WEEKLY MARKET UPDATE: VALUATIONS REMAIN HIGH

Mon 27 Apr 2020

After several weeks of recovery, equities fell in all major regions last week. Due to weak Sterling, both US and Japanese equities were flat for UK investors. However European (-0.5%), UK (-0.5%) and Emerging Market (-1.1%) equities were all negative in Sterling terms. The Energy sector was the best performing globally, even though the outlook remains dire for Oil prices, which have fallen c.70% year-to-date. Healthcare was the other sector which was up for the week, with Financials and Utilities the worst performing sectors. Government bond yields fell slightly in the UK, US and Germany, with Gilts gaining +0.7% for the week. However, as mentioned, Sterling fell against the US Dollar (-1.1%), the Euro (-0.6) and the Yen (-1.1%). It was a positive week for Gold, up +2.8% in US Dollar terms. The coming week will be a test of financial market sentiment, which so far has been surprisingly sanguine, with a significant number of firms announcing earnings

VIEW FROM THE DESK

For once behavioural science and fundamentals would agree: the market trading at 18-year-high valuations (>21x forward P/E) despite a global pandemic and a certain deep recession can’t be a sign of rational thinking. Surely when restaurants fail to open traders will see the truth and prices should fall? Our view is slightly more nuanced. Trading at high valuations reflects the will to buy. The market appears to be looking for a positive narrative that would allow it to allocate the onslaught of new money printed by central banks. It is, however, hamstrung by negative economic news, the persistence of the pandemic and very high valuations. There are two arguments we would consider. First of all, the S&P 500 trading at high multiples does not represent the whole economy. The World’s biggest companies are the long-term winners when smaller shops close. A small restaurant owner that closes down and takes a job as a manager at a Taco Bell which opened in the old business’s place suffers, but Taco Bell (Yum Brands, an S&P 500 company) wins. The key is to treat this year’s earnings not as a game changer, but rather as an outlier, which is really what Wall Street is currently doing. The cycle may change, but core profitability for large companies is not currently expected by markets to suffer over the long-term. Second, the crisis hasn’t really hit Wall Street, which is why optimism is still prevalent. We don’t see news of layoffs, hedge funds crumbling etc. Consider that when BP caused a huge environmental disaster, only its own stock suffered. But when lines formed outside of ATMs in 2008, the whole world economy shut down. Financiers are natural optimists. For pessimism to prevail, a direct threat to the decision makers must become credible. Global Finance reacts to what it sees as a threat to Global Finance. Traders hardly see companies and earnings any more. They see “risk assets” collectively, and right now they have an unprecedented amount of liquidity and hopes that deregulation is on the cards. So the sector to watch in order to understand markets is Finance. Traders are eager to spend all the money central banks have printed, but prohibitively expensive bonds, stocks and gold give them pause. Real assets may seem like a good option, but commercial real estate doesn’t feel too well these days, nor do commodities. So they wait. What can change that narrative? Bank layoffs, hedge funds and PE vehicles failing, borrowing costs soaring, exactly all the things that QE seeks to prevent. Better than expected earnings (like Deutsche Bank this morning) and deregulation news can further improve sentiment. So, for financial market sentiment to change, we would need to see pressure on the financial sector. Without this, QE-backed optimism may well prevail.

David Baker, CIO