The Covid-19 crisis seems to have damaged the link between stock markets and economies around the globe, but investors believe that financial markets will eventually realign themselves with economic fundamentals.
In 2020’s first quarter alone, China’s economy - the engine of global growth - fell by almost 10 per cent, the eurozone’s economy contracted 3.8 per cent, the UK economy shrank 2 per cent and the US economy is estimated to have contracted by 5 per cent.
The economic shutdown has also come with record levels of unemployment and business expenditure cuts globally, pointing to a typical recession.
Yet despite the dire-looking economic data, the S&P 500 is only down around 4 per cent from its previous highs and the Nasdaq has recovered from the coronavirus crash. The FTSE100 is down around 12 per cent from its previous highs.
FTSE 100 and S&P 500 performance from February highs
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Source: FE Analytics
Joseph Amato, president and chief investment officer of equities at Neuberger Berman, argued that this dispersion between stock markets and economies “may not be as strange as it seems”.
“While it may look as though Covid-19 has somehow damaged the link between the two, this link was not very strong in the first place,” he said.
Amato pointed to the US economy and how certain parts of the index – the most cyclical, economically sensitive parts – look as battered as the economy itself. He highlighted the financials sector, which is down more than 30 per cent year-to-date, and the autos sector, down more than 40 per cent.
“Those losses are obscured by the performance of other non-cyclical stocks – such as healthcare and consumer staples stocks – or those deemed cyclical under normal circumstances but are solving big problems right now – such as technology and ecommerce stocks,” the CIO added.
“Since the turn of the century, defensive and growth-oriented technology and non-cyclical stocks have expanded to represent 70 per cent of the S&P 500 market capitalisation. Analysts forecast an earnings decline of 13 per cent for these stocks in the second quarter, as opposed to 71 per cent for financials and cyclicals.”
In the UK, the FTSE 100 is indeed dominated by banks, energy companies and other cyclical stocks, which make up around 30 per cent of the index.
“The performance of the S&P 500 is driven by mega-caps, whereas about 45 per cent of US GDP is generated by small businesses employing fewer than 500 people,” Amato continued.
Performance of S&P vs growth and value stocks in 2020
Source: FE Analytics
He noted that the dispersion could be seen clearly in other stock indices, such as the Russell 2000 index of small and mid-caps, which is down 30 per cent year-to-date.
“At the extremes, the large-cap Russell 1000 Growth index is down less than 3 per cent year-to-date, versus a decline of almost 40 per cent in the small-cap Russell 2000 Value index, which is dominated by financial and cyclical stocks,” the strategist said.
“In short, the S&P 500 is not the economy. We should therefore not be surprised the S&P 500 has been relatively resilient in the face of such horrendous economic data.”
However, he conceded that the S&P 500 is not immune to the virus and that over time “economic fundamentals converge with financial markets”.
He reckons the economy is a long way from getting through this, taking time to recover the losses, highlighting that even the most resilient companies face a double-digit decline in earnings over a single quarter.
David Eiswert, manager of the $2bn T. Rowe Price Global Focused Growth Equity fund, believes that “while there are parts of the economy that are disasters – and that entails risk to the equity market recovery – there are many that are likely going to improve.”
“I see no reason why we can’t get back to that stable economic environment that we had before,” the manager said.
He asserted that equities still offer good return prospects versus most alternatives over the next 12- 24 months. He added: “We must remember that this is a natural disaster and not a credit cycle. That’s important.”
In his opinion, companies like Netflix, Amazon, and Zoom were not overvalued going into this crisis: “The coronavirus boosted their positions and accelerated their adoption – this is part of what makes this kind of cycle very different.”
He also said investors should not underestimate the effect the US Federal Reserve and other central banks have had for risk assets.
“If the Fed is potentially going to buy every asset class, and if central banks are going to step in and support the economy through the coronavirus pandemic, then earnings multiples should go higher, especially since there is more credit available and interest rates are lower,” he explained.
“The fact that asset prices go up after that sort of response is not surprising. You could argue that there is now even more liquidity out there than before the virus.”
He mentioned that going into the crisis T. Rowe Price Global Focused Growth Equity started to sell “unwanted risk”, especially balance sheet risk, then started buying companies that would potentially benefit from the lockdown situation.
“The next phase we believe we are entering now is more what we call ‘pleasant surprise’, where companies are reporting better developments than expected,” he said.
A datapoint he is looking for to make him more optimistic for improvement is the “stop getting worse” point.
“Whether it’s the prospects for an individual country or individual company, this idea of ‘stop getting worse’ is one of the most powerful things I have learned in my career,” he said.
“What it means is that markets tend to bottom, not in the absence of risk, but when risks stop accelerating – when you start to see how risk could moderate.”
Performance of fund vs sector and index over 5yrs
Source: FE Analytics
T. Rowe Price Global Focused Growth Equity has delivered a total return of 136.49 per cent over the past five years compared with 55.77 per cent from the IA Global sector. It has an ongoing charges figure of 0.88 per cent.