When we consider the last six weeks, we should not lose sight of how remarkable markets have been. For example, we have experienced the fastest US equity correction in history - in the space of just 22 days markets plunged more than 20%, a magnitude which, by convention, defines a “bear market.” Of equal significance the VIX index, often called Wall Street’s “Fear Gauge”, hit a record high – over 85, implying future daily moves for US equities in excess of 5%. Fund-flow data indicate the extent of investor risk aversion, with investors withdrawing large sums of money from equity and bond funds alike, instead moving into cash funds. Interestingly, sustainable investing funds have bucked the trend, with Goldman Sachs noting that “ESG-linked funds” have received almost USD 100 billion of inflows in 2020. Credit markets were also heavily impacted, with USD and EUR high-yield spreads widening to a recent peak of 1100 bps and 904 bps respectively. We all know the culprit behind these moves: the coronavirus pandemic and the associated economic impact of containment measures. While the economic impact on both the US and European economy is only starting to show in the conventional economic data, the early signs are disconcerting. On Thursday US initial jobless claims were reported at 3.28 million, more than four times the previous record high of 695,000 - recorded back in 1982. We expect second-quarter economic data to show severe contractions in GDP in both the US and Europe.
WHAT ARE MARKETS CURRENTLY PRICING?
Utilising market prices to infer investor expectations is fraught with challenges. We know that market prices do not only reflect fundamental expectations, but they are also impacted by technicals and sentiment. In periods of market stress, technicals and sentiment often dominate fundamentals, which can lead to counter-intuitive outcomes, such as the correlations between risk-on and risk-off assets breaking down. We recently experienced this when gold, US Treasuries, and equities sold off simultaneously as investors rapidly liquidated financial assets. Another severe dislocation occurred in the US dollar funding markets, where substantial demand for US dollar liquidity led to rising funding costs and strong performance from the US dollar. Despite these caveats, it is a worthwhile exercise to determine what’s priced in the main financial markets we follow.
EQUITIES
We look at current equity pricing from two angles:
Price to earnings ratio (P/E) - This valuation metric is typically not helpful for shorter-term investing as the chart overleaf shows. However it helps to contextualise how expensive or cheap the market is compared to history. The chart overleaf confirms this assessment by showing how US equities have historically performed, conditioned upon the starting forward P/E level.
Past performance is not a guide to future returns. Source Bloomberg
CORPORATE BONDS
Corporate bond spreads can be used to estimate the implied annual default rate in credit markets. Simplistically, the credit spread represents the compensation required by corporate bond investors for assuming the risk that the underlying company will default. Current spreads for EUR and USD high yield over government bond yields are 8% and 9% respectively. Assuming these spreads represent pure compensation for default, and assuming a 40% recovery rate post-default, the implied 12-month default rate for each market is 13% and 15% respectively. As a comparison, based on Moody's data, the realised default rate for EUR and USD high yield during the GFC peaked at 13.1% and 14.7% respectively. As per our prior observation, we acknowledge that this is an oversimplification, particularly since we know investor risk appetite is currently very low and that credit spreads include a risk premium. Still, it provides a useful framework to compare with historical default rates.
In this CIO note we expand our analysis in order to generate a Counterpoint which asks how confident one should be in the reported Covid-19 growth rates, and does the reported data reflect the “real-world” medical - and thus economic - reality?
To do this we use testing data. Unlike confirmed cases and deaths, there is no central authority for the number of tests each country has undertaken. Data is aggregated using country-specific sources and therefore the results need to be treated with caution. In the chart below, we normalise testing counts by considering the number of tests each country has conducted for every one million inhabitants. It follows that those countries that have done more testing relative to their population size are likely to have more reliable infection-count data than those with a lower figure due to the larger sample size. A higher figure often indicates that a country experienced the Covid-19 outbreak earlier than peers and it may also indicate which countries have dealt with the outbreak with greater diligence.
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