Coronavirus and markets – our latest views

Current markets: 19 May

• Major stock markets rallied significantly in April. Investors have been encouraged by unprecedented support from governments and central banks as well as signs that the worst of the pandemic is past. Equities have largely held onto their gains in May.
• The UK announced the lifting of some restrictions on 11 May, alongside plans to further ease the lockdown over the summer. The UK furlough scheme has been extended until October.
• Many US states are now emerging from lockdown. However, strict restrictions will likely remain in place in New York City – the epicentre of the pandemic in the US – until June.
• German chancellor Angela Merkel and France’s president Emmanuel Macron called for a €500 billion eurozone recovery fund on 18 May. Other eurozone leaders have indicated they are unwilling to support the plan in its current form.

Our longer-term view

Global stock markets have largely shrugged off some of the worst economic data in modern history. US GDP fell by close to 5% in the first quarter, with significantly worse figures expected in the second. The US unemployment rate is now approaching 20%. Yet global equities, as measured by the MSCI World Index, have rallied by almost 30% from their lows in late March.

The disconnect is partly explained by optimism about the pace of recovery. There are now clear signs that the pandemic is being contained in major economies, allowing for the restart of some sectors. This is fuelling hope that economic activity will rebound in the second half of the year.

Policy support

Decisive policy measures have helped. In the US, recent fiscal stimulus measures equate to approximately 14% of US GDP, replacing a huge amount of the output lost as a result of the response to Covid-19.

There are also encouraging signs that eurozone leaders are closer to agreement on a fiscal support package for the region. Under a plan proposed by French president Macron and German chancellor Merkel, the European Commission would raise €500 billion to make grants – rather than loans -  across the eurozone. Though it has not yet been agreed by all member states, the plan would be a significant step towards closer fiscal union.

Meanwhile, central banks have greatly reduced the risk of a “credit crunch”. In March, the credit markets effectively froze as investors worried about the ability of companies to repay their debts. Those fears have been greatly eased by central banks’ commitment to support the corporate bond markets. Corporate debt issuance has since boomed. Even companies in the hardest hit sectors, such as cruise operators and airlines, have managed to raise money.

Stock market performance

Looking more closely at the stock market’s performance, however, suggests that the rebound has not solely been fuelled by optimism about economic recovery. Investors are clearly favouring sectors that are still able to offer growth in today’s very uncertain environment – principally technology and healthcare. They are also turning to more defensive sectors, such as telecoms and consumer staples. By contrast, industries which depend on robust economic growth, including energy and banks, have lagged the broader market. Typically, these more economically-sensitive sectors lead equities out of bear markets.

In aggregate, equity markets now look expensive based on near-term earnings prospects. The MSCI World Index is trading at a multiple of 19 times forecast earnings for the next year, well above the long-term average of 15. Yet for now, investors appear willing to look past this year’s reduced profits – and high valuations – assuming that they will quickly rebound to pre-crisis levels.

A rapid rebound now looks optimistic

While we remain confident that recovery will come, we are less optimistic about its speed. Pent-up demand will boost growth to some extent as lockdowns are lifted. However, it looks increasingly likely that the pandemic will limit the pace of expansion for many months after restrictions are eased.

Some sectors will face lower levels of demand as consumers and firms avoid activity that could increase the risk of transmission. Many businesses will also have to deal with significantly higher costs as they implement new working practices to protect staff and customers. The combination does not bode well for profit margins.

Even without measures to ensure social distancing, demand may suffer as a result of reduced confidence. While they face the risk of a second wave of infections, and potentially further lockdowns, consumers and businesses may shy away from large purchases and investments. And, at some point, governments will have to step back from generous support packages, creating further uncertainty.

Positioning for a slower recovery

The economic outlook has improved since March, but we think equity markets may now be too optimistic about the pace of recovery. If activity does not recover as quickly as expected, we could once again see higher levels of volatility. While we are not making significant changes to our asset allocation, we are prepared for a more challenging environment.

Within multi-asset portfolios, we have increased the defensiveness of our fixed income holdings through the purchase of long-dated gilts (UK government bonds). These have a negative correlation to global equity markets and should therefore protect portfolios in the event of a further stock market sell-off. We also maintain significant exposure to gold, which has historically tended to perform well during equity market drawdowns.

Managing risk in our equity exposure

We benefited from adding to equities late in March. Given our expectation that the global economy will in time recover from the shock of the pandemic, we are maintaining our equity weighting within portfolios at current levels. However, we have taken steps to modestly reduce the risk profile of our equity exposure and tilt it towards sectors that are better positioned in the current environment.

On average, the underlying companies within our portfolios now have lower levels of indebtedness than their benchmark. We are also switching some of our broad equity exposure into more defensive parts of the market, such as infrastructure. Finally, we continue to favour exposure to “growth” over “value” sectors. While the former have outperformed the latter consistently for much of the past decade, we think Covid-19 could prolong the trend even further.