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août 07, 2020
Global markets: Are the easy gains behind us?
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août 07, 2020

Global markets: Are the easy gains behind us?


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Global markets: Are the easy gains behind us?

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août 07, 2020

 
 

Q2 2020 saw the US and eurozone both suffer their sharpest quarterly contraction in GDP1 on record. In contrast, asset markets reflected great optimism as global equities recorded their strongest quarterly returns in over a decade,2 supported by positive economic surprises, generous government packages and the rebound after depressed economic activity in March and April 2020. It appears that equity markets have front-run the economic recovery. However, mounting evidence continues to support our belief that the underlying damage to the economy is likely to result in an economic shock, despite elevated valuations suggesting that the market is not pricing this in.

 
 

We maintain our belief that caution is warranted as easy gains from the re-opening of the economy are likely behind us and we continue to see sustained, sporadic outbreaks of COVID-19. Whilst positive momentum in economic data started to emerge during the second half of Q2, we believe the next chapter in the recovery is a reversal of this. In this note we provide an update on a number of factors likely to derail the recovery:

Household uncertainty over future finances is set to rise in 2H 2020

Government-funded furlough and supplementary income schemes have likely delayed rather than prevented a rise in unemployment, while at the same time meaningfully supporting consumption in recent months. The most visible debate in regard to the extension of government payments has taken place in the US. Since the last note, Congress has not yet approved a new spending package, despite the expiration on 31 July of the US Federal Pandemic Unemployment Compensation (FPUC) programme, resulting in households facing a near term loss of income. Without any Federal supplement to state benefits for the average unemployed person, income falls to 45% of previous employment income. Moreover, even with the Federal and State support available at the time, the US Bureau of the Census reports that over 20%3 of unemployed renters missed June’s rent.

Temporary unemployment likely to become permanent unemployment

The combination of expiring furlough scheme benefits, rising bankruptcies and new resurgences in COVID-19 cases suggest that many individuals deemed temporarily unemployed are likely to become permanently unemployed in the coming months. The first signs of unemployment starting to tick higher again were evident in the US jobless claims data released at the end of July. After a steady decline in continuing claims since the 8 May peak, claims have climbed to 17.0mn (from 16.2mn) in the week ending 18 July4. Our analysis shows, unsurprisingly, that continuing claims are a strong explanatory variable for consumption and in the near term we expect consumers’ willingness to spend to decline.

Earnings have beaten a low bar

In a similar manner to the economic data, Q2 earnings have beaten a low bar. For two-thirds of companies in the S&P 500 which had reported so far this earnings season, EPS at the index level was 22%5 above expectations, as of 31 July 2020. Despite upside surprise being extremely strong versus an historical average of 4%-6%, price action in stocks has been muted. In Q2 2020, generally the positive response to a company beating earnings was muted and even negative, while companies who missed earnings often had significant negative stock price reactions. Companies may have accelerated write-offs in Q1, knowing that the quarter would be bad no matter what and thereby “flattering” Q2 earnings. If this is true, realising the better Q2 earnings were “optical” and a result of this potential acceleration of write-offs, the market did not react as positively as it would normally. Looking ahead, the key question is whether earnings revisions can continue to move higher, and in turn push stock prices higher. Our base case is that the optimism for 2021 earnings is already in the price and the combination of reduced liquidity attributable to summer and a lack of positive catalysts in the upcoming months, makes markets vulnerable to a correction.

Tactical Positioning

Since our last note on 24 July, we have not made any changes to our broad asset mix beyond minor adjustments to help maintain target volatility in our portfolios. However, we have made a key tactical change:

US dollar

We moved from neutral to underweight the US dollar and to overweight euro. The US monetary and fiscal stimulus have removed the interest rate differential advantage which was one of the biggest supports for the US dollar compared with other developed markets. The nominal rate differential is indicating the EUR/USD could regain 1.25, which would be an 8% upside from current levels.

Furthermore, with many US states struggling to contain COVID-19, this puts the US economic recovery at greater risk. Though Europe has had its own struggles, overall better virus control should lead to a faster domestic recovery. In addition, if we do not encounter a broad-based second wave of the pandemic, the euro should benefit from the cyclical recovery. The eurozone has also received a boost from the swift approval of the EU Recovery Plan and overall Europe’s fiscal and current account balances are both stronger than the US.

It is important to note that a weaker US dollar is also positive for global growth. As the US dollar is still the world’s major liability currency, US dollar weakness translates into a loosening in global financial conditions.

 
 

1 US GDP contracted 9.5% quarter-on-quarter (annualised 32.9%). The eurozone seasonally adjusted GDP contraction was 12.1%. Sources: U.S. Bureau of Economic Analysis (BEA) www.bea.gov/data/gdp/gross-domestic-product release date 30 July 2020 advance estimate and Eurostat – European Commission, news release 31 July, preliminary flash estimate for the second quarter of 2020.

2 MSCI ACWI Index (USD) up 18.7%, Bloomberg, as of 30 June 2020.

3 U.S. Census Bureau Household Pulse Survey, Week 12. Data collected between 16 July 2020 to 21 July 2020.

4 US Department of Labor. News Release Unemployment Insurance Weekly Claims. Published 30 July 2020 www.dol.gov/ui/data.pdf

5 Source: Bloomberg.

 
 

RISK CONSIDERATIONS

Diversification neither assures a profit nor guarantees against loss in a declining market.

There is no assurance that the Strategy will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them.  Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events.  Accordingly, you can lose money investing in this portfolio. Please be aware that this strategy may be subject to certain additional risks. There is the risk that the Adviser’s asset allocation methodology and assumptions regarding the Underlying Portfolios may be incorrect in light of actual market conditions and the Portfolio may not achieve its investment objective. Share prices also tend to be volatile and there is a significant possibility of loss. The portfolio’s investments in commodity-linked notes involve substantial risks, including risk of loss of a significant portion of their principal value. In addition to commodity risk, they may be subject to additional special risks, such as risk of loss of interest and principal, lack of secondary market and risk of greater volatility, that do not affect traditional equity and debt securities. Currency fluctuations could erase investment gains or add to investment losses. Fixed-income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes.Equity and foreign securities are generally more volatile than fixed income securities and are subject to currency, political, economic and market risks. Equity values fluctuate in response to activities specific to a company. Stocks of small-capitalization companies carry special risks, such as limited product lines, markets and financial resources, and greater market volatility than securities of larger, more established companies. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed markets.  Exchange traded funds (ETFs) shares have many of the same risks as direct investments in common stocks or bonds and their market value will fluctuate as the value of the underlying index does. By investing in exchange traded funds ETFs and other Investment Funds, the portfolio absorbs both its own expenses and those of the ETFs and Investment Funds it invests in. Supply and demand for ETFs and Investment Funds may not be correlated to that of the underlying securities. Derivative instruments can be illiquid, may disproportionately increase losses and may have a potentially large negative impact on the portfolio’s performance.  A currency forward is a hedging tool that does not involve any upfront payment. The use of leverage may increase volatility in the Portfolio. Diversification does not protect you against a loss in a particular market; however, it allows you to spread that risk across various asset classes. 

 

 
andrew.harmstone
Managing Director
Global Balanced Risk Control Team
 
manfred.hui
Managing Director
Global Balanced Risk Control Team
 
christian.goldsmith
Executive Director
 
 
 
 

INDEX DEFINITIONS

The indexes shown in this report are not meant to depict the performance of any specific investment, and the indexes shown do not include any expenses, fees or sales charges, which would lower performance. The indexes shown are unmanaged and should not be considered an investment. It is not possible to invest directly in an index.

Earnings per share (EPS) is the portion of a company’s profit allocated to each outstanding share of common stock.

MSCI All-Country World Index: The Morgan Stanley Capital International (MSCI) All Country World Index (ACWI) is a free float-adjusted market capitalisation index that is designed to measure equity market performance in the global developed and emerging markets.

DISCLOSURES

The views and opinions are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all portfolio managers at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.

Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific Morgan Stanley Investment Management product.

Except as otherwise indicated, the views and opinions expressed herein are those of the portfolio management team, are based on matters as they exist as of the date of preparation and not as of any future date, and will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date hereof.

Certain information herein is based on data obtained from third party sources believed to be reliable. However, we have not verified this information, and we make no representations whatsoever as to its accuracy or completeness.

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Past performance is no guarantee of future results. Charts and graphs provided herein are for illustrative purposes only.

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