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Markets are certainly seeing reasons to be optimistic. The strong performance last month in risky assets has continued into June, with sentiment driven by signs of improving activity as lockdowns are lifted. Whilst the pace of the market rise in recent weeks is a pleasant surprise, it is encouraging to see economic activity starting to get off its knees. We are in the early stages, but so far there is only limited evidence that removing social distancing restrictions is leading to any increase in infection rates (watch some of the US states though were the return to normality might have been somewhat rushed). The market rally has been led by the higher beta equity markets, cyclicals over defensives and high yield (more risky bonds, so they pay a higher income to attract investors) over investment grade in the fixed income world.
To repeat some of the themes of recent weeks – investors clearly believe that the worst is now behind us, the momentum of activity is turning positive and will continue to be so in coming weeks. There continues to be a focus on the development of vaccines and cures, while macro-economic policy continues to be massively supportive. Moreover, investors appear to have discounted bad news they can already see coming this year in terms of GDP growth and the hit to corporate earnings and are now focussing on a recovery in 2021.
Our job as professional investors is to remember that although this is very good news, markets are fickle things. There is a risk of relying too much on a sentiment driven rally without the fundamentals to support it. The escalation of tensions between the United States and China over Hong Kong, social unrest in the US and Brexit returning to the fore could reverse some of the good feeling generated by the removal of lockdowns. So could any evidence of increases in infection rates or disappointments from clinical trialling of drugs.
Sentiment and valuation are linked. Sentiment can be both a momentum and a contrary indicator. Over the last month it has certainly reflected positive momentum allowing a bullish view on cheap assets like credit and cyclical sectors in the equity market. A clear example is the airline sector which has been one of the best performing in the S&P500 over the last few weeks. There is some support for the industry from governments, yet the fundamentals remain challenged and there is little evidence to suggest that airline bookings are starting to recover quickly. Without macro support (explained in more detail below), the improved investor sentiment and attractive valuations will only take these stocks so far. Some investors might see sentiment as a contrary indicator – one could certainly put forward the argument that the recent rally in markets is based on little more than the uplift to activity that was guaranteed once social distancing started to be relaxed. If activity plateaus because consumers and businesses will need to remain cautious in the way they operate, the sentiment rally will peter out.
Over the medium term the macro factor is the key driver. The performance of many asset prices is driven by where we are in the economic cycle. Obviously, this is not a normal cycle. We have a very abrupt recession on our hands and face an uncertain recovery. There are therefore several layers to the macro situation. One is the first order recovery in activity levels. A second is the level of policy support for markets. Beyond that it becomes more nuanced. How sustainable is the policy support? What are the longer-term implications of rising government debt and central bank balance sheets? Will there be a permanent loss of capacity and employment? How can emerging market economies recover with limited resources and weaker medical support? Will there be changes to global supply networks and trade flows?
We must keep reminding ourselves that we are still in the middle of a global pandemic and the worst (but hopefully quickest) recession ever. The sentiment led rally could become vulnerable over the summer and there will probably be setbacks along the way. Despite this uncertainty, we have to make investment decisions and as always investors need to embrace risk to get returns that are positive and above the rate of inflation. We keep coming back to the policy support and the massive boost to global liquidity that is being provided by central banks. The Congressional Budget Office in the United States currently estimates that the Federal deficit will be $3.7trn this year, a lot of the borrowing to finance that will be bank reserves created by the Fed that flow into deposits and broader money growth. This will ultimately be the key driver of both the recovery and ongoing market performance.