A view from the markets – True Faith

Forward markets don’t see US 2-year Treasury yields above 1% again for at least five years. The technology sector has just delivered blow-out earnings numbers for Q2. The change to economic behaviour delivered by the coronavirus is presenting new growth opportunities. It’s hard for the “naysayers” to accept but the strength of policy and the collective determination to recover has driven risk asset returns. Will threats to policy or recovery even be strong enough to overcome FOMO? So far, they haven’t. The “True Faith” market might continue for a while.   

Two powerful beliefs 

Don’t fight the Fed or the FAANGS. The Fed is ready and willing to extend support for financial markets and the economy. The FAANGS have proved that it is possible to grow earnings as the online economy booms. Both are symbolic of what I believe are the two fundamental core faiths that we can derive from a stunning return from risk assets this last four months. The first is faith in the strength of the policy support for markets and the economy. The second is the underlying faith that we will defeat the virus and achieve economic recovery. There are lots of threats to both but to fully subscribe to a more bearish view, one has to make the argument that policy support will be less effective and the recovery will stall and lapse into a second downturn. Lastly, if you don’t fully buy my thesis or the alternative bearish view, there is always the FOMO explanation – with interest rates at zero there is a huge fear of missing out on returns even when things like a 33% decline in GDP are reported tell us the market shouldn’t be going up.

Policy remains the source of fuel for markets 

It’s clear that policy has been quite effective. It has put a floor under activity, incomes and markets. Central bank credit and liquidity policies have allowed markets to remain orderly and for credit to flow. Banks have been supported, therefore cutting off the risk of a downward spiral of a credit crunch. Central banks have created fiscal space for governments to spend to support jobs. Large fiscal stimulus provides a potential base for a solid medium term recovery. Central bankers and politicians suggest more is to come if needed. The manifestation of this in markets is ultra-low yields which is the trade-off in the bond market for investors benefitting from capital protection and credit impairment. It should not be underestimated how much the policy commitment and the liquidity that goes with it has been responsible for the performance of markets. Quantitative easing, lower real interest rates and credit backstops have reduced systemic risk in a more convincing and rapid way than was ever the case in 2008. No wonder the market recovery has been quicker.

We want better 

The second belief, whether explicit or unconscious, is that things will get better. In aggregate we don’t want to expect that the worst case outcome is the most likely (millions dead from coronavirus, economies devastated). Why? Because as a race we are pretty good at recovering. Pretty inventive and flexible. There is a belief that a vaccine will be found, that social distancing can control the rate of infection and that people want to get back to working and consuming. The data has evidenced recovery and looking forward there is a view that there is plenty of pent-up demand, that changing consumer patterns and business models can still be consistent with growth. Moreover, there is a realisation of the opportunities around digitalisation, carbon transition, basic human security (health, water, food) and a broad range of ESG factors. Collectively enough investment is driven by this inherent optimism or by the fear of missing out on higher returns than cash and bonds can deliver, to drive equity prices higher.

Constantly challenged 

This is my observation of the world. These two beliefs, for now, appear to have cut off the left-tail of the distribution of outcomes and provide support for higher markets. There are nuances to how we look at both the policy belief and the growth belief, and that creates volatility. Betting against them, especially on the basis of short-term noise, is betting against a deep-rooted – if not universally shared - psychology. So what would one need to see to make those bets. Or more realistically, a series of bets. One bet might be to see enough in the news-flow to question how rock solid the two beliefs are. Data flow can impact sentiment and positioning and lead to market set-backs or much lower returns going forward. Another bet might be that either the policy environment changes markedly or the virus/growth environment deteriorates enough to really think about a significant growth and market reversal.

Risks, clearly

What shakes the level of confidence, even if we don’t always recognise it, in the two pillars – the robustness of policy and the positive recovery outlook? In fact, this is what is discussed every millisecond of the day. Just turn on any financial news or read any market commentary and the debate is about what can go or is going wrong. Let’s think about some risks. To start with, the policy making process is likely to become marginally more constrained by balance sheet, deficit or political concerns going forward. Secondly, existing programmes might start to run off, creating economic risks (cliff-edges for consumers as income support is removed). Non-COVID-19 political dimensions such as the US election, China and Brexit might manifest themselves in investor actions to reduce risk. On the recovery side, this recent increase in infection rates in Europe might result of a second set of restrictions on economic activity, flattening the recovery curve and reducing growth forecasts again. Lastly, there could be disappointments in the vaccine development process. 

Fed still there

This week’s news provided a rebuttal to some of the bearishness. The Fed is not going to do anything to dilute its super-accommodative monetary policy and, indeed, could do more. That was the message from the FOMC. Two-year Treasury yields are currently at 12 basis points (bps), bang in the middle of the Fed Funds target range. The 5-year yield is just at the top of the range, at 24 bps. This means markets don’t really expect the Fed to raise rates for some time. If the Fed chooses to strengthen its forward guidance by some level of yield curve control it may need to continue to be a significant purchaser of bonds, maintaining a high level of liquidity provision from the central bank. 

And upside attainable 

The earnings season has also rewarded the recovery belief. Of the 288 companies reporting at the time of writing, earnings announcements had beat estimates by 23% for the S&P500. Some of these companies were those that have benefitted from the surge in online consumption and service provision over the last four months or so. Others are those that will see opportunities from the roll-out of 5G technology. The household technology, online retailing and payments and social media massively beat earnings expectations.

Scenarios 

Looking forward we can think about travelling along two axes in terms of how we look at markets and how the news impacts our views. The first is the policy axis – is policy support remaining in place or will it weaken? The second axis is the recovery – will the data on the virus and activity improve or deteriorate. The combination should help investors position themselves to the appropriate level of risk. A scenario of policy withdrawal and deteriorating news on the virus and the recovery is clearly the most bearish and would dictate reduced exposure to risk, increased exposure to cash and safer assets like duration and high quality credit. The most bullish would be that policy support remains robust and the data improves. That would sustain strong performance in equities and credit. Better data with some element of policy withdrawal might not be a bad scenario as it would point to a more sustained cyclical recovery, some increase in inflation and steepening of yields curves. Policy support remaining in place and the data deteriorating – a scenario we are potentially on the brink of – would also have a more bearish tilt, favouring credit over equities and curve flatteners. My own view is that the most likely scenario for the coming months is continued policy support and continued recovery.

A lot has happened already 

The last word though has to be about expectations and valuations. Markets have come a long way since March. The surge in earnings for the online and technology giants might not be repeated, especially if and when more of the traditional economy opens up. Real yields might not fall that much further given that a lot of nominal yields have converged on the effective lower bound of policy. Markets are arguably priced for perfection. That also suggests they are sensitive to bad news, and August has seen some adverse market shocks in the past. I am taking two weeks holiday. That will be a good chance to reflect whether the twin pillars will remain standing in the final third of this traumatic year. Before then, I suspect I will be listening to New Order’s “True Faith” a couple of times (the line “The chances are we’ve gone too far, you took my time and you took my money” may turn out to be particularly poignant!)

Stay safe and have a good summer!