Four themes driving our Midyear Market Outlook.
- The sustainability of rallies in equity and credit markets will depend on the trajectory of the coronavirus and the strength of the economic recovery.
- The pandemic appears to have accelerated the growth and market power of the major technology platform companies by at least several years.
- Corporate credit is likely to offer the most attractive opportunities to fixed income investors, but wide dispersion requires selectivity.
- We believe the pandemic could exacerbate political risks in some countries and prompt a major reassessment of corporate finances and supply chains.
Fiscal and monetary stimulus appeared to stave off the worst in capital markets since the coronavirus spread across the globe. But as economies gradually reopen, we believe a sustained recovery will largely depend on controlling the virus in the second half of 2020 and beyond.
“Investors should pay close attention to whether we get a second wave of infections as economies reopen,” cautions Robert W. Sharps, group chief investment officer (CIO) and head of investments. Expectations that a vaccine can be developed and administered relatively quickly may be overly optimistic, he adds. Nor is it clear when effective drug therapies might become available. “There’s very limited visibility about that sort of relief.”
Amid uncertainty, asset returns are likely to remain uneven across countries, sectors, industries, and companies, creating potential to add value with a strategic investing approach but requiring careful analysis to identify opportunities and manage risk. “Investors will need to dig deeply to find the green shoots of recovery at the local level,” says Mark Vaselkiv, CIO, fixed income.
In this environment, valuation metrics could be particularly difficult to interpret, warns Justin Thomson, CIO, international equity. “Aggregate market valuations have never been more meaningless because of the huge bifurcation between companies that are on the right or the wrong side of change.”
“This is very different from the tech boom we lived through 20 years ago,” Thomson argues. “Today’s winners are backed by superior cash flow and cash‑rich balance sheets.”
The Road to Recovery
Although the coronavirus pandemic delivered a staggering blow to the global economy, equity and credit markets rallied dramatically in the second quarter through mid‑June. The central issue now is whether those rallies have gotten ahead of themselves, Sharps says.
“Anytime you’re in an economic downturn, there comes a point where markets begin to anticipate improvement,” Sharps notes. “Given that the spread of the virus appears to have slowed and many businesses are reopening, I’m not too surprised that markets are off their lows.”
Recent signs that U.S. employment is bouncing back more rapidly than expected as the economy gradually recovers are a significant “green shoot” that has pushed yields on 10‑ and 30‑year Treasury bonds modestly higher, Vaselkiv notes.
That said, the near‑term earnings outlook remains grim. While consensus forecasts at the start of the year anticipated global economic growth of around 3%, current estimates see a 3% decline for the year, Thomson says. Taking operating leverage into account, that could produce a 50% to 60% aggregate decline in corporate profits.
“We’re still very early in the recovery,” Sharps warns, “but I do think the second quarter will prove to have been the most challenging for economic activity and earnings.”
The key question, Sharps says, is how long it will take for companies to regain enough earnings power to justify current valuation levels while compensating investors for the risk that an economic recovery might not progress as rapidly or evenly as expected.
Global Economic Stimulus to Fight COVID‑19 Impact
(Fig. 1) Percent of Gross Domestic Product
January 31 through May 31, 2020
Sources: Cornerstone Macro, used with permission. Additional T. Rowe Price analysis using data from FactSet Research Systems Inc. All rights reserved.
Stimulus Can Only Do So Much
To a large extent, the rally in risk assets has been driven by massive doses of fiscal and monetary stimulus, which have been even larger than during the 2008–2009 global financial crisis. This, Thomson says, has set the stage for a tug of war between ample liquidity and the collapse in earnings. Further market volatility could result, he cautions.
While fiscal and monetary stimulus have bolstered global markets, there are limits to what governments can do to sustain the recovery:
- In the U.S., a significant portion of the stimulus funds sent directly to low‑ and moderate‑income Americans in April appear to have gone into savings, Vaselkiv says. This could hinder a recovery in consumer spending, which typically accounts for roughly 70% of U.S. gross domestic product (GDP).
- Although French President Emmanuel Macron and German Chancellor Angela Merkel have proposed a European recovery fund to finance EU‑wide fiscal stimulus, unanimous agreement among the EU’s member nations will be required to implement it, Thomson notes.
- Many emerging market countries don’t have the economic and financial strength to undertake massive fiscal stimulus, Thomson adds.
With much of the anticipated benefits of stimulus already priced into risk assets, economic fundamentals will have to take over for broad markets to move higher, Sharps says. “I think the going will be tougher from here.”
The economic and social consequences of the pandemic appear to have accelerated the rise of dominant technology platforms in retail, social media, streaming content, and remote conferencing. This trend is likely to widen the divide between industries and companies benefiting from disruption and those challenged by it.
T. Rowe Price analysts are carefully assessing companies to identify the ones they believe have the balance‑sheet strength to get to the other side of the pandemic and how that could impact recoveries in equity and credit markets.
“The changes over the past few months in the ways we work, socialize, and entertain ourselves have advanced the fundamentals of the big tech platform companies by several years,” Sharps says.
Through the first five months of 2020, Sharp notes, technology was the strongest performing sector in the S&P 500 Index while energy—hurt by collapsing demand and a price war between Russia and Saudi Arabia—was the worst performing.
The largest of the mega‑cap technology giants appear well‑positioned to benefit from accelerating disruption, according to Sharps.
- Collectively, the five largest U.S. technology stocks by market capitalization—Microsoft, Apple, Amazon, Facebook, and Google—have more than USD 500 billion in cash reserves, potentially enabling them to acquire startups or younger companies that are having difficulty obtaining financing in a distressed environment.
- We believe the major technology platforms not only have the ability to continue to grow earnings and cash flow in a challenging economic environment, but also have opportunities to gain market share from weaker competitors, such as bricks‑and‑mortar retailers.
- The tech giants can attract the best software developers, engineers, and business people, Sharps argues.
Technology Weathers the Storm While Energy Struggles
(Fig. 2) Cumulative Returns on the S&P 500 Technology and Energy Sectors
Past performance is not a reliable indicator of future performance.
December 31, 2019, through May 31, 2020.
Sources: T. Rowe Price calculations using data from FactSet Research Systems Inc. All rights reserved. J.P. Morgan Chase & Co., Bloomberg Finance L.P., and Standard & Poor’s (see Additional Disclosures).
Market Leadership Remains Narrow
Going forward, Sharps suggests, disruption and the pandemic both should continue to favor the top five U.S. technology platforms, which, as of early June, already accounted for more than 20% of market capitalization in the S&P 500 Index—greater than the bottom 340 index constituents combined.
Meanwhile, a number of sectors with heavy weights in the value universe—such as energy, transportation, and financials—have been deeply damaged by the crisis. “Large parts of the market still haven’t recovered yet,” Thomson says.
While better‑than‑expected economic news prompted a shift back toward some challenged sectors—growth to value, large‑cap to small‑cap, and U.S. to non‑U.S. equities—in early June, a more sustained reversion trade will require an uptick in inflation and a weaker U.S. dollar, Thomson argues.
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