Square root
#Articles — 26.05.2020

Square root

Patrick CASSELMAN, Senior Equity Specialist

With weekly gains of 3% for the S&P500 and 3.6% for the Stoxx Europe 600, stock markets offset the previous week's losses.

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The markets drew hope from the encouraging results of vaccine-testing and the gradual resumption of business activity since lockdown. The most spectacular rallies were seen in cyclical sectors (e.g. materials, the automotive industry, tourism) which were seriously hurt by the effects of the Coronavirus epidemic. The price of oil also continued to rise, reaching its highest level in 5 weeks thanks to production cuts decided by OPEC + and the "reopening" of the economy.

National People's Congress

Chinese stock markets, however, lost some ground following the decisions taken by the National People's Congress. China no longer provides a growth target for 2020 and the announced fiscal incentives were equivalent to 3.5% of GDP versus 5% expected. Moreover, the adoption of a law to gain more control of Hong Kong has fuelled tension, not only in Hong Kong but also in relations with the United States. 

Forget the ‘V,’ the ‘U’ and the ‘W’: now focus on the square root

There is a lot of debate about what form the recovery of the economy will take:  a ‘V,’ ‘W’ or ‘U’? In China (the first country to emerge from lockdown) the bulk of manufacturing activity has resumed, but consumption and services, still hampered by social distancing rules, are still lagging behind. With its economy still largely driven by industry and infrastructure, China is set to recover more rapidly than the United States, where more than 80% of the economy is dependent on consumption and services. China seems to be the early and undisputed winner in the post-Coronavirus world, just as the US was the unexpected but clear winner during the financial crisis triggered by the collapse of Lehman Brothers in 2008.

For Western economies, we initially expect a sharp recovery following lockdown that should flatten out within a few months. It could take a few years before returning to the initial level.  First of all we will need to take into account the virus until the end of 2021 (with potentially new waves of contamination and selective confinement measures), since it could take that long before a sufficient proportion of the population is vaccinated. In addition, consumption and services will continue to suffer the effects of high unemployment rates, bankruptcies and loss of income. So we have a picture of a steep decline, followed by a vigorous but incomplete recovery which will flatten out. Seen from this angle, the economic curve will take the form of a square root, with the horizontal line lower than where it started.

Equity markets in consolidation phase

We have also seen this square root pattern in recent months in equity markets.  Since the strong rally between mid-March and mid-April, when stock markets recouped about half of their previous losses, share prices have been moving within a relatively stable trading range. This initially rapid increase was mainly driven by the huge incentives from authorities and central banks. But just like humans cannot survive on water alone, equity markets cannot live on liquidity alone. Indeed liquidity is helping things temporarily, but stock markets will eventually need fundamentals to support them.  In other words, it is time for a clear and sufficiently vigorous economic recovery to take over. 

Although the second quarter is set to end with perhaps the most abrupt economic downturn in history, the worst month is behind us. This can be seen in the rise in May of European PMI indicators (business confidence) compared with the historical weakness observed in April: from 33 to 39 points for manufacturing and from 12 to 29 points for services. It is certainly encouraging to see an improvement, but before talking of a convincing recovery, we would still need to see PMI figures above 50.

A wide gap between equity markets and the economy…

The rally in equity markets since mid-March, and in particular, the almost complete recovery in the Nasdaq (which is up year-to-date, and now only 5% off its record), is in stark contrast to the recession we are experiencing at present, described as the worst one since the Second World War. If we had predicted at the beginning of the year that the US economy would shrink by 6% in 2020 leading to record unemployment but that the Nasdaq would nevertheless post gains, we would have been considered mad!  Yet this is really what is happening at the moment.  For one thing, this contradiction can be explained by zero interest rates and by investors seeking yield in sectors and companies, which are holding up well despite the Coronavirus crisis, or even benefiting from it. This reasoning almost inevitably leads to a number of themes (digitalisation, e-commerce, social media, online gaming, streaming and biotechnology) which had already existed for some years, but which have accelerated as a result of lockdown measures. Furthermore we must admit that the Nasdaq is comprised of a few large tech stocks betting on these themes. Amazon and Facebook reached record prices only last week.

... but also between growth stocks and value stocks

Although these growth stocks clearly have rosier prospects, the valuation tends to be overdone. A comparison between the valuation of Tesla and that of Volkswagen, or even between Amazon's and Carrefour’s, is very revealing in this respect. The valuation gap between the new economy and the old has returned to its record levels seen in 2000. The then Fed chairman, Alan Greenspan, used the term ‘irrational exuberance’ to describe the situation. In the years following the burst of the dotcom bubble in 2000, we saw a significant rotation into traditional value stocks. The same phenomenon was observed shortly after the 2008 crisis, and it is likely that a similar rotation will take place in the near future.