What shape will the recovery take?

We hope you didn’t blink, because if you did, you may have missed the fastest bear market in history. Although COVID-19 continues to carve its way through the world, at first glance it seems equity markets have moved on. But is that really the case? Or, is this just a lull in a longer storm?

In our last quarterly report, we surmised that the first leg of the market recovery would be quick, a reflection of panic easing rather than any assessment of the economic damage done i.e. stage one would be a V. However, at that point, there was significant uncertainty as to what came after that, but the likely scenario was that stage two would be slower and more challenging, something more like an L or a U. Even in our most optimistic scenario, never could we have dreamed that the S&P500 would touch back to its 2020 opening level during that “first stage” of recovery.

What has fuelled this optimism? A combination of exogenous factors such as diminishing cases of COVID-19 in Europe and New York, expectations for treatment or a vaccine, and hopes for a rapid economic recovery combined to restore investor optimism. But without the fuel of liquidity provided by Central Banks around the world, these embers of optimism would not have flared into the blazing recovery experienced over the last three months. As some would say, “follow the money”, in this case, you can follow the money directly from the vaults at the U.S. Federal Reserve to equity markets.

This leads us to the next question: How sustainable is this bounce? This is where it becomes more challenging. This is like a heavyweight match with the fire hose of liquidity provided by the central banks taking on the regularly returning champion, fundamental value. We know that for the last decade liquidity has been a driver for all risk assets with equity markets rising during each bout of quantitative easing. Not surprisingly, equity prices have responded again to central bank intervention in financial markets.

The problem is that an evaluation of fundamentals suggests that this cannot be sustained. Despite some modest short-term deviations, historically, equity markets have trended higher in line with earnings growth. But current expectations for earnings suggest that earnings per share for the companies making up the S&P500 are only expected to return to 2019 levels by the end of 2021. So, unless the economic recovery is stronger than most currently expect, having equity markets rise above the levels of 2019 in the near term seems unjustified.
Source: FactSet

However, we have only examined half of the fundamental equation. Earnings growth is a key metric, but valuation is equally important. Using the most common valuation metric, we look at the Price / Earnings ratio based on those estimated future earnings. The long-term historic average P/E is a little over 15 times earnings. In other words, the average share price is 15 times its profitability. Skipping over 2020 earnings estimates and moving on to 2021, current valuations are near 20 times, a significant jump above the long-term average.

Many will argue that given low-interest rates and lack of investment alternatives, that this higher level of valuation is natural and that given the current circumstances is unlikely to change any time soon – there is nothing to worry about. And we recognize this view may very well be correct. However, history suggests that when equity market valuations reach this level, future average returns are well below average. An assessment of historic data on a Price to Sales basis confirms this, indicating that in the past when the ratio has reached this level, returns over the next few years were below average.
Provided Courtesy of Credit Suisse

Data: S&P, Thomson Financial, FactSet

So, who will win this heavyweight fight? We wish we knew. We are loath to bet against the central banks – the expression “Don’t Fight the Fed” was coined for a reason, but we would be foolish not to be concerned about the elevated valuation levels in a world where earnings growth will face numerous challenges.

At this point, there is little valid economic data to guide expectations for what the economy will look like in three months, six months, or even a year.  As economic data is backward-looking, the data currently available reflect periods where the respective economies were either completely shut down or in the early stages of opening, therefore mostly useless as a guide.

Many institutions are tracking real-time data to try and get a framework for consumer spending and intentions. This data is generally based on google phone tracking data, credit card spending, and various consumer surveys. There are some consistent themes across the data. People are still staying home and travel for leisure and work is significantly below prior levels. Most individuals are prepared to return to shops if reasonable precautions are put in place. Travel is not happening nor is there much intent. Spending is rising, particularly in Europe, but in North America, it is still a long way from where it was.  As infection rates increase in the U.S. even this tepid recovery may be forced to slow further.

However, what seems likely is that governments will continue to spend massive sums to maintain, support, and jumpstart the economy.  The next risks to financial markets likely come from a premature removal of the stimulus.  This could result in a second round of business failures and job losses in 2021. Going back to our letter references for the shape of the recovery, this would create a W. At this moment, Canada and Europe have extended support for workers, reducing the risk of a W-shaped recovery.  The first wave of benefits provided by the U.S. expires at the end of July and, those benefits have not been extended, although there is significant optimism that a deal will be reached.

Perhaps more concerning at this point is the prospect of the K shaped recovery. This suggests different outcomes for different segments of the population – the rich get richer and the poor get poorer. Given the social unrest already taking place in the U.S., this type of recovery could (justifiably) magnify that outrage, hampering the long-term recovery for everyone.

Although we believe equity markets are richly valued at this point, we believe a significant pullback is unlikely.  A 10% – 15% dip is quite possible and even probable. Given the swiftness of the bounce back some volatility would seem reasonable. Due to the intervention of central banks, it is unlikely we will see markets drift towards the previous lows and even less likely that new lows will be achieved.

The risk premium built into corporate bond prices remains somewhat elevated from levels witnessed over the previous two years but has recovered from the panic levels struck in March. Fears that inflation pressures will push interest rates higher are likely overblown in the near term. The deflationary pressures of weakened demand and low commodity prices will likely outweigh any inflationary pressures.  However, as consumers, we may notice pockets of inflation due to disruptions in global supply chains, but these issues are not likely to be broad-based.

Risk Premium on Corporate Bonds Over Government Bonds

Source: FactSet

It is hard to write a report for this quarter without discussing oil prices. For the first time in history, oil prices sunk to negative values – implying that you had to pay someone to take your oil away. Although this bizarre circumstance came and went very quickly and was triggered by structural factors in the oil futures market, the chaos cannot be ignored.

At the time of writing, oil prices have recovered to a low but relatively normal price at $39. The market continues to have excess supply, but as the global economy recovers this will likely be absorbed quickly. In March and April, global oil demand dropped by about 20 million barrels of energy per day, but the IEA now expects demand for the full year to decline a much lower 8 million barrels of energy per day.

Some natural attrition will take place in North American supply over the remainder of the year as a reduction in drilling prevents the replenishment of production. If OPEC and Russia keep their productions in check, the market should be relatively balanced as production is expected to decline an average of 7 million barrels a day. The only remaining issues will be the inventory built during those weeks of excess production by Saudi Arabia and Russia when their original agreement crumbled.

Political upheaval may become more of an issue in the third and fourth quarters, as we head towards the U.S. election. Further trade disruptions are a possibility as the U.S. responds to China’s more aggressive stance.

Uncertainty remains high, but as we look around the world, we see glimmers of light as various economies begin to recover. With continued government support, we would expect that process to continue. Although financial markets appear to be fairly valued at this point, history suggests that central bank support could put further upward pressure on prices.

In this environment, we continue to seek reasonable value and to create cash flow through stable dividends and interest payments. The returns available in financial markets over the next several years will likely average less than those in the last decade, which will make disciplined portfolio management even more critical to success.


Logan Wealth Management
July 14, 2020


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