Over the last six weeks share prices have rebounded strongly from the virus-induced lows of mid to late March, causing consternation amongst financial journalists and professional investors alike. Their surprise is perhaps understandable. Many countries are only in the first stages of lifting lockdown restrictions, we therefore have next-to-no visibility on the shape or strength of the economic recovery upon which optimism about share prices is, in part at least, founded. In short, markets appear to be jumping the gun. In this note we discuss some of the factors at play, consider what the second half of the year might have in store for investors and how we are advising clients to position their portfolios at present.
Those who considered that any bounce in share prices from the March lows was based on misplaced optimism, and therefore likely quickly to give way to renewed weakness, have been caught on the wrong side of a sustained rally. From its low point, the UK market, despite a setback last week, is close to 25% higher. Looking at the all-important US indices, the recovery is even more marked with the S&P 500 index having gained 37.5% from the lows and recovering almost all of its coronavirus-related losses.
In considering the drivers of the stock market recovery we believe three factors are worthy of note. Firstly, although not smooth, news on the spread of the virus and casualty numbers have been improving. Taking the UK figures, coronavirus related deaths, having grown at a terrifying pace from mid-March, peaked (notwithstanding a second wave) in the second half of April – at close to 1,200 deaths in a single day. As we write, the latest comparable figure was 36. This is still a large number of people to lose in a day, but it is clearly a major reduction in a little under two months. Share prices, having begun to price in very grim scenarios, have therefore moved higher to reflect what is, while still a tragedy of generational proportions, not as bad as investors might have feared as the number of infections bounded higher and higher in late March.
Our second factor is that, while stock market indices, which aggregate the movements in the share prices of hundreds of companies are useful in themselves for indicating the broad direction of investor sentiment, they tell us precisely nothing about the broad composition of the index, or indeed about the businesses whose shares are included in that index. So, as journalists point accusing fingers at speculators driving share prices higher (in aggregate), it might be helpful to consider that the sweeping headlines omit the detail – wherein lies a different perspective entirely. For example, the worst affected company listed on the UK’s major index is the cruise operator Carnival. The cruise industry has been indisputably hugely impacted by the lockdown, and, while its share price has rallied by more than 100% in the past six weeks, we should note that it is still 75% below it pre-crisis levels – no irrational exuberance here. Investors have just reappraised Carnival’s prospects from perhaps, ‘terminal’ to ‘very bad indeed.’
At the other end of the spectrum household goods group Reckitt Benckiser, manufacturer of a huge range of brands such as Dettol has been one of a handful of beneficiaries of the pandemic, and accordingly its shares now trade at a higher price than pre-coronavirus. For the most illuminating example of this point we can cross the Atlantic and consider the US’s NASDAQ index. This hit an all-time high last week – regaining all its coronavirus-related losses and breaking into new ground. Can we make any sense of this? Yes. We note that NASDAQ is a technology-laden index, full of global giants that dwarf any business listed in the UK. And, whatever we may think of the likes of Microsoft, Amazon, Netflix, Facebook and even the newly floated Zoom, they have been major beneficiaries of the change of habits forced upon us all by the lockdown. It is this that is being reflected in the NASDAQ index. If we contrast this with the UK’s major index, dominated by businesses in the firing line of the coronavirus-driven recession such as banks, oil companies and miners we can better understand why the performance gap between the two exists.
Our final point concerns the other key component of share price valuation, the rate at which future earnings, and dividends are discounted. This, financial theory states, is closely tied to interest rates, and in particular the interest rate on government bonds which provide the cornerstone for establishing the value of innumerable financial assets from infrastructure projects and commercial properties, to corporate bonds and share prices. As US central bank chairman Jay Powell made clear last week, interest rates are set to stay extraordinarily low for an extended period. However, even before that, prices of high-quality bonds were soaring (sending the interest rate they carried lower) – as investors sought the safety of secure capital and income in an uncertain world. Therefore, when comparing the level of share prices before and after the impact of the lockdown, we have to factor in that the lower rate at which future earnings are discounted has a positive effect – and will have helped to support, or at least cushion the fall of share prices. Clearly, for the likes of airlines and high street retailers any support here is far outweighed by the impact on their profit outlook while for a company such as pharmaceutical giant Glaxo, the two effects appear broadly balanced – and the company’s share price is little different from pre-coronavirus levels.
Coming, finally, to the outlook and our thoughts on portfolios, we believe that share prices can move higher over the remainder of the year as long as concerns about a renewed surge in infections prove unfounded. Yes, many businesses have been badly impacted, and the stock market is likely to see cash calls to strengthen balance sheets but we do not subscribe to the view that the impact of the lockdown will only be fully reflected in share prices when the economy fully reopens. The best estimate of what future earnings will look like is already factored in and as this becomes less uncertain and assuming the ‘second wave’ discount is removed, we believe there is room for optimism as regards equity markets. Turning to the other side of portfolios, the defensive or diversifying element, the challenge here has been heightened further by the renewed decline in bond yields. For example, a ‘safe’ fixed income asset – the 10-year UK government bond, offers a miserly redemption yield 0.21% p.a. – less than one-tenth of the UK rate of inflation. Perhaps more importantly, it offers little of the diversification benefits that historically merited the inclusion of bonds in portfolios. We are, at present, taking a long-hard look at how to address the twin challenges of the lack of return on fixed income securities and the scarcity of diversifying assets and will communicate our findings in the second half of the year.
Our next note will delve into the medium-term picture and consider some of the trends which may hinder or help investors in the 2020s. In the meantime, we hope you are all keeping well and enduring these extraordinary times as well as possible. If you have any comments, questions or feedback we would be delighted to hear from you.
