28 August 2020.

By James Cook, chief investment officer.

At the end of another tumultuous quarter, equity markets seem locked into a range bound trading pattern amidst no shortage of mixed messages. Over the last three months we’ve seen conflicting noise from economic indicators and corporate earnings data, increasing global rates of COVID-19 infections and rising geo-political tensions. Hopes are still pinned on a breakthrough in coronavirus vaccine development, but the timeline remains uncertain.

Equities vs Bonds – the bull and the bear?

Against the shorter term positive gains from equities, bond markets and the performance of the US dollar appear more rooted in reality – digesting the poor outlook with low yields indicating weak growth ahead. This provides a marked contrast to equity markets.

Equity market activity at a broad index level has masked some fairly telling moves from underlying sectors and individual stocks. All of which paints a story of a polarised world. Companies benefiting from ‘stay-at-home’ orders such as Alphabet (Google), Amazon and Netflix have generated positive gains, with online retail and high profile tech sectors performing well.

Sector fortunes fluctuate on changing conditions

Countering the upside has been companies and sectors exposed to high unemployment and a prolonged economic recovery including hospitality, tourism and education, although this is now beginning to turn. Energy, which had been the worst performing sector since markets peaked in February is now the standout sector over the last few months. Healthcare, which obviously rallied very hard on the outbreak of the pandemic has been virtually flat over June/July – although the recent Moderna results from its vaccine trials which produced positive antibodies may turn the performance around.

The chart below is illustrative of how hard the growth (big name technology) sector has run. This demonstrates the momentum of investors chasing growth stories while shunning core companies which offer a fairer representation of what is going on in the underlying economy. The unusual observation about this behaviour is that while typical across the normal investment cycle, it usually peaks just before an economic recession hits. Consistent with the unique behaviour across financial markets in the COVID-19 world, this bullish behaviour is now occurring through a definite recession – the most disruptive experienced since WWII. Unless we see a prolonged economic recovery, this pattern, along with absolute market levels and valuations may rapidly dismantle.

Market activity decoupling from economic reality

The behaviour does suggest a decoupling from economic reality and market activity. Unsophisticated retail trading has exploded with punters pushing valuations to extreme levels. This has even produced the bizarre scenario of retail investors bidding up the price of stock in car rental company Hertz – which had already declared bankruptcy. A lot of these investors are unlikely to see their money again. This situation has also prompted a wave of profitless technology companies now being listed.

The earnings outlook also very mixed. Perceived clear cut winners in the post COVID-19 world such as the ‘big tech’ names previously noted are pushing the market higher while broad based indices like utilities, consumer staples and real estate are lagging to reflect the ongoing constraints to consumption and falling aggregate demand as the pandemic fallout continues.

Importantly, government support (we’re reluctant to use the term stimulus) and central bank intervention to maintain liquidity through the system continues. Real demand has still not recovered, leading capital flows to revert to financial markets, particularly equity. We’re now seeing diminishing returns from this market intervention as every dollar of public debt raised is only generating about $0.30 in GDP growth.

Share markets: the only game in town?

The argument seeking to justify the current levels of equity markets is that equity inflows will continue in absence of any viable alternatives as yield curves remain flat and interest rates sit at very absolute low levels. There is literally nowhere else for investors seeking returns to go.

In sum, volatility, noise and uncertainty prevail. The world is awash with mixed messages. Equity market momentum has been fuelled by an increasing number of online retail investors. These investors, effectively taking a punt on the market, have pushed names such as Amazon, Alphabet (Google) and Netflix to record highs, and led the recent recovery of some previous bombed out cyclical sectors such as energy. While the bond market is sending very different signals, the equity market is currently not faced with a high hurdle rate in order to maintain its position as the only sector amongst core asset classes that might offer some chance of a positive return. Whether the influx of smaller unsophisticated investors in the market all ends in tears, remains to be seen.

An uncertain outlook raises the risk

We maintain the view that downside risk is currently greater than any upside opportunity from hereon. High levels of uncertainty across most fronts make the job of forecasting highly presumptive without much science. In such circumstances we believe prudence to be the most appropriate policy. We are maintaining relatively high cash positions as insurance against another ‘second pandemic wave’ and the slow realisation that the world’s economy will be disrupted for a number of years here on – a contrast to the current investment activity which suggests a v-shaped recovery and a fully adaptable economy is more than likely.