , we have been here before. The equity declines registered on Wednesday may not be the biggest daily falls this year but they are not far away from some of the dramatic swings recorded in March. On the one hand there is some scope for cautious optimism in that we have a rather better idea of what we are letting ourselves in for. Accordingly, equity indices may not fall as sharply since we are operating in less unfamiliar territory. Against that, markets may be on the verge of capitulation as the pandemic proves not to be the short, sharp shock that was expected in the spring. As is usual at times of equity market stress the tech sector comes in for the closest scrutiny (chart 2). In addition to concerns that the pandemic may take the edge off demand, the fact that Apple’s iPhone sales and Twitter’s user growth both missed estimates added to the sense of market uncertainty. Next week’s US Presidential election may have longer-lasting consequences for the tech sector if Joe Biden is elected to the White House and embarks on a programme of cutting the tech companies down to size.
However, for the time being I tend to take a more optimistic line. For one thing we should not read too much into equity volatility just a few days ahead of the most important US election for years. Part of the recent wobbles may reflect some position squaring ahead of the main event. Moreover, central banks are pumping in liquidity on an unprecedented scale. The Fed has increased its balance sheet by two trillion dollars this year, primarily due to purchases of Treasury securities which will suffice to keep bond yields at ultra-low levels. Here in Europe, current estimates suggest that EMU governments will issue €1.2 trillion of gross debt next year but maturing bonds and interest payments could reduce the net figure to €405bn. Even without the promised monetary expansion the ECB is expected to buy €460bn of debt in the secondary market – more than planned issuance. This downward pressure on global yields when plugged into a simple discounted cash flow model ought to be enough to put a floor under equity markets.
But even if markets do hold up, the economy will take a long time to recover from the scarring effects of Covid. In the US, for example, the unemployment rate currently stands at 7.9%, twice as high as in February prior to the pandemic whilst employment is around 11 million below pre-recession levels. What makes me somewhat uneasy is that we have entered a period where there is a mounting disparity between what is happening to markets and conditions in the real economy which underpin them.
This will be manifest in elevated P/E ratios. I have frequently referred to the Shiller trailing 10-year P/E ratio for the S&P500 as a measure which smooths out cyclical variations and have noted that over recent years it has remained very high in a historical context (chart 3). In just the last few months it has rebounded back to pre-recession highs following a dip in the wake of market panic in March. This is a clear illustration of the extent to which traditional valuation metrics no longer apply and for the foreseeable future the equity market will be running on the back of the support given by central banks. Given the lack of clarity from the normal pricing metrics it could be a very bumpy few months for markets.
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