As economic activity improves, investor focus turns to the path of the subsequent recovery and the risk of a second wave of Covid-19
Global risk assets (equities, speculative grade corporate bond spreads) entered Q3 on a positive footing, due, inter alia, to the fact that economic activity is growing at a fast pace following the easing of lockdown measures across the developed economies. Indeed, the MSCI ACWI is up by 1.4% since June 30th, after recovering in Q2 a substantial portion of its -22% qoq pandemic-related sharp losses in Q1 (+19% qoq | the strongest quarterly performance on a price basis since Q2:2009).
Equity valuations appear to be running ahead of fundamentals, with the 12-month forward P/E ratio (share prices divided by consensus estimates for 12-month forward earnings per share) at 19x for the MSCI ACWI versus a 15-year average of 14x. In the US, the respective valuation metric stands at 22x versus a 15-year average of 15x, even with robust expectations for the 12-month forward EPS at $144. Indeed, bottom-up expectations suggest a strong and sustained “V”-shaped recovery for corporate profitability, with consensus pointing to a bottoming out in annual growth from a trough of -44% yoy in Q2:20 to -24% yoy in Q3:20, -12% yoy in Q4:20, +14% yoy in Q1:21 and +69% yoy in Q2:21.
The latest economic data corroborate the view that a strong rebound in activity took hold from mid-May into June following the phased easing of the restrictions. Specifically, the US ISM manufacturing index rose by 9.5 pts to 52.6 in June and its non-manufacturing counterpart by 11.7 pts to 57.1, both overshooting consensus estimates (49.5 and 50, respectively) and well above the expansion/contraction threshold of 50. Moreover, the US labor market improved significantly for a 2nd consecutive month in June, but began to slow following the labor market report’s reference week (June 7th to June 13th) (see Economics). Furthermore, the easing of social distancing also appears to have weakened in recent days in the US, as suggested by mobility reports from both Google and Apple (these reports track movements of people | see graph). Overall, caution is warranted regarding the subsequent path for the recovery, in view, inter alia, of the recent deterioration in epidemiological data (e.g. higher infection rates), especially in the US.
Accommodative monetary policies remain a major pillar for economic recovery and for risk appetite. In the event, the minutes of the US Federal Open Market Committee (FOMC) meeting on June 9th – 10th suggest increased likelihood of the Federal Reserve’s forward guidance to be soon linked to certain economic outcomes. Of the various candidates, a guidance tied to inflation outcomes “that could possibly entail a modest temporary overshooting of the Committee’s longer-run inflation goal but where inflation fluctuations would be centered on 2%” appears relatively more probable (Average Inflation Targeting). Such a development would set a high bar for policy tightening, consequently strengthening the case for a “low-for-long” interest rate policy, since the chance of inflation reverting back to target is currently not on the cards (headline PCE inflation was +0.5% yoy in May | core PCE: +1% yoy). Extensive discussions took place regarding potential policy approaches that cap or target interest rates along the government bond yield curve in the footsteps of Reserve Bank of Australia and/or Bank of Japan. FOMC members expressed reluctance for such policies, but called for further respective analysis.