July Investment Strategy - And after the summer?

Key points

• Europe has been enjoying a rare moment of outperformance recently.
• Still, given the abundance of “cliffs” ahead, Europe would do well with a nice policy “parachute”. For now though, the US is still doing more on the stimulus front.
• Equity gains have been strong despite the know concerns about the virus, the economic impact and other uncertainties like US elections.
• A pre-election fiscal boost, a peak in the current infection rate of success in the hunt for a vaccine could provide a meaningful positive boost.
• Earnings will be important, particularly when analyst expectations of a rebound begin to be confirmed by companies themselves.

Can Europe stay “in the good place” for long?

To borrow recent words from Christine Lagarde, the Euro area has been “in a good place” recently. This is a relative notion of course. Compared with the US, the pandemic is now much better controlled, and the real-time indicators continue, for the most part, to normalise at a strong clip, in sharp contrast with the US where they are now reporting a relapse in activity. This was reflected in equity indices lately, with Europe enjoying a (rare) moment of outperformance. The situation remains precarious though and we would focus on three risks for the near future.

First, although the re-acceleration in virus circulation is nowhere near the pace seen in the US even in Spain, which at the moment is Europe’s hotspot, risk tolerance on this side of the Atlantic is low and containment measures – bringing in some disruption on the supply-side – tend to be re-imposed faster than in the US for 

any given pace of Covid propagation (the recent news from Barcelona are a case in point). Real-time indicators have started to reflect some marginal relapse in activity in Spain, which may also suggest that the European public may react more cautiously than US citizens, as important as government reaction.

Second, so far monetary policy transmission has been swift – reflected in the record flows of loans originated to the business sector since March. But the European Central Bank (ECB) Bank Lending Survey (BLS) is now suggesting that banks are preparing to tighten their credit standards, anticipating the closure of the window of access to state guarantees. Christine Lagarde called on the governments to re-profile their schemes to avoid such “cliff”.

Third, the labour market is currently artificially propped-up by extraordinary measures such as very generous part-time unemployment benefits. Business surveys suggest there is ample “pent-up layoffs” ready to materialise when those government schemes are scaled back. This could impair consumer spending after the current, stronger-than-expected rebound observed since the late spring across the Euro area.

Against those cliffs, the European economy needs a “parachute”. This is where the contrast with the US works the opposite way. Treasury Secretary Mnuchin is openly discussing the possibility of “blanket forgiveness” for the smaller loans granted through the Paycheck Protection Programme (PPP), while the House passed an additional stimulus package worth 8% of GDP in 2020 and 7% in 2021. Faced with an uphill struggle in his re-election bid – as polls now steadily favour Joe Biden – President Donald Trump is sounding more and more open to some of the aspects of the House package. Finally, the Federal Reserve (Fed) is explicitly having a conversation on shifting to “yield control” should stronger forward guidance fail to contain market expectations.

In Europe, national fiscal stimulus packages still look small. Fortunately, although negotiating the EU’s Recovery and Resilience Fund proved more painful than expected, a deal was found which sends a powerful political message, in particular with the taboo of debt mutualisation breaking. Still, the scheme will result in an additional push of only 3 to 4% of GDP cumulatively over seven years. It is not a game-changer from this point of view, and national budgets will need to do more.

Since the start of the crisis, markets have been oscillating between focusing on the pandemic risk itself or on policy support. On the first leg, Europe continues to do better than the US. But on the second, the US is still in the lead. This may hamper the capacity for European markets to outperform much more.

Triumph of the recovery

Overall though, equity investors continue to experience strong returns. While short-term trends may respond to the subtleties of the policy making process and news-flow, the overwhelming force behind rising markets is the belief that 

the world will recover, both economically and from the pandemic. That is an important psychology and helps explain the apparent disconnect between market momentum and valuations on the one hand, and the insecurities created by the pandemic on the other.

An expectation of superior returns to equity investors as the world adapts to a post-pandemic reality should not be tinged with complacency however. The world economy has taken and continues to take a big hit. There is already and will continue to be less employment. The US election will create medium-term policy uncertainty. The virus could surge again as we approach winter. We are yet to fully understand the extent to which the long-road of globalisation will reverse and the implications of that. But a lot of this we have already known for some time.

The coming months, however, could sustain markets. The European deal, a pre-election fiscal boost in the US, breakthroughs in the search for a vaccine and the potential peaking of the infection rate would be positive drivers. It should be remembered that returns from most equity indices are still negative year-to-date. The shock of the first quarter (Q1) propelled bond returns above those from most equity strategies. Even today, the total return from a US Treasury index from the end of 2019 stands well above returns from most equity strategies. Unless we experience severe reversals in growth or the health crisis it is unlikely that this fixed income outperformance will persist. Investors will struggle to get returns above low single digits from most bond sectors while owning equities provides exposure to the upside of a recovery.

Earnings are important. We are just into the Q2 reporting season in the US and the early results are on the positive side. Consensus forecasts see a return to positive year-on-year earnings per share (EPS) growth at the start of 2021, based on what we have already seen from the bounce in economic activity. However, guidance is still fragile as companies have little visibility about just how the recovery proceeds. Analysts expectations need confirmation from companies themselves. When we start to get that, the doubts about the stock market’s ability to stay elevated will begin to diminish.

The fact that markets are up with what we already know suggests that something much worse needs to come along to put us into a bear trend again. That of course could be something as straightforward as a meaningful second wave and renewed lockdown for a large part of the global economy. Returning to the economic activity levels of early April is highly unlikely but the fear of such a scenario could be enough to push markets significantly lower at some point. For now, thankfully, the signals are not pointing in that direction.