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Reposition on the relief rally – things can get worse

3/3/2020

Market Views
  • Relief rally unlikely to last
  • Beyond COVID-19, economies could flatline or enter recession
  • Corporate earnings could stop growing at a time of heightened valuations
  • There is a tail risk of credit defaults on liquidity and cashflow squeeze

Don’t overstay the unfolding rebound on global risk asset markets. This is likely to be only a relief rally, not a reversal of the broad market trend. 

As written start of last week here, before markets sold off in earnest, a rebound could emerge after a 10% correction. We have already seen nearly 13% knocked off the S&P 500 from 19 February’s close to the close on 28 February. But as written in the same Premia Partner Insight, “beyond the coming rebound, there is a deeper malaise which may show up on markets later.”

Already faltering economic growth will likely be driven to zero or recession in many countries.  To recap, hopes in 2H19 for an economic recovery in 2020 appear overly optimistic. The much-vaunted rebound in the global economy was either on unstable ground or already fading before the arrival of COVID-19, whether we go into a global recession or we simply stop growing may be academic. In coming months, conditions will look and feel a lot like recession in many countries. 

US earnings growth likely to disappoint expectations. Meanwhile, US corporate earnings will likely flatline. My earlier estimate of 3% growth in 2020 for S&P 500 earnings – which I said was “hardly inspiring given a forward PE ratio of 19x” – was probably generous. 

Goldman Sachs has just revised its earnings growth forecast for US companies this year to 0%. According to a Factset survey, higher visibility 1Q20 earnings expectations have already come down sharply from 4.4% to 0.7%. Yet, forecasts further out – hence lower visibility forecasts, particularly with the unpredictable nature of pandemics – are for US earnings to miraculously pick up to 4.1% in 2Q20, for a full year earnings growth of 7.3%. This could set the market up for earnings disappointment, resulting in more selling pressure, in coming weeks and months. 

Bear in mind that the central argument driving the continued bullish equities view is that earnings growth will prevent further valuation multiple expansion. That’s been a necessary narrative because markets have been finding it harder and harder – even in the face of ultra-low and negative interest rates – to swallow higher valuations. The divergence between the S&P 500 index and underlying earnings has driven the S&P 500 forward PE from 16x to 19x over the past 12 months. 

Strategy implications – use the bounce to cut weights on equities, increase weights on high quality bonds and cash equivalents. There will be better buying opportunities. The risks are on the downside. Developed Markets are at cyclically high valuations; already faltering economies could now suffer zero or negative growth; and earnings will likely disappoint.

Beyond that, there is the tail risk that highly leveraged companies could suffer financial stress as a result of a cashflow squeeze caused by a COVID-19 driven demand shutdown. That could in turn cause credit spreads to widen, with higher corporate borrowing costs, possibly triggering credit events. That could deepen the downturn for equities. Within equities, ironically, Chinese equities could outperform DM stocks, given how much bad news they have already absorbed – negatives including concerns over China’s corporate debt; the economic slowdown associated with deleveraging; trade tensions with the US; and now COVID-19.