If the speed and scale of the collapse in equity markets during just four short weeks in February and March took investors by surprise, it is as nothing to that which has followed. With very few exceptions, professional investors have been astonished by the pace and persistency of the rebound in equity markets, led by the famous ‘FAANG’ stocks taking the tech-heavy NASDAQ index to new all-time highs in less than three months.
Given the size of the damage caused to economies by the lockdowns imposed to effectively shut down economic activity – and the impact on company profits, anticipated to be down some 40-60% globally on last year’s levels – few investors would have forecast such a rapid recovery in equity prices. Never have bearish observers been more required to reflect on the old adage ‘Don’t fight the Fed’, as the expansion of the US central bank’s balance sheet has been without parallel, and the buying of asset types like high yield bonds without precedent.
Liquidity provided on this scale – and by other central banks, too – has worked its magic in supporting asset prices and ensuring that companies can gain access to credit or issue bonds at yields much lower than perhaps their current creditworthiness would merit. Governments have played their part in trying to enable companies of all sizes to maintain access to credit, to support employment through lockdown via furlough schemes or direct hand-outs to households.
Governments and central banks are trying to ensure that both potential supply and future demand are preserved to the greatest degree possible for when activity resumes post-lockdown. But of course, they can only partly succeed in this ambition. So what should we be watching to navigate the coming months as the UK’s lockdown restrictions are eased?
The virus itself, of course. In recent weeks it appears that the severe lockdowns undertaken in the UK and Europe have succeeded in curbing the virus to the point of little consequence. Scientific studies vary and indeed conflict in their findings, but the suggestions that either COVID-19 has been with us for some months longer than initially thought, and herd immunity is much greater consequently, or that only around twenty percent of the population is susceptible anyway, appear to be gaining traction.
Sadly in the US, with shorter and more varied types of lockdown, cases are rising again in numerous states. This reality calls for close monitoring of the pace of economic recovery there, irrespective of central bank support.
In the UK, our focus is on behaviours as the lockdown is eased. For many consumers, greater freedom of movement and opportunities to shop, visit the pub, dine out or travel will be welcomed and could see a mini spending spree, especially for those desperate to salvage a summer holiday. For others, continued caution will be the watchword until there is some form of sounding of the ‘all clear’ from Government. This itself requires delivery of reliable mass testing facilities, or track and trace technology or, ultimately for some, a proven vaccine.
As the Government furlough scheme ends, critical will be how high the level of unemployment rises. Many large companies have announced substantial cuts to their workforce, underlining the point that there is only so much Government can do to preserve productive capacity, as companies will respond to a weaker demand outlook by closing it. Excess capacity in restaurants, for example, long pre-dated COVID-19 but it is clear that many chains will downsize or disappear.
Growing unemployment and the fear of unemployment usually sees a rise in precautionary savings and reluctance to spend, until unemployment is firmly on an established downward trend again. This is where the Government’s pre-COVID-19 agenda of public spending on infrastructure projects and attracting investment into the regions as part of its ‘levelling up’ ambition may prove to be the key to economic recovery.
It was clear pre-coronavirus that we are in a new era of big public spending and there will be no return to austerity. Irrespective of the cost to the Exchequer of the coronavirus, the Government will borrow and spend even more than promised pre-virus. Expect an autumn Budget ‘for the recovery and jobs’. Expect a renewed emphasis on transitioning to greener energy sources and a greener economy.
So what is the outlook for company profits? Investors appear willing to look across the valley of crushed earnings in 2020, and accept that whilst 2021 will be better than 2020 it will not see a return to 2019’s level of profitability. Will it be 2022 or 2023 before those heights can be attained again? And what is the right multiple to pay today for those recovered earnings so far out?
This is where the trajectory of economic recovery and the level of unemployment will be so crucial in determining the pace of profits recovery, and hence stock market progress. We are encouraged by conversations with companies that remain confident that they can regain previous levels of margin even on revenues markedly lower, while accepting that it may take some time to get there.
In part, this will be through job cuts which, in aggregate, cannot help the wider economy – unless Government initiatives stimulate investment to pick up the slack in the labour market. Post-virus, might we see companies encouraged to invest in their workforce, in improving productivity, in new technologies; it seems highly probable that this will be priority over share buybacks.
In part, companies will exert pressure on their suppliers – and nowhere is this more so than with their landlords. Swathes of retail tenants have not paid their rent, and the Government has legislated in their favour over eviction by the landlord. We are witnessing the death of the upward-only rent agreement. In retail, this is shifting to turnover-related rental agreements. But do not expect industrial or office space to be wholly immune from both downward pressures on rents and changes to more flexible types of rental agreement.
As so often in a downturn, the strong will emerge aiming to get stronger at the expense of weakened competition. We are seeing equity capital-raising to do precisely this – apply greater competitive pressure to rivals with weaker balance sheets or inferior products, in a search for market share gains. Expect mergers and acquisitions, as the strong seek to consolidate their market position through deals. But expect also that companies may wish to operate with less leverage and stronger balance sheets going forward. This can only make it harder to generate previous levels of return on equity, with less debt to ‘juice’ those equity returns.
The virus. Consumer behaviour post-lockdown. Levels of unemployment. Government spending and investment initiatives. All of these will help determine the pace and path of the recovery in profits on which ultimately this rapid rebound in equities will rest. It is going to be an interesting summer. Stay tuned.