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8th July 2020

Market Update

Debate rages on as to how countries can best negotiate the exit of lockdown without inviting the much talked about second wave.

In England pubs re-opened on “super Saturday” with some expecting the less attractive elements of British drinking culture to be on full display. Happily, only a few minor incidents were reported. Less positive was the news that several pubs have had to close again, a mere four days after re-opening, due to customers testing positive for Covid-19. This is a microcosmic example of how we may see localised lockdowns for a while yet. Indeed, Melbourne, Australia has reintroduced a strict lockdown after a surge in infections, meaning over 5 million people have been told to stay at home for at least 6 weeks.

Over in the US, the situation is arguably worse. Dr Anthony Fauci, the director of the National Institute of Allergy and Infectious Diseases, said on Monday that America’s grasp of the pandemic was “really not good” and urged further action as new cases of the virus continue to surge to record highs of about 50,000 a day across the country. He went on to say “We are still knee-deep in the first wave of this. And I would say, this would not be considered a wave. It was a surge, or a resurgence of infections superimposed upon a baseline,” during an interview on Facebook Live. The following chart clearly highlights Dr Fauci’s concerns:

Daily number of new Covid-19 Cases (per million people)

graph1 marketupdate July10th

This brings me neatly to financial markets and the expected shape of the economic recovery. After the best quarter for equity markets in many decades, we move into Q3 with little more certainty over the shape of the recovery or direction of asset prices.

Equity markets have largely shrugged off the surge in new cases in the US and equity prices remain relatively expensive, on many measures. The chart below shows a commonly used ratio, the forward price earnings, over the past 30 years:

graph2 marketupdate July10th

This clearly shows that equities, particularly in the US, have rarely been as fully valued. But how can this be? We are facing extreme economic uncertainty so does this mean that markets are completely out of touch with reality?

Possibly not. Let me try to explain; equity valuations are usually an estimation of the future value of earnings and growth. To express this in today’s money, the value of these earnings must be discounted for the cost of capital, which includes the cost of borrowing, i.e. interest rates. Because central banks around the World are pumping money into their economies, they are effectively depressing long term interest rates, thus reducing the discount rate applied to equity valuation models. Still with me? The combined effect is to make future earnings more valuable in today’s money and, somewhat perversely, raising the fair value of equity markets. Nonetheless, US equities do appear to be pricing in the perfect “V” shaped recovery and may, therefore, be vulnerable in the short term.

Elsewhere, as my colleague Graham has eluded to in his monthly piece, bond markets remain extraordinarily expensive, with the UK 10-year Gilt yielding circa 0.20%. Bond markets have been a hot topic for investors and investment strategists for a decade with some expecting a material decline in prices. This, however, has not come to pass.

Conceptually, bonds appear extremely unattractive at these levels although we would encourage a pragmatic view on the asset class to ensure proper diversification of your portfolio. Whilst bonds are unlikely to offer much in the way of return, they continue to hold valuable diversifying properties. A sharp and dramatic reversal in bond prices is theoretically unlikely as central banks remain buyers, via quantitative easing programmes, with unlimited buying power. In addition, there are numerous large forced buyers, such as pensions schemes, meaning that bonds should remain well bid.

So, equities, particularly US equities, look expensive and bonds look extremely expensive. So where can investors find any value? Non-US equities are, relatively speaking, attractively priced most notably in the Emerging Markets. The following chart shows the relative valuation of Emerging Markets versus Developed Markets:

graph3 marketupdate July10th

This enticing valuation combined with a widely expected weakening of the US Dollar could mean attractive returns from Emerging Markets going forward.

But, as always, investors would do well to remember that additional returns never come without additional risks. The Emerging Markets and Asia are inherently risky places to invest with geopolitical, governance and currency risks just a few of the factors which need to be carefully considered. Allocations to these markets should always be in the context of a well-diversified portfolio which is designed to be in line with your risk tolerance.

Until next time, stay well.

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