It’s been a very strong quarter for equities and credit as central banks and governments provided enormous amounts of stimulus and economies started to reopen. Despite the strong rebound in risk assets, traditional portfolio hedges such as government bonds and gold have held up well. US Treasuries are up about 9% year to date, while gold is up close to 18%.
As economies have started to reopen, economic data has shown signs of a sharp rebound. For example, US retail sales rose 17% month on month in May, while UK retail sales rebounded by 12%. While sales are still down 6% and 13% year on year respectively, the speed and magnitude of the bounce back is a clear positive.
The other positive is that central banks globally have made clear that they stand willing to use their full firepower to keep government and corporate borrowing costs low. The Bank of England, for example, recently increased its quantitative easing programme by a further £100 billion, helping to keep UK 10-year Gilt yields low at around 0.2%.
The worst-case scenario of the Covid crisis morphing into a liquidity crunch has thus been avoided, and central banks don’t appear to be in the mood to back away from providing liquidity support where necessary. This central bank support has helped US high yield rally by nearly 10% this quarter, while global investment-grade credit rallied by almost 9%.
However, some risks remain. First, the Federal Reserve and other central banks have been clear that they can only lend, not spend, and so won’t necessarily be able to save companies that face solvency concerns, rather than just liquidity concerns. Some companies will therefore still face administration, and we have unfortunately already seen some examples this quarter.
In addition, the virus has not been fully contained, nor a vaccine approved. In continental Europe, Australasia and some parts of Asia, including China, new infections have fallen to low levels and economies are reopening. In the UK, new infections have also continued to fall, albeit not to as low levels as in Europe. However, in the US, the number of new infections is rising again, while several emerging markets, including India and much of Latin America, have been unable to get the virus under control.
Another risk comes in the form of potential fiscal fatigue from governments, which could potentially roll back their fiscal stimulus too soon before the virus has been fully contained and the economy and labour markets allowed to recover. The UK’s announcement that companies will have to contribute to the furlough scheme costs from August, with the scheme set to expire at the end of October, is one example of this risk. Some currently furloughed workers could, unfortunately, find themselves unemployed in the coming months. UK equities were up 10% this quarter but remain down 17% for the year.
In the US, incomes have so far been supported by stimulus cheques and unusually generous unemployment benefits, which are due to expire at the end of July. If these benefits are not extended, many unemployed Americans could experience a significant reduction in their incomes in the second half of the year.
Political risks also remain, with the US election fast approaching, tensions between China and the rest of the world escalating and Brexit still unresolved. On a positive political note, the European Union has taken steps towards reducing the risk of a politically induced rerun of the European sovereign debt crisis. The proposed recovery fund would essentially provide support to some of the worst-affected countries, such as Italy and Spain, from countries such as Germany and France. European equities were up 15% this quarter.
The S&P 500 looks to be pricing in a V-shaped economic recovery, but it is worth noting that sector performance tells a more differentiated story. For example, online retailers are up very strongly year to date, while department stores are down sharply, along with other sectors that have been most affected by the virus, such as hotels, airlines, retail REITS, energy companies and banks. While most of the worst-performing sectors year to date have also lagged during the rally since late March, energy companies have actually been one of the best-performing sectors, as oil prices partially recovered. And some of the best-performing sectors year to date, such as food retailers and supermarkets, have lagged the most during the rally. So it is important to look beneath the index level for both opportunities and risks and to be aware that many companies aren’t starting the second half of this year where they were at the beginning of the year, even though some indices may give that impression. Value stocks are down 17% this year, while growth stocks are up 6%.
Overall, the market has rallied on the back of fiscal and monetary stimulus, combined with the reopening of economies. The belief is that monetary support is here to stay, but that in some countries there is a risk that fiscal stimulus may become less generous. Meanwhile, rising infection rates could lead to further social distancing measures being imposed or voluntarily adopted.