With the benefit of hindsight it appears as though we are still in the “response phase” sweet spot for equities. With an apparent peak in the US and European COVID-19 infection and mortality rates approaching, markets are choosing to emphasise the positive developments. In particular, the extreme monetary and fiscal policy response with the promise of even more driving the hope of a V-shaped recovery once activity resumed. To be fair, credit markets appear to be responding with the trough in equities (so far) on March 23 coinciding with peak global US dollar funding stress, widespread de-leveraging, short term funding stress, peak pandemic fear and extremes in cross asset volatility, positioning and beliefs.
Perhaps that is how it will play out. There does appear to be a bifurcation in market beliefs about whether the current rally is of the bear market variety and the worst is yet to come, or the prevailing bias to not fight the Fed and this policy stimulus is unprecedented. Either way, the key question to ask is what is your quarrel with price? It is entirely possible that the equity market has already put in the low given the dire economic news flow already evident (the bad news is in the price) and the vehemence of the policy response. That is, it might be rational to back the efficacy of policy. However, there are a few key counterpoints to note.
First, the rally to 2750 using the S&P500 as the global risk proxy is already pricing a fairly aggressive recovery. The S&P500 is now up by more than 22% from the March 23 low having retraced almost 50% of the decline. That has actually pushed the 12 month forward valuation multiple up to 19.0 times based on heavily revised earnings. To put that into perspective, that is the same valuation multiple it held at the all time high for equity prices on February 19. Put another way, the equity market is at cyclical peak (not cheap) valuation multiples.
Of course, it is important to consider equity valuation relative to or in the context of interest rates. Extreme monetary policy has had a material downward impact on Treasury yields, future short rate expectations and therefore the cost of capital and competing asset for equities. However, the big picture point is that the market has already re-rated back to a relatively optimistic valuation multiple on still relatively optimistic earnings expectations relative to the economic news flow and the prospect of a material credit downgrade cycle (even with the various debt support mechanisms).
Second, the markets are clearly shifting their focus from medical developments and the shock of proliferation to the hope of economic recovery supported by (almost) unlimited monetary and fiscal policy. The consensus belief based on a large poll by Citi is that the majority of business will likely be back to work by May or June. However, even with large policy support mechanisms, the damage done to small, medium sized business and household income from a cash flow perspective by then could be catastrophic. From our perch, it appears optimistic to expect a rapid normalisation and return-to-work. From a medical perspective, it is also possible that there is a second round of infections and secondary shutdown as a result.
In conclusion, markets appear to be placing an emphasis on positive developments, with the focus shifting from medical developments to the shape of the economic recovery, v-shaped or otherwise. That said, the S&P500 or the global risk proxy has already priced a fairly aggressive recovery. After the decline in earnings expectations, the forward price earnings ratio has already returned to 19 times or the multiple at the peak in February. On the positive side, extreme monetary and fiscal policy with the promise of more ought to support the expansion once activity normalises. Our bias is that the economic and earnings impact is not fully priced and there may be another test of the low. However, either way, there are equities, particularly in Asia, trading at distressed valuations with leverage to the recovery whenever that gets underway.