The recent recovery in equity markets has been at odds with the gloomier top down predictions from economists. On the face of it, the disconnect could be described as equity market complacency or perhaps the triumph of policy makers and central bankers. We suspect that the truth is rather more mundane, and altogether unwelcome for equity market bulls.
The main driver behind the recovery appears to be the technology sector, reaping the stay at home rewards of an economy in growth freefall. The future will likely involve more commercial use of technology and sustainably higher returns to many of these companies. For markets more generally, however, the immediate future may not be so ebullient. We continue to expect another meaningful correction lower.
Equity markets have recovered a long way since the depths of the initial down draft of February and March this year. At the worst point, the US equity market was down 34% peak to trough. That felt very much like the ballpark equity market adjustment to previous recessions (figure 1). Now, with equities just 15% below previous peak it seems unbelievably complacent.
Figure 1: US equity drawdown in context
Since the equity market lows, the unemployment rate in the US has risen to almost 15% from a 50-year low of just 3.5% (Bloomberg 2020). To place that in context, the previous high over the last 70 years was just 11%. The most worrying aspect, however, is that the weekly unemployment claims suggest the unemployment rate will continue rising. In the UK, the Bank of England have released forecasts for growth. These forecasts suggest we are in the deepest recession for 300 years. Not much cheer there. So why then the recovery in equities? The first clues come from comparing equity returns across countries.
Comparing equity market returns year to date (figure 2) reveals an interesting dynamic. The US equity market has captured more of the recovery than either the UK or European equity markets. That may be in part due to the Brexit hangover which seems to have been partly forgotten amongst the Covid-19 news flow. There may also be a global trade dynamic in play too. European equity markets have been particularly well geared into global trade dynamics, and again slowing global trade growth was a feature of the pre Covid-19 landscape and has continued to deteriorate since. The most likely reason for the difference in performance, however, is likely to come from the sector differences between these markets.
Figure 2: US, UK and European equity market returns year to date
As can be seen from figure 3, the NASDAQ has been the best performing US equity market, followed by the S&P and then the Dow Jones Industrials. Technology stocks clearly dominate the NASDAQ and that is the sector that has experienced the strongest bounce back from the March lows. The S&P and the Dow Jones have, however, performed very differently given they have almost identical weightings to technology, at around 15% each. The difference is Amazon. This appears in the S&P as a retail, rather than a technology stock, but it does not feature at all in the Dow Jones Industrial Average. Adding back the weight of Amazon in the S&P takes the weighting to technology up to almost 30%.
Figure 3: US equity market returns year to date, NASDAQ, S&P500, and Dow Jones
The technology sector has clearly been a major driver of equity market returns this year, such that the best performing equity markets have been those with the highest weighting to it. Neither economies nor equity markets can be driven indefinitely by technology alone. A sustainable recovery needs to be more broadly based, and ideally led by the cyclical sectors of the economy such as financials, consumer discretionary and industrials. One way to assess that mix of cyclical drivers is to plot cyclical company returns as a ratio of defensive companies (Figure 4).
Figure 4: S&P year to date returns versus Cyclical / Defensive return ratio (rhs)
On the face of it, cyclical companies have been driving the recovery. The rising grey line against the right-hand side axis indicates higher returns to cyclical rather than defensive companies. When we remove tech (and Amazon) from the cyclical index, however (figure 5) this driver disappears. The cyclical bounce back is not broad based, it is just technology.
Figure 5: S&P year to date returns versus Cyclical (ex tech) / Defensive return ratio (rhs)
Without a broad-based recovery in cyclical stocks, it is difficult to see anything sustainable in the recent recovery in stock markets. While the past week has shown some “catch-up” from cyclicals, the weight of top down gloom is consistent with significantly lower equity markets. Our best judgement about the immediate future for returns is that the balance of risks remain to the down side. English new wave band, The Buggles, may have been prescient with the lyrics, “We can’t rewind we’ve gone too far. Pictures came and broke your heart, put the blame on VCR”. Indeed, we cannot rewind, and the economic impact of Covid-19 may be long lasting and very supportive for returns to technology. That does not, however, mean that we are already through the worst, and investors should brave for more volatility ahead.
Further reading: Investment themes for volatility to manage the risks