As global stocks recover from the coronavirus shock, are investors too optimistic?

Global equities have staged an impressive recovery from their descent into a bear market earlier this year. In the case of the US, they even managed to erase the year’s losses, before wobbling again last month (see chart below). 

Markets have been quick to latch on to good news – and perhaps more willing to overlook the bad. At least in developed markets, coronavirus cases have been on a clear downward path. On the economic front, the US economy was reported to have rather surprisingly added 2.5 million jobs in May, even though economists had been expecting job losses. This drew some doubt into how the data is recorded, but still leaves net job losses at close to 20 million. The change in the direction of travel was notable and suggests the US economy may be on the road to recovery if there is not a resurgence of Covid-19 later in the year.

Investors are increasingly viewing the coronavirus as a one-off shock with little long-term impact. Perhaps slightly surprisingly, earnings forecasts for companies in the MSCI World Index are currently expected to regain 2019’s level by the end of next year, according to data from Goldman Sachs. Investors are effectively “looking through” this year’s reduced profits in the expectation of a quick return to normality. A strong show of support from the Federal Reserve, with its open-ended commitment to the banking system and credit markets, has helped.

However, as the global economy emerges from lockdown, there are challenges ahead which suggest that the recovery may not be as fast or strong as many investors hope. One indication of this is the uneven nature of the equity rally. Stocks in sectors that depend on economic recovery, such as financials and energy, continue to trade well below where they started the year. Those sectors that are perhaps less dependent on robust economic growth, chiefly technology, have clearly led the rally.

US equities briefly recovered this year's loss in June

Performance of S&P 500 in 2020

^{Source: Refinitiv Datastream}

The long shadow of the pandemic

Sadly, the threat of coronavirus is not simply going to disappear – at least until a vaccine becomes widely available. Cases are still rising in emerging markets, particularly Brazil. There are also worrying signs that the spread of the virus may not be under control in parts in the US. In early June, for instance, Texas reported a record number of patients in hospital with coronavirus, just over a month after ending its lockdown.

Fear of contagion will be with us for many months and this will surely have an impact on businesses. While some may experience a rush of pent-up demand on reopening, others will see lower activity as people avoid contact and behave in a more cautious way.

This has been the experience of China – where supply has largely returned to normal, but demand remains more subdued. The combination does not bode so well for profitability.

This more cautious view of re-opening has prompted Schroders’ economics unit to lower its global growth forecast for this year and next. Next year’s rebound in GDP of 5.3% is not enough to offset this year’s contraction of -5.4%, the worst since the 1930s.

The steepest contraction in global GDP since the 1930s

Year-on-year change in gross domestic product %

^{Source: Schroders, June 2020. UK is included in Europe}

The political temperature rises and the US election looms

By and large, Western governments enjoyed far greater public support than they might have expected in dealing with the pandemic. It was perhaps inevitable that as the acute phase of the health crisis passed, division and conflict would return to public life.

In the UK, this was apparent in the widespread outrage at Dominic Cummings’ questionable travels across England as he “tested” his eyesight. Elsewhere hundreds of thousands of people have taken to the streets around the world to protest racial inequality and police brutality, following the killing of George Floyd.

So far, stock markets have shrugged off these protests, as they have so much distressing news this year.

This, however, is an election year in the US and the impact of the unrest is far from clear. Taking a tough line on protesters may help President Trump establish himself as the “president of law and order”. But by contrast, the protests and Trump’s response may galvanise support for Joe Biden. One outcome that would come as a surprise to markets is a Democrat victory in both the presidential and senate races. This would allow Biden to deliver on his campaign pledge to reverse Trump’s tax cuts, which provided a significant boost to company profits and household spending.

Electoral calculations are likely also influencing the US response to China’s imposition of security legislation on Hong Kong, with the Trump administration initially taking a hard line. While its position has since softened, the risk of renewed trade tensions between the US and China is high. Needless to say, this would not help the global recovery from a pandemic.

Towards a new normal

History suggests that pandemics can leave longer-lasting scars on an economy. Growth suffers as consumers and businesses become more inclined to save than spend or invest. Interest rates remain at very low levels as central banks attempt to stimulate demand. My colleague Keith Wade explores these and other long-term investment implications of Covid-19 in an excellent article here.

In recent months, markets have shown an impressive ability to shrug off shockingly weak economic data relating to the period of lockdowns. We expect they will pay closer attention to indicators that shed light on how quickly confidence is recovering. They may be less forgiving if it becomes apparent that economic activity is not rebounding as quickly as they currently expect.