The markets appear fully recovered, but looks can be deceiving
If you are watching the S&P500 you will know that as at the end of July, it was approximately 4% off its pre-Covid mid-February highs. If we dig a bit deeper however the index starts to tell a very different story.
As at late-July, 186 of the S&P500 stocks, or 37% were showing a gain. The remaining 64% were still showing a loss since the start of the year. Delving deeper still we see that 226 or almost half of the S&P500 are still down at least 10% since the start of the year.
Facebook, Amazon, Apple, Netflix, Google, Alphabet, and Microsoft (the FAANGM’s) currently make up 25% of the total S&P500 market cap. Put another way, seven stocks equate to a quarter of the 500-stock index. This is up from c.8% on mid-2013. The rally we have seen in these tech stocks has had a larger impact on the index’s performance, making it appear as if the US share market has recovered.
S&P Mega-cap growth vs “the rest”
Mega Cap = MSFT, AAPL, AMZN, GOOGL, GOOG, FB, V, MA, NVDA, NFLX, ADBE
Source: Bloomberg Finance LP, DB Global Research
A more concerning outcome from these overweight index positions is that as passive investments are directly linked to index weights, the large mega caps stocks will continue to receive a greater share of every dollar invested using passive index strategies.
According to research from Hedgeye, the total global assets under management (AUM) in passive & exchange traded funds has grown from US$218 billion in 2003 to an incredible US$6.3 trillion in 2019 and “only” US$3.2 trillion in AUM within global hedge funds in 2019.
This massive increase in passive investing may mean that share markets become less efficient in establishing fair prices for stocks creating the ‘high risk’ potential ate of a self-fulfilling price bubble within the larger market cap stocks.
The stock market may be in a bubble…but maybe not
At present the Price to Earnings ratios (P/E) for most developed markets are at, or are close to, their historical high levels. There are many other quantitative measures that can be used that will reinforce this view, a view that we at PWA also hold.
It appears as if markets don’t seem to care about this type of quantitative analysis any more however so below, we have discussed a couple of views that are being used to justify share values at these levels.
Firstly, at a macro level we have a new acronym “TINA” to support current high valuations. TINA stands for There Is No Alternative. At present this is a pretty accurate statement. Examples of this can be found with the US yield curve almost completely below 1% (30-year bond is still at 1.23% as at start of August) or the sum of global bonds trading at negative yields (the return to maturity is below 0%) at a rate of US$15 trillion and rising.
Secondly, as yields on other investments decline the yields on global shares become more attractive. As shown below the interest margin that US share investors are receiving above the US 10-year government bond rate (the spread) is close to record highs.
S&P500 yield minus US 10-year bond yield
Source: Sun Trust Private Wealth Management
If the yields on US shares are historically high there are a few possible outcomes that will lead to a reversion to the average spread. These are:
- Earnings in the US can drop, reducing the dividend payments from shares;
- The risk-free interest rate (government bond yield) can increase, possibly making bonds more attractive;
- The S&P500 share values can push higher, reducing the yield on shares, and the spread above the 10-year government bond rate.
S&P500 – Q2 reporting season has started
At the time of writing this month’s commentary we are in the middle of the second quarter (Q2) reporting season in the US. Within the S&P500 128 companies have reported. Of these 128 companies only 60 (47%) commented on their earnings per share.
Of those 60 companies that commented on their earnings 32, or just over half of all the companies commenting either withdrew or did not provide any earnings per share guidance due to the increasing uncertainty in the US.
Of the other 47% of the companies that have discussed their Q2 earnings just 13 (10%) of all companies that have reported so far have upgraded their 2020 and 2021 earnings forecasts, and eight have decreased their guidance from previous calls.
EPS results from those that provided it – S&P500 S&P Historical P/E during earnings uncertainty
Source: Factset Source: Pavilion Global Markets, The Daily Shot
As we see an increase in the number of new daily cases of Covid in the US this uncertainty and lack of clarity around future earning’s will continue. For those analysts still brave enough to provide EPS forecasts for companies that have not provided their own views the margin for error is now much higher than we have historically seen.
Developed world interest rates reach new record lows
As we progress into this new Covid driven economic environment we have seen global central banks pump unprecedented levels of quantitative easing (QE) into markets and record high levels of fiscal stimulus from individual governments to support their economies.
Central banks and governments are taking these unprecedented steps to bridge the earnings gap created by countries locking down their economies as they try to “flatten the curve” on Covid cases.
At present the stimulus appears to be working as share markets continue to climb to new record highs and with some retailers continuing to see high demand for goods. What we are all still unsure about however is just how long this support will last and what asset values will look like once these supports are removed in the next year or so.
With Central banks continuing to purchase most of their governments (and now corporate) bonds there is a shortage of bonds left for the investor market. Given this supply/demand shortfall prices of bonds have risen to new record high levels, leading to US government bond yields moving to record low levels, as shown below.
US 10-year government bond at record low yield
Source: BoA Global Investment Strategy, The Daily Shot
The government bonds are the risk-free rate used above to calculate the spread as discussed above. If the risk-free rate has been manipulated lower by central banks bond buying programmes. What happens when the support stops? The risk-free rates (interest rates) will likely increase.
We don’t expect central banks to stop supporting their local markets for the next two-years, hence bond yields should remain at these low levels. At some point however they will start unwinding the QE programmes at which time yields will start to rise. This could also occur if the remaining investors start demanding higher yields to justify their continued investment.
Historically the average risk-free rate is c4%. At present the US 10-year has a yield of just 0.50%, so in a “normal market” interest rates should be between 2.5% – 3.5% higher.
If we see global interest rates climb, bonds values will decline, and in some cases this could be dramatic. We would also potentially see some share values decline in a rising interest rate environment as the cost of borrowing also rises, eroding company profits. US & Europe update
The Gross Domestic Product results are now in for the second quarter of 2020, ending July 31st. The US has produced its biggest drop in quarterly GDP ever with a decline of –9.5% (-32.9% annualised). Even though the numbers were bad for the US, Europe exceeded this with a GDP contraction for the quarter of -12.1% ( -40.30%
US & Euro GDP quarter change (annualised)
Source: Bureau of Economic Analysis, Eurostat, IMF, WSJ Daily Shot
One of the reasons for the US didn’t produce a worse result is the significant level of fiscal stimulus that the government has pumped into the system (12.3% of forecast 2020 GDP vs. Germany’s 9.4%). This has been achieved via “helicopter money” in the form of unemployment payments in excess of US$1 trillion to US households. The US wage stimulus is so large that is caused real incomes to rise by 16% across the US, while wage growth fell -8%.
Fiscal Stimulus for Covid – percent of projected GDP
Source: Bureau of Economic Analysis, Eurostat, IMF, WSJ Daily Shot
The level of monetary and fiscal stimulus to support the economies has been unprecedented with the US government debt to GDP increasing from 109% to a forecast 131% for 2020. This is an increase of debt to GDP of 20% in just 12-months.
The US may appear to be coming out of this global slowdown better than the Eurozone, but US has several states moving back into lockdown, while most of the Eurozone member states are now opening back up.
At a global level we have seen the manufacturing Purchasing’s Manger Index fully recover back to levels seen at the start of 2020. It is now just over 50 meaning that the manufacturing sector is growing again at a global level. Economists are debating if this is a sustainable recovery, or simply a relief rally driven by pent up demand for goods as consumers come out of lock-down. We will not know the answer to this until we have completed 2020 and had the final numbers, but the rest of this year is certain to produce more surprises both to the upside and downside.
New Zealand Economic update
Given New Zealand has come out of lock-down earlier than most of the world, the impact to economic growth, has been less negative than we are seeing in other economies.
Recently Standard and Poor’s stated that New Zealand was one of a small number of countries that had well-targeted stimulus plans, and good management of the pandemic. Other countries were China, Korea, Taiwan, Australia, Japan and Singapore.
Obviously, sectors such as tourism are going to suffer more meaningful long-term damage, but the most recent forecasts are promising. S&P forecasts that NZ’s Gross Domestic Product (GDP) will decline 5% in 2020 before rebounding back 6% in 2021.
The chart below shows the different pandemic responses by country. Interestingly, this shows that New Zealand had one of the most stringent lock downs initially but has also now moved to the most relaxed level. This adds credence to the Prime Ministers catch phrase of “Go Hard & Go Early”.
Oxford Covid-19 government response stringency index
Source: Oxford Bloomberg, ANZ Research
New Zealand is currently seen as a shining light in this new post-Covid world with the internal economy back open for business and Covid cases currently under control. Given we are one of very few countries that are fully open internally the NZ Economic Activity Index has recovered to be down only 1% on the same month last year. Businesses are still struggling with profits and business confidence is still down, but as shown below business data is also recovering to now be down just c.20% from the start of the year.
NZ Business Activity index– down but not out
Source: Haver Analytics, ANZ Research, Nikko Asset Management July Commentary
The Wage Subsidy and Wage Extensions have supported about 1.7 million employees in New Zealand since late March. The Wage Subsidy has ended, and the Extension is due to end 1st September. At present the government is still providing support to about 500,000 employees (10% of NZ population) across New Zealand.
NZ Wage Subsidy 2020
Source: MSD, Nikko Asset Management
We have recently had the latest unemployment data from Stats NZ which is suggesting that the unemployment rate has dropped from 4.2% to 4% for the June quarter. We would all love to believe this is an accurate result, but as we all know there is no way this is an accurate reflection of the local employment scene where we have 63,000 more jobseekers and income relief recipients than we did in March.
NZ Jobseekers and Covid relief payments
Source: MSD, Nikko Asset Management
Tony Alexander (independent economist and producer of “Tony’s Views”) is forecasting an accurate unemployment number of 5% – 5.5%, or around a 20% increase from the previous reading of 4.2%. What this does suggest is that the next reading of unemployment ending the third quarter will see a marked increase from the previous official reading of 4%.
Breaking down how the survey was done we can see a lot of room for error due to the timing of the survey and the ongoing government support. To be counted as unemployed a person must:
- Not currently have a job;
- Have been actively seeking work for four weeks (they were in lock down), or
- Be due to start a new job in the next four weeks.
This means that people who were not actively seeking work, including those 500,000 on the Wage Subsidy Extension plan are not counted. According to work done by Michael Andrews of The Spin Off NZ underutilisation (unemployed and underemployed) rate rose from 10.4% to 12%, and hours worked was down 10%, both record drops in New Zealand.
Closer to home we see a similar story to the S&P 500 index concentration in the NZX50. Back in 2003 Fisher and Paykel Healthcare (FPH) was 2.8% of the index and A2 Milk (ATM) was not even in the index. Today these two stocks make up c.30% of the NZX50.
F&P Healthcare/A2 Milk – NZX50 weighting
Source: Bloomberg, S&P Dow Jones Indices, Castle Point Fund Managers
Again, the performance of FPH and ATM when measured as their weighted average of the NZX50 is arguably skewing and mis-representing the overall NZX50 market performance.
Given the rapid rise in the price of the NZX50 shares as foreign buyers flood into the market, the slower growth in earnings and the higher impact from the stocks that make up a higher weighting in the index it is unsurprising to see the PE ratio also reach a new record high.
NZX50 PE ratio & Yield
Source: Nikko Asset Management July Commentary
Record high valuations have also led to record low yields being offered by the NZX50 at present of only 3.14%. This may seem ridiculously low for an investment as risky as shares, but when benchmarked against the NZ government 10-year bond rate of 0.93% the spread of 2.21% is still around the historical average.
This means valuations can again be justified if interest rates remain at these record low levels.
We have excluded charts on the NZ property sector this month as the data is unlikely to reflect the real economy. This is due to the mortgage holiday’s that residential borrowers are currently still on, and the wage subsidy extension. Both are set to end in September, but there is already discussion around some continued relief.
If the government support ends, we will likely see a truer reflection of the local property markets. Economists are still forecasting a fall of between 7% and 15%, but anecdotally house prices in Auckland and other part of the country are still getting good support with record low mortgage rates, and increased demand from ex-pats returning home.
As discussed above there are reasons to justify share valuations at these historically high levels. If the bond market continues to enjoy record low and negative yields in response to central bank quantitative easing, then share values appear to be reasonable.
What we don’t know is when QE will end, or if we will see a rise in inflation on the back of the fiscal stimulus which has been provided. If anything was to trigger interest rates to move higher that would likely be bad for both share and bond markets At this stage we do not see any risk of rates rising on the horizon given central banks clearly indicating that they are planning to support markets for the next one to two years.
The developments of the last 5 months have been anything but normal. Typical market cycles have been unexpectedly disrupted by a pandemic which has impacted every economy at unbelievable speed. Some sectors of the market such as travel, tourism, sports, entertainment and hospitality have been impacted to a much greater extent than general economies, whilst others such as technology have benefitted from changed work environments, changes to the way we do business and how we shop for goods and services. Similarly the recovery has occurred at a speed and to an extent we have not seen before, creating an uneven distribution of the benefits, with those who have retained their jobs and have invested assets being at a significant advantage to those who have neither.