The virus – lockdown pattern broadly followed, all eyes on easing pattern
First, the virus. The numbers of new cases have reacted broadly as predicted for two to three weeks after lockdowns were imposed. It is particularly encouraging that the growth in fatalities in Spain and Italy has been running at around 2% in the last week or so. As countries in Europe begin to gradually ease their lockdowns, all eyes will be on the size of the expected second wave of infections. If it is small and easily contained, all will be well. If it is large and a full lockdown has to be re-imposed, fears will grow.
Data – no surprise on weakness, big surprise on wrong forecasts
Second, the data. It is no surprise that we have seen some spectacularly weak economic data recently. After all, large chunks of the economy have been closed down by government dictat; this is unprecedented. The surprise has been that forecasters were so slow to recognise the scale of the downturn. When initial unemployment claims jumped by over 3 million in a single week in the US, although a few forecasters had anticipated a move of this magnitude, the consensus was way too low. This pattern of ‘under-forecasting’ was repeated the following two weeks. Only last week did analysts get the number more or less correct. GDP figures are obviously not so timely but at least some forecasters now have declines of 10% or more for Q2 – which equates to nearly 50% annualised as the US reports its numbers.
Earnings – top down numbers slashed, bottom up numbers oblivious
Third, earnings, and here the story is even worse. Top down estimates for whole markets or sectors have been slashed. But the bottom up numbers have been slow to respond. Whereas top down numbers are showing large scale overall losses for the S&P500 in Q2, bottom up estimates are still suggesting a small positive. This is a big week for companies reporting Q1 earnings. The traditional pattern is that analysts cut their estimates in the run up to the reporting season, allowing most companies to beat the initial estimates. The numbers have been cut this time, but by nothing like enough. It’s very early days but the average miss, led by financials, has been 9%. It’s the same story for dividends, top down forecasts suggest dividends are likely to fall by 23% this year; bottom up estimates show no change.
By the end of this week, markets will have a reasonably clear idea of the actual outturn for Q1, and although many companies have suspended guidance for Q2, the story across all will be relatively straightforward: all will depend on the timing, scale and sustainability of the lockdown.
Underlying factors at play
I had expected this process of adjusting to the realisation of just how badly the economy and earnings are suffering from the pandemic would lead to a market setback following the very strong rally since the upturn on 23 March. In the event, despite all the bad news, markets are a little higher over the last week. This suggests to me that there is an underlying demand for equities. This takes several forms:
- First and most obviously, rebalancing flows. This is the process whereby institutions with fixed percentage weights for bonds and equities, buy equities and sell bonds to restore the weights to target. These flows are big and are continuing.
- Second, some trading accounts had built up large short positions as markets fell and are gradually, and painfully, buying them back in rising markets
- Finally, volatility targeting and risk parity funds are beginning, slowly, to restore their risk positions. The VIX (a widely-used measure of the stock market’s expectation of volatility) is still very high, at 40, but this is half where it peaked.
So where to now?
I’m still cautious about the negative news on earnings. The impact of lockdowns being eased is another source of deep uncertainty. But if markets survive this week, I would expect a further rally.