Consolidation in June – pause before another all‑time high or start of major reversal

Darius Svidleras
Investment Portfolio Manager
 

• Second COVID‑19 wave potentially starting in USA and FED taking a pause with creating new liquidity put a hold on the rally in financial assets that has started in late March;
• As future economic outcomes remain highly unpredictable, volatility is likely to remain high with significant upward and downward price moves to be expected in second half of 2020;
• Starting Q2 earnings season should help understand the exact damage made from lockdown on revenues and earnings as well as to what extent those indicators improved after the reopening. 

By any standards 2020 is very challenging year for making investments. Only six months have passed, but we have already seen one of the fastest and most significant market crashes in history followed by one of the most rapid recoveries in asset prices ever. Changes that usually take at least few years to realize, in 2020 happened over the course of few months. And with market environment becoming increasingly volatile, even difference of few days is capable to make what appears to be a good investment a bad one and vice versa. 

What complicates things even more in 2020 is that investors have to operate somewhat in the dark. As we discussed previously, there are plenty of unknown risk factors that may play out in one or the other direction, and these factors raise many questions, which cannot be really answered right now. Nobody can tell how future situation with coronavirus will play out around the globe and in separate countries. Will there be new lockdowns leading to even more economic destruction or the worst is really over? How soon companies will be able to fully recover from COVID‑19 crisis and would bankrupted entities be replaced by new entrants?  Moreover, will there be a deflation induced by oversupply and decreased aggregate demand problems, or central banks will manage to create as much liquidity as needed to actually trigger inflation around the world? This is the question of utmost importance as completely different combination of financial assets should be held depending on which scenario would play out.

Lately we see that even economists and analysts, people that are paid to make forecasts, provide estimates that miss actual numbers by a wide margin. In fact, it is hard to blame them, as relationships that used to work under normal business conditions, in post‑coronavirus world became broken and increasingly hard to model.

For now, markets, boosted by excess liquidity and massive inflow of general public that is willing to invest, provide most positive guesses as answers to all the unpleasant questions. We in its turn do not want to play a guessing game, but want to operate with facts or at least with high probabilities that certain scenarios are likely to happen. And from what we continue to observe, facts suggest that reality may turn out to be much bleaker than what markets continue to predict¹. 

Key point here is that the harder it becomes to predict the future, more volatile, emotional and chaotic price movements in the markets become. Overall, since early 2018 when global economic slowdown has first started, speed and magnitude of price movements have been only increasing, while tops and bottoms are becoming more and more extreme. Such “roller coaster” makes financial system less stable and more fragile, and thus probability of even more severe moves either up or down than what was observed recently remains high in the upcoming months. In such environment waiting out for more clarity to appear may be the most optimal solution, even though in the end some opportunities may be missed and less potential profit earned. Remember, 2019 was an excellent year, with separate equity markets rising by more than 40%, and market trending higher almost every day. But then in March 2020 in about a month not only all those gains were wiped out, but losses generated as well. 

Global equity index (MSCI ACWI in EUR)

Source: Bloomberg

With that in mind, let us return to developments which happened in June. Rally that was observed in majority of financial assets since late March has slowed down in early June, with equity indexes consolidating since then in a gradual drift lower. 

Two key catalysts why equity markets at least temporarily stopped their ascent are related to spike in new COVID ‑19 cases being registered in USA and FED making pause in creating new liquidity. 
Either due to mass gatherings, not wearing masks, widespread use of air conditioning or other less known reasons, but significant acceleration in new cases was observed in large southern US states likes Texas, Florida and California, resulting in what appears to be second coronavirus wave starting in USA. This is incredibly worrisome, especially if these states have to be put on lockdown once again. 

But just as it happened in February, when many hints suggested that COVID‑19 epidemic is likely to spread from China to the rest of the world, while equity markets were updating new all‑time highs, similarly today, market participants for now believe that it is temporary solvable problem. Two factors which contribute to their optimism is the fact that overall trend for number of new deaths still continues trending down and that situation in New York, state with largest amount of cases during first wave, is fully under control right now. 

COVID‑19 trends in USA

Source: Bloomberg

New daily cases in selected USA states (7‑day average)

Source: Bloomberg

Additionally, with stabilization of financial system, return of investor optimism and increase in asset prices FED reduced usage of their emergency facilities and interventions in the market. Liquidity created by central banks was the main driver of asset price increases in spring, so not surprisingly that without newly created money, demand for assets in June also was not as strong as before.

Change in FED balance sheet  and S&P‑500

Source: Bloomberg

In July we expect that volatility in the markets is likely to continue. Apart from either positive or negative COVID‑19 developments, central bank stimuli and macroeconomic releases, another very important factor in July would be linked to corporate earnings. Companies will finally release their financial results for second quarter 2020, helping to understand the exact damage made from lockdown on revenues and earnings as well as to what extent those indicators improved after the reopening. Hopefully, guidance about second half of 2020 would also be provided.

S&P‑500 vs profit margin

Source: Bloomberg

Summing up, there are currently two contradictory trends, where from one side there is a new increase in COVID‑19 cases, while on the other hand we are seeing an improvement of global economic indicators. However, we must bear in mind that economic indicators are improving from extremely bad levels and in absolute terms are still far from normal. At the same time increase in COVID‑19 cases brings more uncertainty on whether there will be a new lock‑down and how fast full reopening will be achieved. In such environment it extremely hard even for companies themselves to provide any more or less reliable future guidance. This may result in big swings in analysts’ estimates of forward corporate earnings. And with equities already not cheap, this may cause big swings in prices. Therefore, investors should be prepared to embrace volatility while sticking to their long term investment plan.

¹Please see June 2020 Overview for more detailed discussion on economic reasons for our cautious view