Financial markets continue their unstoppable growth. After the impressive recovery of April, also May disappointed the expectations of many short sellers[1] who were betting on a downward correction in the market. After a prolonged period of lockdown, the opening in all countries have generated a great euphoria on the financial markets, making the run-up to pre-coronavirus levels continue.
For a long time, we have relied on earnings as the main value driver in the stock market. Wasn’t the price / earnings (P/E)[2] ratio one of the main multiples for valuing stocks? So far, although most companies have reported earnings well below the levels provided by both guidance and analyst forecasts (except those in the technology sector, communications and stay-at home stocks[3]), the market is slowly returning to its pre-crisis level. The Nasdaq composite has returned to very few percentage points from the historical highs.
The numerous negative macroeconomic data amplify the paradox of this overview, almost one-way upwards. The International Monetary Fund estimates[4] predict negative GDP projections in almost all countries of the world, with rare exceptions such as China and India (respectively + 1.2% and + 1.9% in 2020) which in turn are far from the standard growth rate. In 2020, a 7.5% drop is expected in the Euro area with a 4.7% rebound in 2021. We wonder how long it will take to return to the levels of GDP before the coronavirus.
| 2020 | 2021 | |
| United States | -5.9 | 4.7 |
| Germany | -7.0 | 4.7 |
| France | -7.2 | 5.2 |
| Italy | -9.1 | 4.5 |
| Spain | -8.0 | 4.8 |
| Japan | -5.2 | 4.3 |
| United Kingdom | -6.5 | 4.0 |
| China | 1.2 | 9.2 |
| India | 1.9 | 7.4 |
| 2020 | 2021 | |
| United States | -5.9 | 4.7 |
| Germany | -7.0 | 4.7 |
| France | -7.2 | 5.2 |
| Italy | -9.1 | 4.5 |
| Spain | -8.0 | 4.8 |
| Japan | -5.2 | 4.3 |
| United Kingdom | -6.5 | 4.0 |
| China | 1.2 | 9.2 |
| India | 1.9 | 7.4 |
Additionally, the estimates on unemployment in the United States reached 14.7% in April, more than triple from 4.4% in March[5]. We must keep in mind that about 70% of the consumption in the United States is due to the US families themselves. Who will consume in the USA considering that unemployment increases?
Together with the macroeconomic assessments there is the total uncertainty concerning the vaccine too. Although some (few) trials have been successful, an effective vaccine seems to be far from being achieved. Nowadays, the most promising vaccines are being tested. However, it seems that investors have recently forgotten the main uncertainties that this health and economic crisis has caused: there are no effective treatments, we do not know if, and possibly when, profits will return to pre-covid 19 levels, we do not know the consequences of the reopening or if the autumn period could lead to a new wave. And I could continue with many other uncertainties.
So, where does all this optimism come from? The real question is to wonder if perhaps ‘there is no alternative’ market. In fact, alongside all these uncertainties, we have unquestionable certainties: the central banks continue and will continue to print money unceasingly, guaranteeing unlimited stimuli (two examples are the Federal Reserve and the Bank of Japan). The decisions of the main central banks to provide disproportionate liquidity on the market have probably favored a recovery in the short term, but its sustainability will have to be assessed. Inevitably, all these interventions have brought the returns on cash and bonds to such low levels as to generate an implicit investors’ willingness to expose themselves more on the stock market, in order to obtain a more satisfactory risk-return. Added to this is the so-called ‘fear of missing out’ (FOMO) by investors, or the fear of missing the opportunity at the time of the bullish trend to take advantage of the rally[6], which in turn feeds further rises. The problem remains, however, the macroeconomic context, which could lead to an upward trend only in the short term.
Another factor of extreme importance is the possible cold war between the United States and China which could further fuel uncertainty on the markets. The immediate reaction was naturally negative. Such contexts increase the risk-premium and endanger global development. Obviously, an increase in the risk-premium[7] leads, in most cases, to a decrease in the share price. Bear in mind that we are talking about the two major powers in terms of global GDP, and serious repercussions could, with a chain effect, involve all markets.
As for the European market and in particular the Eurozone, the main news concerns the Recovery Fund proposed by the European Commission which should guarantee 750 billion with an issue of thirty-year securities guaranteed by all countries, with a mix of loans and grants. Very complicated negotiations will open in the following months. We are finally approaching a debt mutualization at the European level (eurobond). The problem is that the funds will be accessible no earlier than 2021. Consequently, the instruments available in European countries will be, at least until the end of 2020, the Sure, the Esm and the purchases of government securities by the European Central Bank. These initiatives were taken with great euphoria on the markets, above all that of government bonds which saw a narrowing of spreads[8].
We cannot predict whether the stock rally will last much longer since we are in a truly anomalous market. In this context, investor sentiment seems to count far more than macroeconomic and microeconomic fundamentals. However, there is a crucial principle of the economy: in order to be sustainable in the long term, growth must be based on solid structures and these, nowadays, seem to be very fragile. In the extreme case, there is the risk of creating a bubble which, if it explodes, would cause further negative consequences on the market.
Gianlorenzo Zeccolella
[1] https://en.wikipedia.org/wiki/Short_(finance)
[2] Price over earnings is one of the most important multiples, used to assess the equity value of a company. When P/E = 15x, the stock price is 15 times its earnings per share.
[3] Typical examples for stay-at-home stocks are Netflix or Zoom.
[4] https://www.imf.org/external/index.htm
[5] https://www.bbc.com/news/business-52591262
[6] In finance, a rally is a period of sustained increase in the price of an asset. https://en.wikipedia.org/wiki/Rally_(stock_market)
[7] https://www.investopedia.com/terms/r/riskpremium.asp
[8] The spread is the differential between the returns of two securities with the same maturity (typically 10 years). One of the securities compared is considered as a benchmark.