Over the past month there has been an epic battle between the light (monetary and fiscal stimulus) and dark side (economic and earnings weakness) of the force. Currently, the light side of the force is winning. The ever evolving scope and duration of the Federal Reserve’s bond buying program is probably a key reason why the Fed’s April 9 package was a pivotal moment. That obviously followed unlimited quantitative easing on March 23. However, as Tony Dwyer at Canacord noted, it wasn’t the amount of money that was important (although that is incredible), it was the fact that as soon as the Fed saw an area of stress, it attacked it with an enormous amount of money. That action was likely pivotal because it probably reduced the odds of the worst case scenario.
Although the S&P500 has rallied modestly since April 9 and a lot since March 23, the average stock has lagged with gains concentrated in a few names. The rally has been famously narrow. The nature of the leadership (the generals) suggests that it has been driven by liquidity rather than a genuine economic recovery (led by the troops) or early cyclical sectors like industrials, materials and banks. To be fair, there have been some signs of life in “value” and cyclical sectors over the past few days with a breakout in the Russell small cap index, banks and the industrial sector which appears poised to move higher.
The recovery, when it comes, may see a reversal of relative performance, but as Gerard Minack noted recently, the next expansion will need to be stronger and broader than the last expansion to lead a sustained change in market leadership. That in turn, will likely depend on whether policymakers are willing to sustain large central-bank funded budget deficits. Even before this episode commenced, we had noted that a shift in the post-2008 regime of low trend growth, inflation and interest rates was likely to require aggressive and sustained fiscal policy and a shift in the relative performance between growth and value styles within equities.
For now, the policy response has reinforced the prior regime by collapsing policy rates to zero, supressing sovereign yields and providing unlimited liquidity. The nature of vicious collapse in economic activity has also reinforced the existing regime. Growth is clearly scarce. Therefore, investors have bought growth in what is perceived to be a severely growth starved world. Growth is obviously concentrated in a few mega cap technology companies in the United States. The winners remain (technology) by sector, growth (by style) and the United States (as a market with a large weight to technology and health care). Growth companies with long duration cash flows also benefit from a decline in the discount rate. Of course, in other sectors of the market, where cash flows are near zero, it does not matter how low the discount rate falls. Zero divided by zero is still zero.
The other likely winners in this regime and consistent with the last decade are companies with perceived stability of cash flows and dividends (or bond proxies). Of course, not all bond proxies have had sustainable cash flow or income through the current crisis, for example Real Estate Investment Trusts. Therefore, it has been important to filter equity exposure by balance sheet strength, free cash flow and dividend cover. That is exactly what we have done in our own equity exposure, albeit little has been deployed so far. Looking forward, if the extreme monetary and fiscal policy does contribute to a stronger cyclical recovery once the lockdown restrictions ease, leadership may shift to the traditional early cyclical sectors where value is more compelling, particularly in emerging Asia. In the medium term, if policymakers are willing to sustain large central-bank funded fiscal deficits, there could be a genuine shift in the regime from disinflation to reflation.
As we noted above, the extraordinary nature of the policy response may have reduced the odds of re-testing the low. However, we still have a quarrel with the notion of a “V-shape” economic and earnings recovery given the depth and likely duration of the contraction. Even if a “V-shape” recovery was probable or the central case, the S&P500 price to expected 2021 earnings is now right back to where it was before the healthcare crisis. Put differently, the US equity market has already priced a V-shape recovery in valuation terms. In the short term, it is plausible that the policy and liquidity driven rally will persist and push equity prices higher still. However, a genuine cyclical recovery likely requires more broad based participation from early cyclical and value sectors like industrials and materials.