Up until very recently it is easy to imagine that many people might be wondering why equity markets in Europe and the US had been performing so well. The Chinese economy has ground to a halt due to the Covid19 virus and the supply chain disruption is unprecedented. Jaguar Land Rover are now shipping key fobs out from China by air in suitcases in order to keep the production line flowing in the UK and toilet roll is a black market item in Hong Kong.
The rationale comes back to the same dynamic that drove markets to deliver strong returns in 2019, namely liquidity. In the current environment, the firehouse of Central bank liquidity is the principal source of stability driving stocks well beyond the fundamentals.
There is possibly also a fair amount of parochial naivety outside of Asia due to the lack of any immediate visible consequences given that the global supply chain has a natural lag of around six weeks. The normal inventory build ahead of Chinese New Year also provided more of a buffer than usual and I suspect it will not be until the end of March that investors are fully cognisant of the secondary effects.
Clearly, the markets have also assumed that any disruption will be short lived with a V-shaped recovery, which is a reasonable argument for markets not to correct sharply. However, it is not necessarily an argument for stocks to reach new highs.
Excessive savings support the Red Dragon economy
China is the second largest economy in the world, with an interdependent supply chain across Asia that makes it the most important economy for global growth. At the moment, it is essentially in lockdown. Investment research provider BCA notes that the economic statistics in China are “off-the-chart bad”. The good news is that the rate of infection is slowing, but initial estimates suggest Chinese GDP will struggle to reach 3.5 per cent on an annualised basis in Q1 compared to the initial 6 per cent estimate. It goes on to note that “the direct and indirect effects of the outbreak should be enough to push global growth down to zero on a quarter-over-quarter basis in Q1. Under a baseline scenario, growth will recover in the second quarter, leaving the level of global GDP down 0.5 percentage points for the year as a whole compared to what would have transpired if the virus had never emerged”.
In aggregate, BCA believes the global economy to be in relatively good shape compared to 2007-2008, with a private sector surplus of earnings versus spending of 3.5 per cent. Although debt levels in China have soared over the past decade, BCA points out that China’s private-sector financial surplus reached 7.1 per cent of GDP in 2019 – higher than in Japan or Germany. Therefore, rather than suffering from excess debt levels, China suffers from excess savings. It is these savings that have forced the authorities to push state-owned companies and local governments to engage in debt-financed investment spending in order to prop up aggregate demand and employment. It is also these savings that will allow the government to stimulate the economy to prevent an outright economic collapse.
The World Health Organization is also increasingly concerned about the spread of the virus outside China, and articles in the American Journal of Epidemiology suggest that the death rate from infection, when adjusted for time-lags between reported infection and death, is closer to 5 per cent. This ratio implies that the outbreak is more serious than suggested in the press and is possibly understated in terms of numbers affected. SARS is considered a less deadly virus than Covid19, yet the WHO estimated a mortality rate of 14 per cent in the 2002 SARS outbreak, with a key determinant being the age of those infected. For those over 65, the mortality rate was closer to 50 per cent and 1 per cent for those under 30. Changes in the public health response will no doubt play an important role in the outcomes of Covid19, but it would be complacent to dismiss it as being similar to a normal flu season.
The People’s Bank of China has responded with a record CNY3.34 trillion of new loans and a record CNY5.07 trillion increase in aggregate financing, both of which provided a temporary boost to markets. However, it is questionable whether the warm glow of liquidity can continue to console investors if we see the physical and economic impact of the virus spread more broadly.
The markets’ five stages of grief
BCA quite sensibly admits to having no evidence of a pandemic emerging at present and suggests that if the number of new infections continues to decline, investors will likely look through the Q1 plunge in growth. The latest news of infections in Italy and Iran would suggest that this optimism might be premature.
Recent data outside of China, such as the purchasing manager indices, imply that global growth had already turned the corner in the weeks before the viral outbreak, so pent-up demand may mean a rebound in growth in the second quarter. Under this benign scenario, equities still have upside in their view, while bond yields will start rising again. As a countercyclical currency, the US dollar would also give up some of its recent gains.
In a pandemic scenario, a recovery in growth would obviously be delayed. And when the output does recover, it will be from significantly lower levels. In BCA’s view, markets will end up going through their own version of Kubler-Ross’s five stages of grief: denial, anger, bargaining, depression, and acceptance. Unfortunately, before we reach the acceptance stage, global equities could easily fall by 20 per cent from current levels.
One reason not to get too bearish is that the Federal Reserve may cut interest rates in the wake of falling global demand. The efficacy of such a decision may be questionable, but one sector that stands out as a beneficiary of the contorted environment of Central bank largesse is technology. Deutsche Bank recently noted that Apple, Amazon and Google now have a combined market capitalisation of US$3.4 trillion, which is US$0.5 trillion larger than the combined market cap of all the companies in the German DAX and French CAC indices. It is worryingly reminiscent of 1990, when the Imperial Palace in Tokyo was worth more than all the property in California combined. Thirty years on from its all-time high, the Nikkei Stock Average is still languishing about 40 per cent below the peak of 38,915 per cent on 29 December 1989. The Japanese stock market’s uphill climb to regain lost ground is the longest in history and a poster child for an asset bubble.
Perhaps we have not reached the extremes seen in Japan just yet, and there is no doubt that the dominant technology stocks in the US benefit from monopolistic or oligopolistic power last seen in the era of Standard Oil. Their business models and growth are tempting to every investor who fears missing out and it is hard to see how this will change in the short term. Equity valuations for growth stocks in particular are inflated by the low interest rates and liquidity that the US Federal Reserve has pledged it will provide. The moral dilemma for the Fed is that the US economy has become dependent on the stability and growth of equities, essentially putting them in charge of the S&P500. The economic fallout from the market correction in 2018 was a reminder of this interdependence and forced a complete reversal of US monetary policy normalisation. Subsequently, investors recognised an asymmetry of market risk with the Fed on their side, which has led to undesirable excess in certain parts of the market.
We have been reducing our exposure to the US in our managed strategies, finding it increasingly difficult to justify current valuations. The earnings picture remains weak across the world and even Apple announced that there would be a significant impact from the slowdown in Asia. It had little impact on the stock.
Sustainable capitalism requires regulation and discipline
Adam Smith, often regarded as the godfather of Capitalism, believed that to be sustainable capitalism requires regulation, and regulation is probably the most immediate risk to the likes of Facebook, Microsoft, Amazon and Google. Their concentration of power through data, socio-political influence and labour markets are clearly of increasing concern in both the US and the EU. Vera Jourova, the EU commission’s vice-president in charge of transparency and values, wants the “black box” algorithms that power parts of the internet to be open to “audit” so that the public has a better idea of what determines what they watch and consume via the web. Competition commissioner Margrethe Vestager is also examining Facebook’s treatment of online classified ads following complaints from players in the sector. In the US, the Federal Trade Commission issued orders to Google, Apple, Facebook, Amazon and Microsoft to turn over a decade’s worth of information on past small acquisitions as part of anti-trust investigations. The regulatory environment in the US may also deteriorate if the democrats win the Presidential election, but with Bernie Sanders the current favourite, that risk appears small and Trump is relatively secure for a second term.
Our preference with regard to asset allocation is to maintain our valuation discipline. This has cost us relative performance in the short term and, in all honesty, momentum is likely to continue to beat value while the global economy remains uncertain and Central banks continue to add liquidity. However, we draw comfort from the fact that the top stock-pickers to whom we speak see unprecedented idiosyncratic value beyond the momentum names. Dislocation creates windows of fantastic opportunity, with past examples being the unloved US compared to Japan in 1990 and consumer staples versus technology mania in 2000. We back our managers to find these opportunities and to protect and grow capital in the long term, rather than chase momentum-driven performance where little protection from valuation exists.
The outlook may be uncertain but timing markets in the short term is very difficult and usually costly in terms of performance. The most successful strategy is to let the compounding of real growth in earnings work in your favour over a long term investment horizon.