In this week’s market update: Investors brace for the key second quarter earnings season; central bank meetings and economic announcements vie for attention in a busy week ahead; and markets prepare for life under Biden.
The biggest test of the optimistic V-shaped recovery thesis was always going to be second quarter earnings season. Results for the three months from April to June will confirm whether or not the stock market has gone too far, too fast in its remarkable recovery from the sharp falls of February and March. And the wait is over. This week’s numbers from a clutch of big US banks will, as usual, kick things off and then the flood-gates will open for a few weeks of reporting hell.
The optimistic view is that company profits will follow the lead set by economic data as lockdowns are eased and people get back to work and play. The hope is that both the downturn and recovery will be rapid, and growth will soon get back to its long post-financial crisis trajectory.
The current expectation is that profits will indeed plunge this year - by more than 20% during the calendar period, and much worse than that in the second quarter when most economies were frozen, possibly a 45% fall between April and June - but then bounce back quickly in 2021 by nearly 30% on the back of revenues nearly 10% better.
There’s a less rosy view that sees more of a U-shaped recovery, resembling more of a bathtub, with a long slow recovery. Even more likely in my view is a more up and down path, with apparently strong recoveries hitting the buffers, relapses giving way in turn to renewed upswings, until eventually we do indeed get back to a new normal. It could take longer than expected, or be much quicker. We just don’t know but earnings season starting this week will provide the first despatches from the front line.
Last night’s near 1% fall on Wall Street, more than 2% for Nasdaq, on the back of a roll-back of easing measures in California, showed the risks to the market at today’s elevated levels. Markets in Asia picked up on the gloomy tone, with falls in Japan, China and Australia, after California joined Texas and Arizona in shutting down cinemas, bars and eat-in restaurants after a sharp rise in new cases and hospital admissions.
Analysts are perennial optimists and if they are too positive with their forecasts then the market, which already looks fully valued, could turn out to be much too highly priced in the short term. The strategists at Citi think that’s the case, with the MSCI World probably trading on around 24 times the earnings that will actually be delivered in the next few weeks rather than the 17 or so that is currently pencilled into most models.
Investors don’t just need to keep an eye on what’s coming down the pipeline in the next few weeks and months, they also need to take a medium-term view too. And in the US that time-horizon is dominated by the Presidential election in November. This is shaping up to be a big deal for stock market investors because the opinion polls are pointing to a big reversal from the chaotic but basically business- and market-friendly policies of Donald Trump to the more measured but potentially more radical proposals of his opponent, Democrat Joe Biden.
Biden leans to the left of centre on the political spectrum and, thanks to pandemic, his tax-raising and higher spending policies have become much more mainstream. The opinion polls suggest that America would settle for a change of direction, even if that included higher corporate and individual income taxes, a higher minimum wage and more regulation and red-tape generally.
It’s early days yet but a Biden White House would be a very different proposition and arguably the stock market is beginning to price it in. Two of the sectors that have done well under the Trump administration, and have led the stock market higher - technology and healthcare - might be in the firing line.
As well as the start of earnings season this week, investors will have plenty to chew on in the form of some big central bank meetings and a string of economic data. The European Central Bank will be in focus this week as investors look for signs that it will follow up on last month’s €600bn expansion of its emergency asset purchase programme. On Thursday Christine Lagarde, the ECB president is expected to confirm that the central bank remains in full accommodation mode. That should settle doubts about whether the central bank is committed to the massive stimulus it has announced.
Markets have warmed to European assets on the back of the ECB’s largesse and the fact that the region seems to be following Asia out of the worst of the pandemic. Bond yields in the more vulnerable countries like Italy have fallen back to levels they last saw in March where the premium they offer investors over the yield on safer German bonds is back to pre-pandemic levels.
Over in the US, its not just earnings that will be in focus this week. There’s a string of economic data too, with consumer prices, retail sales and the so-called Beige Book, which collates anecdotal evidence from business owners.
The US economy has surprised on the upside recently, with jobs data, in particular, showing the flexibility of America’s easy fire, easy hire again culture. The latest jobs report showed nearly 5 million new jobs were added last month. That followed 2.5 million the month before when experts had expected another big fall.
The big question is whether that recovery is sustainable alongside a truly shocking Covid-19 picture in the US. The numbers of new cases in the worst hit states like Florida - which this week posted the biggest single day increase since the pandemic began - show that things could get worse before they improve.
Worries about Covid-19 have provided support for government bond prices, which investors view as a safe haven in troubled times. This is despite heavy issuance of new bonds by governments looking to finance massive support operations such as the UK’s furlough scheme.
Because the Bank of England, for example, is buying up bonds faster than the government is currently issuing them the price of bonds continues to rise and their yields fall. In the UK the cost of borrowing for the government fell to a record low as the yield on short-term bonds, those maturing in five years or less, fell even further into negative territory. Gilts with maturities out to as much as seven years now guarantee investors a capital loss if they hold them until they are repaid.
The other principal risk for holders of UK assets like gilts is the exchange rate, with the level of the pound helping to determine total returns for overseas investors. The pound has actually been one of the best-performing currencies in recent weeks as investors bet that the UK and EU will find a way forward that avoids an economically damaging hard Brexit at the end of the year.
Although Britain officially left the European Union at the end of January, it has entered a kind of limbo for 11 months known as the transition period in which it still operates within the bloc’s customs union and single market on a temporary basis. That will come to an end at the end of December and if no deal has been struck by then the UK’s trading arrangements with its biggest trading partner could be a lot less favourable. That in turn could hit the pound, especially if the Bank of England responds to that situation by pushing interest rates from their current 0.1% into negative territory.
The need to avoid a damaging Brexit was well illustrated this morning by GDP data for May showing a recovery of just 1.8% in the month, much less than the 5% expected by economists. That left the UK economy 25% smaller than it was in February as consumers proved more reluctant to return to the old ways than retailers and other businesses are to open up again.