Sasfin Month in Review – May 2020

Fiscal measures combined with the unprecedented response in monetary support by central banks has been the biggest tailwind behind the recovery in markets.

Stock markets in developed economies have continued their recovery from the lows of March, trading with a more positive tone. During the month, indices such as the S&P 500 (+4.5%), STOXX Europe 50 (+3.0%), FTSE 100 (+3.0%) and the Nikkei 225 (+7.5%) all achieved strong gains. Technology stocks continue to lead the way as we saw the Nasdaq close 6.5% higher for the month, and as of writing, the technology heavy index has returned to its record level seen in February earlier this year, recovering all losses post the sell-off.

The sell-off during February and March saw investor preferences shift towards higher-quality growth stocks with ample liquidity preserves. However, during May, sectors that were most negatively impacted during the sell-off such as restaurants, airlines, hotels and cruise lines staged a strong recovery as seen by the positive performance in the S&P 500 Hotels, Restaurants and Leisure Index, which has gained 16.8% to date following its low in May.

The recovery in emerging markets has not been as strong, with the MSCI Emerging Index, a broad measure of stocks within emerging markets, only gaining 0.6% during the month. Closer to home, the JSE All Share Index rose a modest 0.3%.

Even commodity prices have begun to recover, with gains in aluminium (+3.7), copper (+1.9%), platinum (+8.0%) and zinc (+2.2%). Iron ore (+10.4%) prices were also strong rising to $100 per ton as a surge of coronavirus infections in Brazil triggered a concern over supply for the commodity, in addition to China announcing plans to streamline customs checks on imported iron ore. As drivers returned to work, West Texas Intermediate (WTI) Crude Oil price, a benchmark for North American oil prices, recovered from a record low having dipped below zero at one stage, to close at $36/bbl. Oil price gains were also supported on news that OPEC nations will extend the curtailment in the production of oil which saw Brent crude oil close at $34/bbl (+88.6%).

One factor that appears to be driving the recovery in markets is news flow relating to the testing of potential treatments and vaccines for Covid-19. In general, on days of positive news relating to treatments or vaccines, markets have rallied but subsequently faded as the dose of “hopium” wore off. Specialists and health experts alike continue exercise caution over the results, insisting that we remain patient and wait for evidence that is more conclusive.

The reopening of economies following lockdown has also spurred markets on. Despite the nose dive in US retail sales (-16.4%) and the Federal Reserve’s Industrial Production Index (-11.2%) – the largest decline in its 100-year history – as well as the 40 million Americans that filed for unemployment insurance, there are signs that a recovery may be on the way. US employers unexpectedly added 2.5 million jobs in May causing the jobless rate to decrease from 14.7% to 13.3%.

Close to $3 trillion in fiscal stimulus consisting of small business loans, unemployment benefits and cheques to individuals have begun to flow to employers and households. Perhaps these fiscal measures, combined with the unprecedented response in monetary support by central banks, has been the biggest tailwind behind the recovery in markets. In recent weeks, Europe has bolstered its monetary and fiscal efforts as the European Central Bank balance sheet has expanded beyond €5.0 trillion with the prospect of it reaching €6.5 trillion before year-end. The central bank in the US, the Federal Reserve (“Fed”), has been particularly proactive in this regard as well.

To date, the Fed’s efforts to prevent Covid-19 health crisis from becoming a financial crisis equates to 25% of US GDP. The growth rate in the US money supply (M2) has followed the same trajectory as SpaceX’s Falcon 9. The velocity of money (M2V), a measure as to the number times the average unit of currency is used to purchase goods or services in a specific time period, has remained in check, perhaps explaining why we haven’t seen inflation yet. Without velocity, inflation remains muted in the real economy (main street), but it is visible in asset prices such as stocks (wall street) – at least that is how the theory goes.

What we have not seen yet is the impact that the lockdowns have had on company earnings. Ultimately, stock prices depend on corporate earnings, which are in turn a function of economic conditions. First quarter results did not fully encapsulate the impact of the lockdown as many lockdowns only began in earnest during March. Year-to-date earnings estimates for the S&P 500 have been cut by 28%. This is higher than the 26% cut seen in 2009. At a sector level, the biggest cuts have been in energy (-100%), consumer discretionary (-59%) and industrials (-53%). The pace of the downward-earnings revisions has been slowing, but there may be a reacceleration once results for the second quarter have been released showing the impact of the lockdown for a full quarter.

The collapse in earnings estimates combined with a recovery in the ground stock prices lost earlier in the year has led to a sharp increase in price-to-earnings (P/E) multiples. Currently the P/E multiple for the S&P 500 stands at 22 times putting it close to the 25 level seen during the dot-com bubble of the early 2000’s. One could argue that earnings are only temporarily depressed and that even if results for the year are abysmal, the situation is only temporary and as economies begin to reopen and economic activity picks up earnings will eventually normalise.

This may well be the case, but a couple of questions spring to mind. What about the possibility of a second wave of the virus? What will be the long-lasting effects of the shutdown? How many permanent job losses will there be? How will behaviours change? Working remotely, fear of crowded areas and concerns over travel will certainly have an effect on impacted industries. Perhaps the most immediate question that needs to be answered is how the re-emergence of tensions between the US and China will shape the global economy.

Following an accounting scandal involving Luckin Coffee - a Chinese version of Starbucks - the US senate passed a bill that would require foreign companies to delist from American stock exchanges if they do meet certain requirements. One such requirement is allowing US regulators to access their books to ensure their accounting practices are up to the standard that US companies have to meet to be listed on their home exchanges. Currently, Chinese authorities refuse to allow the Public Accounting and Oversight Board (PCAOB) to examine the audits of firms listed on the US exchanges. The PCAOB is a regulatory board that oversees the audit of public companies and whose members are appointed by the US Securities Exchange (SEC). Interestingly, the bill requires companies to certify that they are not under the control of a foreign government. The bill would also prohibit US pension funds from investing in Chinese stocks as there is a concern that US funds are being used to finance Chinese technology firms.

President Trump has voiced his concern over China’s decision to impose national security laws on Hong Kong but has fallen short of pulling out of the Phase 1 trade deal or imposing sanctions on the Eastern superpower. In contrast to the recovery seen in other markets during the month, the Hang Seng Index ended the month in negative territory, having fallen sharply on the back of the legislation which significantly reduces Hong-Kong’s partial autonomy.

Chinese authorities will hope that focus on events in Hong Kong will be overshadowed by the release of the Caixin China General Manufacturing PMI (Purchasing Managers Index) which rose from 49.4 to 50.7 a sign that manufacturing activity has increased. On the surface, this would appear as a positive result showing supply chains have begun to stabilise enabling manufacturers to ramp up production. However, orders from overseas are falling demonstrating that production remains more robust than demand.