Buoyant markets face critical period as hopes pinned on normalisation of earnings
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Covid-19 continues to wreak havoc worldwide, with virtually no area of economic and social activity left unscathed. However, the likelihood of a worst-case cataclysmic scenario is rapidly diminishing, and if there is a “second wave”, governments are unlikely to reimpose harsh lockdowns given the challenges of severe financial cost, public acquiescence and effectiveness.
Markets have mostly behaved rationally since the pandemic emerged, but their future direction hinges on the depth, longevity and scarring of the recession, valuation distortions and geopolitical considerations such as the US election and heightened tensions between the West and China.
Overall, capital markets have had a truly remarkable recovery and headline indices are nearly back to levels seen in January. A key driver of this has been the huge fiscal and monetary support governments have unleashed to build a bridge over the economy so there is one to come back to when the crisis is over. Markets also have a strong belief in medical science providing a solution in the form of therapeutics and vaccines. But has every market recovered?
If a government and its policy are perceived as having managed the crisis well, their markets reflect this perception. Examples of this include China, Japan, South Korea, Australia, New Zealand, Germany and Canada. The reverse is also true, and the FTSE all-share index was down 17.4% at the end of the second quarter.
Another factor is the structure of an economy and how that is represented in the capital markets. If an economy is highly dependent on retail, tourism, travel and energy, and if those sectors are strongly represented in the market, it will generally have done quite poorly. Equally, if an economy has lots of technology, e-commerce and consumer-staples businesses, and those are well represented in its market, it would have done relatively well. The US is the best example of this.
Future earnings
If things in the real economy look so bad — empty airlines and restaurants, businesses going under, unemployment surging — why does the market look so good? A simple comparison of the S&P 500 index and the S&P 500 profit margin clearly illustrates that while markets are rising, profits are falling. This conundrum is making many investors nervous as, surely, it suggests the market’s current buoyancy is built on a house of cards.
The market has accepted that earnings will be terrible in 2020 and into 2021, but believes that thereafter ...
Markets have mostly behaved rationally since the pandemic emerged, but their future direction hinges on the depth, longevity and scarring of the recession, valuation distortions and geopolitical considerations such as the US election and heightened tensions between the West and China.
Overall, capital markets have had a truly remarkable recovery and headline indices are nearly back to levels seen in January. A key driver of this has been the huge fiscal and monetary support governments have unleashed to build a bridge over the economy so there is one to come back to when the crisis is over. Markets also have a strong belief in medical science providing a solution in the form of therapeutics and vaccines. But has every market recovered?
If a government and its policy are perceived as having managed the crisis well, their markets reflect this perception. Examples of this include China, Japan, South Korea, Australia, New Zealand, Germany and Canada. The reverse is also true, and the FTSE all-share index was down 17.4% at the end of the second quarter.
Another factor is the structure of an economy and how that is represented in the capital markets. If an economy is highly dependent on retail, tourism, travel and energy, and if those sectors are strongly represented in the market, it will generally have done quite poorly. Equally, if an economy has lots of technology, e-commerce and consumer-staples businesses, and those are well represented in its market, it would have done relatively well. The US is the best example of this.
Future earnings
If things in the real economy look so bad — empty airlines and restaurants, businesses going under, unemployment surging — why does the market look so good? A simple comparison of the S&P 500 index and the S&P 500 profit margin clearly illustrates that while markets are rising, profits are falling. This conundrum is making many investors nervous as, surely, it suggests the market’s current buoyancy is built on a house of cards.
The market has accepted that earnings will be terrible in 2020 and into 2021, but believes that thereafter ...
