When Worlds Collide: Reopening Euphoria Meets Q3 Headwinds

Jack Ablin Market Commentary

The global COVID-19 pandemic has prompted investors to view equities like bonds. They are considering which issuers will likely survive a prolonged shutdown and which ones won’t. As a result, US large caps have served as a safe haven, given their outsized balance sheet quality and their oversized technology allocation. But the S&P 500 could become a victim of its own success. From a valuation perspective, blue chips are trading in the top decile of their 20-year historical range and at their highest level in history on an enterprise value-to-EBITDA basis. While valuation is not a great timing tool, extreme valuations represent a barrier to significant near-term gains. Small caps , while seemingly cheaper, carry substantially more balance sheet risk.

With the Q2/20 earnings season about to get underway, investors will be forced to focus on fundamentals, not stimulus. Analysts estimate that S&P 500 companies delivered $23.31/share in earnings last quarter, a 44 per cent year-over-year decline, and its worst quarterly showing since the 66 per cent profit plunge endured at the depths of the financial crisis. While the profit figures are consistent with the decline in business activity, investors will likely hear uncertain outlooks from companies, many of which have suspended guidance. We think it is unlikely investors will walk away from Q2 earnings season with renewed confidence.

The economy is slowly recovering and, thankfully, lawmakers have taken the “worst-case” scenario off the table. Short of a vaccine or effective treatment, daily at-home testing kits would help speed the recovery. Equity markets, notwithstanding the recent rise in COVID-19 cases, continue to price in a “best-case” pandemic outcome that could be subject to disappointment. Lawmakers have covered missed paychecks, but certain industries are bracing for extended droughts.

Recent economic data has surprised to the upside as businesses have reopened, but is now weakening.  Data is beginning to disappoint in China and Japan, two economies that reopened before Europe and the US, which are still showing signs of strength. We expect economic data to begin falling short of optimistic expectations in the coming weeks as reopening plans take a step or two backward, particularly in the US.

Trump set up ideal capitalist conditions: low taxes, low interest rates, low regulation and infighting within the labor class. According to PredictIt, a political futures exchange, both Biden’s chances of winning the White House and the Democrats’ probability of controlling Congress are around 60 per cent, with Trump and the Republicans stymied at around 40 per cent. The implications of a Democratic takeover of the White House and Senate, however, are not currently reflected in market prices. Already, Biden has stated he plans to roll back Trump’s 2018 corporate tax rate cuts. It could be argued that the S&P’s 14 per cent advance between June 2017 and June 2018 in anticipation of, and in reaction to, Trump’s corporate tax cuts could be reversed in the event they’re unwound. The prospect of Democrats controlling both the White House and the Senate represent market risks, as tax rate hikes, which we believe are an eventuality under either party, would be accelerated.

History suggests investors begin discounting November election outcomes in August of an election year.  In 2016, the Mexican peso began trading off Trump’s election success chances in August. We expect investors will begin to factor in the 2020 election outcome later this quarter. This represents a serious near-term headwind if investors perceive a Democratic advantage next month.

Investor caution is a mitigating factor arguing for continuing to climb the wall of worry. As of last week, bullishness among individual investors, as gauged by the American Association of Individual Investors (AAII), is situated in the bottom decile of its historical range. Bearish investors have low expectations and, in a world where the market reflects the intersection of reality and expectations, markets respond better to bearish investors. Market returns following extreme bearishness tend to outpace markets following extreme bullishness by a factor of two to one.

Despite our near-term caution, we do not recommend running away from equity exposure; instead, focus on markets that are more reasonably priced. For example, outside the US, we believe emerging markets (EM) look well-placed to excel and are better positioned fundamentally than US small caps. EM equities are attractively priced on an EV/EBITDA basis, at a little more than 10x EBITDA – an appealing valuation whether relative to the S&P’s 14.8x, or outright.

The dollar has benefited from COVID-induced uncertainty, helping propel dollar-based assets higher. The dollar surged more than 8 per cent in under two weeks in March as the world was shutting down.  Notwithstanding to dollar’s subsequent slide, the greenback remains overvalued relative to the world’s major currencies: nearly 7 per cent overdone relative to the euro and to the British pound, for example.  Dollar weakness, should it continue, represents a tailwind to EM outperformance. History has shown that the dollar’s direction explains the bulk of emerging markets’ relative performance against US markets.

Not knowing how long businesses will be prevented from operating at full capacity, investors are demanding quality balance sheets to insulate their portfolios in this period of uncertainty. Another factor benefitting the S&P 500 is its high-quality constituency. Only 4 per cent of the blue-chip index is rated below investment grade. The Russell 2000 Index of small-cap companies don’t come close on that score: more than 30 per cent of small-cap balance sheets can be categorized as “junk.” From a quality perspective, below-investment-grade holdings comprise only about 5 per cent of the EM index, close to the level of the S&P 500. Similarly, the S&P 500’s 27 per cent technology weight explains a good deal of that index’s outperformance. However, MSCI Emerging holds more than 16 per cent in technology, which is far higher than the tech allocation in US small caps and in foreign developed markets.

Bottom line: Policymakers and central banks worldwide continue to promote and support risk taking. Emerging market equities represent an interesting blend of quality and reasonable pricing.