Our near term thesis of stocks remaining well supported being tested
US stocks tumbled last Thursday as concerns about the resurgence of Covid-19 infections in some parts of the US and the fast spreading of the contagion worldwide threw cold water on v-shaped economic recovery scenarios. In truth, it is difficult to find any respected market practitioners that wholeheartedly believes in such an economic rebound or trajectory. Although talks of effective vaccines have become increasingly hopeful as clinical testing is taking place in an unprecedented speed to get a few vaccines launched by year-end, most virologists and immunologists also cautiously point to their likely binary outcomes that leave such recovery prospects that stock markets seem to have priced in looking too optimistic at this early stage. Nevertheless, we and most market participants believe in the science and given the current global focus on eradicating this pathogen by the best minds in the medical field, we expect one or more effective vaccines to come along sometime in H1 of next year at the latest.
There are also other under-currents at work here that keeps us from turning bearish in the short term, even if the prospects of producing effective vaccines are still months away. As we have previously underlined, we believe the key factor behind the stock markets’ big rebound is the creation of massive amount of liquidity by the Fed and indeed other central banks to stop the pandemic from disrupting functions of the financial markets. With funds parked in US money markets having surged by 30% from late February to record highs of above $4.7trn, cash as percentage of US equity markets having leapt by a whopping 6 points from the start of the year to 16% (despite the stock market’s massive rebound), and government bond markets looking increasingly fraught with danger as ultra-loose monetary policies have raised medium to longer term inflationary expectations, there really isn’t many liquid options left but equities for global asset allocators.
If ETF-related buying wasn’t hard enough to overcome for actively managed funds to capture alpha, this pandemic seems to have created a new breed of individual stock market speculators who are piling into shares of companies with the weakest balance sheets and earnings prospects, creating this “dash for trash” theme which has been mimicked in other markets, including ours in Japan. Although some have pointed to this as a major red flag, likely to be indicating that stocks are poised for a major correction, others have dismissed this notion as an old folks’ tale which overlooks the growing democratisation of the US stock market. Come what may, our thesis that stock prices will remain well supported in any pull-back should be thoroughly tested during the next few weeks as corporate earnings guidance for the 2nd half are likely to point to a far more muted recovery prospects to expect fundamentals alone to be too supportive.
The real second wave of the pandemic has yet to come
In our view the term ‘second wave’ in this pandemic has been thrawn around far too loosely to describe the current spike in infection rates which at least in the US look to have generally occured after some half-hearted lockdown measures that came too late and are now looking be eased too prematurely. Second waves as described in previous pandemics tend to big spikes which are usually associated with the changing of the season to a colder spell (like what Brazil is currently observing) or indeed a nasty mutation of the pathogen which could prove more fatal to a younger age group like the Spanish flu did in autumn of 1918. So although the current infection rates look all but likely to rise from here as lock-downs ease, we do not consider this as the second wave as such and given another lockdown phase looks politically and economically untenable in most countries at this stage, we think the spike in infections will not be too concerning for markets in the short term.
However, we think psychologically, the belief that a second wave is coming should keep economic activity at sub-optimal levels as consumer behaviour is unlikely to dramatically change as long as the fear of catching Covid-19 is out there. As we pointed out last week, we are keeping a close eye on countries like Brazil which are in the southern hemisphere and unlike Australia and New Zealand, it has failed to act quickly enough to isolate those infected. Although Brazil’s government has not been anywhere near as helpful in encouraging social distancing, we wait to see if scientists relate this rapid spread of the contagion there to colder weather. If so, we should prepare for the actual second wave to hit Western markets in autumn. By that time we should also have a much better idea of efficacy of vaccines currently entering clinical trials and whether we must start raising cash in fear of a worst case scenario.