SINGAPORE (June 29): Market exuberance brought about by the lifting of Covid-19 lockdown measures, unprecedented monetary expansion and an upward correction from excessive pessimism over Covid-19 is likely to be brought back down to earth. The resurgence of Covid-19 in the US has seen greater introspection about when the pandemic will end and the possible economic impact, seeing a downward correction in financial markets.
“The “all-in” approach by central banks and governments around the world –particularly by the Federal Reserve and the European Central Bank – turbo-charged [the] rebound, creating a bubble-like mania that saw the indiscriminate and quite frenzied buying of even bankrupt or near-bankrupt companies,” says CGS-CIMB analyst Lim Say Boon. Not any more -- despite a continuing upward trend on the pace-setting S&P 500, fundamentals remain precarious.
Fed buying of debt forces credit yields down, by extension forcing down the yields expected from stocks, and hence forces up stock prices. With monetary expansion relative to GDP being a major explanation of stock valuation rises since the Global Financial Crisis, Lim notes that it was perhaps not irrational given the history of the impact of monetary expansion on stock prices for investors to go on a buying spree. Still, the recent market rally is built on sinking sand.
While continuing liquidity may yet slow the impending downward correction, the failure of the S&P 500 to fill the gap from 3155 to 3181 points is not encouraging for further gains. Should the index break sub-3000 points, investors are likely to turn tail and speed up the index’s decline. The steepness and speed of the decline from late-Feb to late-Mar caused the S&P 500 to bust above its 78.6% Fibonacci retracement -- an unstable breach that will likely turn downwards to form an island reversal formation at its early-June peak. These are not good signals -- a new bear market in deeper hibernation than the last seems to await.
The worsening pandemic, hitherto ignored by markets, has once more been brought starkly back to the fore. Despite Singapore’s entry into Phase 2 of lockdown easing, the World Health Organisation has reported that the pandemic is accelerating at a global level even as markets maintained their optimism. The virus now ravages emerging markets like Brazil, India and Indonesia with impunity while in the US, the Trump administration’s unwise haste in re-opening the economy and cutting testing has seen the pandemic enter what is likely to be a second wave, prompting a possible retreat back into full lockdown.
While vaccine development has been fast-tracked, the scientific community is not optimistic that one will be developed by this year. While there has been some promising results from AstraZeneca (based on Oxford University vaccine research), Moderna and Sinovac, the consensus remains that a vaccine will only be ready between 2QCY21 and mid-2021. This is not nearly quick enough to arrest a prolonged economic decline in the wake of the pandemic.
“The rallies past the human suffering seen during the SARS pandemic of 2002 and Swine Flu of 2009 came after major market declines – respectively, the Nasdaq Crash of 2001-2002 and the Global Financial Crisis of 2008-2009. And the rise in the Dow Jones amidst the 1918 Spanish Flu came after a 40% decline bear market in 1917,” Lim observes. Unfortunately, Covid-19 hit after an 11-year bull market, meaning that there will likely be less policy and valuation buffer available. It is also far more difficult to eradicate than either SARS or Swine Flu.
Far from encouraging economic fundamentals have also been ignored by investors. What awaits is the worst economic recession since the great depression, with the world economy likely to shrink 3% in 2020 and the US economy by 6%, amounting to a US$2.6 trillion ($3.6 trillion) and US$1.3 trillion loss in economic activity respectively. Worse, the US economy is likely to downshift to structurally lower economic growth from here out, with the US’s debt-to-GDP ratio ballooning from 107% last year to 132% by end 2020 and 70% of the Fed’s balance sheet already blown out for the year.
To make matters worse, Lim argues that developed markets like the US, Eurozone and Japan are drowning in debt, slowly approaching Modern Monetary Theory in substance if not form. Despite the fig leaf of central bank independence and the commitment to repaying government debt, the level of financial debt developed markets are entering into may be very difficult to finance. The analyst fears that this bodes for financial instability post-pandemic, adding that high debt in the US is usually associated with low economic growth.
Even worse, much of the initial rally has been sustained by technology companies, which saw an increase in earnings as demand for devices has grown to facilitate online shopping, entertainment and perhaps even work from home. But the dire economic conditions and high unemployment could see a reduction in disposable income, hitting discretionary consumption on online shopping and home entertainment. Questions about the ability of central banks to pay burgeoning unemployment benefits and fiscal cliffs arising from the expiry of government support schemes for the unemployed and SMEs weigh heavily on investor’s minds.
Amid growing instability in the global economy, the wild cavorting global markets resembles Nero playing the fiddle while Rome burns. Surprisingly, consensus estimates for S&P 500 earnings suggest only a 23% y-o-y decline for the full year. With the Global Financial Crisis wiping out 40% of the S&P 500 y-o-y, a repeat in 2020 sees the S&P 500’s trailing twelve-month valuation by December standing at around 26x vis-a-vis the ten-year average of 15x -- in short, criminally over-valued.
“For now, the S&P 500 is still within its uptrend channel. The coming week will be crucial. Our view is that this rally is built on very unstable ground. And that unstable ground may be about to give way to a new phase,” concludes Lim.
