The rally in global equity markets (the US in particular) but including Australia, is starting to reach pain trade levels for anyone who is below benchmark. US equities are now less than 15% from their all time highs while Australian equities are a little further behind at around 25% from their YTD peak.
There is a lot of talk about markets running too far ahead of fundamentals given most economies are on the verge of their largest economic declines since the Great Depression. In light of ongoing health and economic risks, we think there are some sensible concerns around the size of the rally, market leadership (defensive) and what appears to be an optimistic trajectory for the recovery in corporate earnings.
But, equally there are a number of concerns which we simply confine to the “fake news” basket and are not too dissimilar to what is normal coming out of growth driven corrections.
In 2009 as markets emerged from the GFC, the consensus view was that the upswing was counter trend. Those who were around at the time will recall that it started as the “world’s most hated bull market” and that investors were dragged into the rally as the pain trade grew. Investors who held onto a cautious view underperformed on two accounts.
First, they were not fully invested as the market rallied and second, because they doubted the sustainability of the rally, they positioned too defensively. For well over two years, many investors were playing catch up with the market and justified a cautious view by arguing that they were protecting against the downside.
Outside of the flash crash in 2010, it took the European financial crisis in 2011 to provide the first major reprieve for the bears. We all know the story from there as equities went on to record their longest bull market in history.
It feels a little like déjà-vu with how the market is currently rallying and the extent of scepticism that surrounds the rebound. The most common narrative is that the market is ahead of itself, that it will retreat to its lows, that breadth is too narrow, that expectations are overly optimistic and risks are under appreciated. Only time will tell and there is some merit to the concerns, but there are also some sensible explanations for the recovery to date that should not be ignored.
- First, markets always run ahead of fundamentals when they emerge from a downturn. We are seeing nothing different to what normally happens, particularly with scepticism on the size and speed of economic recovery. We also think that uncertainty brings the focus to the near term when in fact it is the longer term where conviction is higher and the trend for improvement more discernible;
- Second, sceptics are overlooking what is perhaps the most important support for risk assets in the Federal Reserve and global policy makers. Markets have learnt not to “Fight the Fed” and we think this adage applies even further when they are buying almost every asset they can with the exception of equities. The Fed Put is clearly in play and the open ended nature of their commitment as well as the potential to extend asset purchases also sits in the background;
- Third, locking up the population and then opening up the door to the outside world generates huge behavioural optimism. The world is gradually emerging from lockdown and whether the speed proves disappointing, the narrative is positive vis-a-vis where we were 8-10 weeks ago. Similarly, while no cure for COVID-19 is imminent and hence the risk of further waves of the virus remain real, there are success stories for containment (if not near eradication) and we think countries will deal with 2nd or 3rd wave events more surgically rather than at an economy wide level. Regardless, from where we were, to where we are, is a giant leap forward;
- Fourth, when an economy comes out of recession there are always sectors that lead and lag. To argue that we should be worried because airlines, hospitality or tourism might lag as the economy begins to recover is worrying for these sectors, but is not a constraint for the direction of the market unless they are economically dominant. In fact, such a trend shares many similarities with how early cycle cyclicals (retail, discretionary, technology) lead late cycle cyclicals (aerospace and defence, capital goods) through recovery periods. The constraint for the Australian equity market will be continued underperformance of banks but if credit channels remain open, this is not a headwind for the economic recovery; and
- Last, there are concerns that valuations are already extended and this is before earnings estimates fully reflect the downswing. We think valuation is a better reference point for market bottoms rather than preventing markets from rallying during turning points (they can trade expensively). In addition, the rapid decline in the cost of capital as a result of central bank actions lends itself to markets trading on higher and not lower valuation levels as growth risks decline into 2021. While few want to consider the potential for equity markets to take out their prior highs, we see no reason why February highs will be a constraint if growth recovers over time.
Markets remain vulnerable to disappointing news flow, but it is important to know what is normal and what is not when we look at performance trends. Concern rightly lies with how quickly expectations are forecasting a return to pre-COVID-19 levels, but we think 2020 should already be a write-off in investors’ minds and 2021 is set to be better even if it sits on the side of optimistic.
The wave of Australian capital raisings alongside the outperformance of stocks which have tapped capital markets is encouraging. To us, it sends a signal that these corporates should be able to absorb further downside growth risks. This is another important support for the Australian equity market even if it isn’t the catalyst for upside.
If history is a guide, a new bull market will be well and truly entrenched before investors are prepared to acknowledge it and that’s because it’s generally harder to come back from being “bullish and wrong” than it is from being “bearish and wrong”.
Jason and the Investment Strategy Team