Market week

Stock markets are in a holding pattern as investors re-assess the rapid rise from the low point reached in mid-March. After a savage retrenchment from the highs reached in January and February, markets rallied much more quickly than in previous bear market recoveries, taking shares back to pre-crisis valuations.

Analysts at Societe Generale have crunched the numbers on bear markets over the past 150 years. Typically rallies from these sharp falls of at least 20% have been shallower and more protracted than the recent steep gains for shares. They also usually include more short-term reversals as investors respond to challenging economic developments.

This time around, the S&P 500 has risen by more than 25% despite a steady stream of alarming economic news, such as last week’s rise in the US jobless rate from around 4.5% of the working population to nearly 15%. US shares are within 15% of their all-time high despite the biggest increase in unemployment since the Depression.

Coupled with falling earnings forecasts, the recovery in share prices has seen valuation multiples rise to peak levels, raising the risk that the rally will fizzle out as economic reality overwhelms optimism about recovery on the back of massive government and central bank stimulus.

It is the scale of that intervention that has fuelled optimism, with investors believing that the self-imposed economic shutdown can be just as quickly reversed, leading to a rapid resurgence of company profits and so share prices.

Investors are divided between those who think that markets have moved too far too fast and those who think it makes sense to look through even the current dire economic headlines to recovery later this year or next. And that two-way pull is putting a floor under prices at current levels even as it makes it hard for the market to make any further progress.

The waning in market momentum suggests the argument may be swinging back towards the pessimistic camp. In the last week of March and first of April, the S&P 500 added nearly 600 points, but it has only added another 100 in the month since then.

One reason investors have become more cautious is the renewal of tensions between China and the US as the two sides trade criticisms of the other’s handling of the Covid-19 crisis and begin once again to use trade as a weapon in their simmering dispute.

The apparent truce in the trade war in January, after nearly two years of rising tensions, has clearly broken as the US weighs a range of retaliatory actions on supply chains, investment flows and even the payment of interest on China’s massive holdings of US Treasury bonds.

The added factor as 2020 progresses is the looming Presidential election in November, with the political benefits for Donald Trump of ratcheting up pressure on China too tempting for the President to resist. The White House’s rhetoric has consequently ramped up in recent days, with plenty of unhelpful parallels being drawn between the Coronavirus and earlier attacks on the US such as Pearl Harbour and 9/11.

The need for Trump to play the geo-political card has been accentuated by the collapse of his previously strong economic hand in the face of the coronavirus lockdown. As the first quarter earnings season draws to a close, the scale of the damage to profits is becoming clear.

Even in the relatively unscathed first quarter, earnings are now expected to have fallen by around 14% on average. This would be the worst quarterly performance since the worst three-month period in the financial crisis of 12 years ago.

Ironically, the fall in earnings was smaller than forecast with two thirds of companies to have reported so far beating expectations. This suggests that the worst may yet be to come and the second quarter results when they arrive in July will be a sobering set of numbers.

Goldman Sachs expects blue-chip earnings for 2020 as a whole to fall by a third. But crucially it also expects a dramatic recovery in 2021 to take earnings back above those for 2019. This is the principal driver of stock market strength right now, even if many market watchers are suspicious of whether the recovery can really be that strong.

Taking a more cautious line this morning, Land Securities, the biggest commercial property landlord in the UK, said it did not expect the economy to recovery to normal pre-crisis levels until 2022 at the earliest. Usage of its offices is below 10% of normal as employees work from home. It is expecting more business failures and rising vacancy rates.

What is also clear is that there will be a huge disconnect between the sectoral winners and losers over the next two years. The slump in the oil price means that energy stocks, down 40% this year, the worst performer in the US market, will continue to struggle. Saudi Aramco’s shares slid today after it announced a 25% drop in first quarter earnings. Airline stocks may never scale their previous peaks. Ryanair said today that it would be resuming flights in July, but only at 40% of previous capacity.

By contrast, technology and healthcare shares have been among the stand-out performers in the first quarter, with three quarters beating analysts’ forecasts and 80% doing better than their own expectations.

The really interesting question looking forward is the extent to which politicians’ desires to re-open their economies run up against the caution of consumers who remain fearful of coronavirus. Real-time economic data from the countries like China which are emerging first from the crisis suggest that a shortfall of demand may yet overwhelm a restoration of supply.

Data on property sales and coal consumption, for example, show activity remains well below pre-covid-19 levels. There is a fear that Western economies, which are more dependent on industries like leisure and travel, may be even slower to emerge.

This is the challenge facing an economy like the UK’s, which is just making the first tentative steps towards re-opening its economy, encouraging those who cannot work at home to go back to work in areas like construction. Watching the resurgence of infection rates in places like South Korea and China, western leaders are likely to adopt a cautious approach to exiting their lockdowns.

But ultimately, it is not governments that will decide how quickly economies get back on their feet but individuals. If they are unwilling to get back on trains to commute to work, or to visit restaurants and hairdressers, let alone fly off on holidays again, then the recovery is less likely to be a V-shaped recovery than a slower U-shaped or even L-shaped economic trajectory.

Fidelity’s top down strategists have attempted to put probabilities to these various outcomes, with the slower but not disastrous U-shaped recovery carrying a 60% likelihood. The positive V-shaped rally is assigned just a 10% chance, however, with the slow or no recovery L-shaped scenario picking up a 30% probability.

With markets currently pricing in the base case, the limbo state for global stock markets looks sensible and the direction of travel from here will be determined by newsflow over the difficult second and third quarters of this year.

Sometimes a guide to future outcomes for shares can be found in the performance of commodities and here at least there is some more positive news. Copper, a bellwether commodity, sometimes known for that reason as Doctor Copper, is now up 20% from its March low point. The metal has risen on the back of hopes for activity in China, one of the biggest consumers of copper.

The price rose another 3% last week in anticipation of news, which emerged at the weekend, pointing to greater government stimulus in China. The People’s Bank of China said that it would lower lending rates and place more emphasis on supporting the real economy. That news put shares in Asia on the front foot at the start of the week, with gains across markets in Japan, China, Hong Kong and Australia.