Darius Svidleras
Investment Portfolio Manager
 

Majority of financial assets continued to show positive dynamics in May predominantly influenced by the same factors that were playing out already in April – improvements in COVID-19 dynamics, which made possible to start reopening economies in developed countries, and ongoing monetary injections pursued by the global  central banks. In addition, with prices going higher, more and more investors started to believe that worst outcomes are behind us and thus it is time to increase risk once again and make new investments.

This last factor is worth mentioning in more detail. In previous report we discussed that coronavirus is changing spending behavior of individuals. Indeed, in April it turned out that population savings rate as proportion of disposable income reached record amount at least in the USA. This is rather logical - while individuals were on lockdown and had to spend most of their time at home, consumption was significantly reduced.  But, apparently, many of these individuals decided that the best use of their saved cash is to start purchasing equities. Several online brokerage apps allow users doing it quickly and for free in the USA, and as latest data from these brokerage houses indicate, trading activity on these platforms in recent months turned out to be significantly higher compared to previous periods. This also somewhat explains, while despite such abysmal recent macroeconomic indicators, from some market participants there was strong demand for financial assets and their prices continued going up.

US personal saving as % of disposable income

Source: Bloomberg

In short term, such investment behavior indeed creates positive impact for financial assets, but such impact should mostly be considered as speculative, with underlying fundamental and macroeconomic reasons hardly supporting higher prices right now. Going forward, if population continues to save more, by definition it would be consuming less, especially if their disposable income falls at the same time (recent unemployment data suggests that it is more than probable). As a result, companies have to react and reduce their production, which leads to lower GDP growth and likely negative affect on earnings and respective equity prices. In order, to reduce adverse impact on profits, companies have to cut costs, laying off more people and postponing certain investments. On aggregate macroeconomic level, as more people are becoming unemployed, and companies are also not making new purchases of productive assets, impact on consumption and investment is becoming even more negative. Such situation continues until some companies are going out of business, and balance between demand and supply is reestablished, thus recession ends. 

US personal consumption expenditures (Y-o-Y growth)

Source: Bloomberg

US capacity utilization as % of total capacity

Source: Bloomberg

US continuing jobless claims


Source: Bloomberg

This time governments and central banks are doing all in their power to mitigate natural impact of recession. Governments increase spending and introduce certain economic packages, which include one-time payments to individuals, so that they can spend and consume more at least in the short term1. Central banks are purchasing financial assets and increasing money supply to make financial institutions more willing to lend and corporates more willing to borrow either by taking loans or issuing bonds at favorable rates. Problem appears to be that this newly created money is not really being transferred into economy – right now companies are focused more at cutting costs and not taking additional leverage; financial institutions are also worried about potential loan delinquencies and defaults, making additional reserves and provisions, to cope with this matter, rather than issuing new loans. Thus, instead of economic support, created liquidity goes more into financial assets, boosting asset valuations and making them significantly more expensive than before the March crash, especially given expected fall in corporate earnings.

Forward P/E multiple of MSCI ACWI (global equity index)

Source: Bloomberg

Another potential problem that might be created due to excess liquidity is the fact that least effective loss producing companies which are still able to take debt in current environment at favorable terms would continue to do business. As a result, it can create oversupply, as lower demand will still be met by higher amount of produced goods and services, leading to deflationary pressures and lower revenues of financially stronger competitors. With lower prices and revenues, most likely companies would have to start to reduce costs, cutting wages and reducing personnel, and thus making problem of lower consumption, excess supply and deflation even worse.

Hopefully, outlined scenarios would not happen and we will see solid economic recovery going forward (especially, if virus threats are gone for real). However, as risks remain high, and markets are becoming more volatile, aggressive risk taking in the end may turn out to be rather costly. Indeed, if we try to zoom out and look at broader picture since early 2018, when first signs  of global economic slowdown started to appear, global equities since that time are almost unchanged in price, but price fluctuations during last two years are getting only more and more extreme on the upside and downside.

Global equity index (MSCI ACWI in EUR)


Source: Bloomberg


1Ironically, according to CNBC recent surveys suggest that one of the most popular uses of these funds was securities trading, but not spending. It also provides another reason, why there was such steep increase in trading activity in spring, which we discussed above.
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