Looking beyond the equity bounce

Fierce equity rallies rarely coincide with record-shattering surges in unemployment numbers, but that is the strange situation that confronted investors this week.

US stocks enjoyed their best three-day performance since the 1930s this week, not even derailed by jobless claims in the country reaching a record 3.3 million and the continued increase in the number of COVID-19 cases worldwide. Indeed, we started the week in a bear market but some equity indices have now technically entered a bull market.

So what explains investors’ sudden optimism, notwithstanding today’s selloff? Essentially, the market reacted positively to the massive interventions by policymakers, particularly in the US where a $2 trillion stimulus bill should soon be passed.

The fiscal stimulus is designed to moderate the underlying economic shock, but in financial markets the interventions of the Federal Reserve are just as important. The principal financial implications of these measures are:

• There is now a de facto cap on government bond yields (via the Federal Reserve’s commitment to unlimited quantitative easing).

• There is now a safety net for investment-grade bonds (via all major central banks buying investment-grade credits).

• There is now enhanced US dollar liquidity (via swap lines between the Federal Reserve and a long list of other central banks)

• There is now better general market liquidity through central banks’ interventions in counterparty markets.

Overall, the tail risk of a truly systemic crisis has become much less likely with these developments.

Hold on

We nevertheless disagree with this newly bullish market consensus. Our reservations fall into three broad categories: economic, earnings, and the epidemic.

On the economy, the market seems to be pricing in a V-shaped recovery. We believe a U shape is more likely. Our virus modelling suggests that the authorities will need to keep social distancing – and the associated restrictions on businesses – in place for at least several more months, otherwise further outbreaks are likely.

On corporate earnings, we expect a much larger collapse than the market seems to be pricing in. Our estimates imply an earnings decline of between 35% and 55%. The equity drawdown should be of the same magnitude as the earnings drawdown, or slightly less if the recession does not turn into a financial crisis. This means equity markets have not been pessimistic enough, although they came reasonably close before this week’s gains. Support from governments and central banks may alleviate some of the earnings pain, but we don’t know to what extent yet and any positive impact is unlikely to have registered by the time of the next reporting season.

Finally, the newsflow about the epidemic is likely to deteriorate further in the weeks and even months ahead. The resultant economic headlines, as the global lockdown tightens, could well be terrible. Yesterday gave us our first glimpse of the massive rise in unemployment, and defaults on debt could soon follow. Separately, France's statistics agency has provisionally estimated a 35% (that is not a typo) hit to GDP from that country's shutdown.

Our modelling suggests we are still weeks from a peak in the number of new infections in the UK and the US: Erik has challenged the presumption that we may be close to achieving herd immunity here, and in this blog Martin analyses what the number of asymptomatic cases means. Moreover, if US president Donald Trump does follow through on his call to restart the US economy by Easter, we could see further waves of the virus in America.

Taken together, this is why we remain cautious on equities even amid these rallies. We know from experience that sudden bursts of risk-on sentiment rarely endure amid such economic disruption and weak fundamentals.

There will be a time when buying the dip is likely to be sustainably rewarded, but we don’t think we are there yet.