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Commentary as of June 22, 2020
Dan: We are broadly seeing financial markets strengthen with some daily volatility. Following comments from Federal Reserve (Fed) Chairman Jerome Powell, we have confidence that interest rates should remain close to zero for the considerable future. However, given the negative rates around most of the developed world, the modestly positive rates in the U.S. seem relatively attractive. That relative value framework also helps inform our view on stocks. Investors are paying about 20-times S&P 500 Index earnings. Inverting that price-to-earnings ratio implies an earnings yield of about 5%. While that yield may be a bit lower than historical norms, compared to the low fixed income yields, it seems attractive.
Is the market currently ahead of itself? The bottom-up consensus estimate for S&P 500 Index 2020 earnings is about $126, down from around $165 before the pandemic. That drop is in line with a severe market recession. Looking at expectations, the S&P 500 Index is trading at about 22-times forward earnings. The lofty valuation is explained by depressed earnings expectations caused by the recessionary market environment. Again, this is fairly typical during downturns, where earnings fall and price multiples rise to heightened levels. Investors are likely looking through the obvious weakness over the next couple quarters to a more normalized environment, where earnings are expected to return to pre-pandemic levels by 2021.
On the surface, the market believes in a continuous recovery and reopening of the economy. However, certain subsectors such as the cyclical and small capitalization companies are experiencing dramatically more depressed earnings, a much more challenging earnings environment, and a longer road to earnings recovery. Thus, we believe that the current environment is supportive for quality active managers who can leverage the leadership of the large cap companies because of their strong fundamentals and at the same time, diversify them across sectors.
Overall, there has been increased volatility and risk in the financial markets. We believe that in such markets an investor should invest with a long-term view with a focus on companies that have strong fundamentals and resilient end markets.
Derek: Given the latest data, we believe growth may have bottomed, and we should continue to see an economic recovery. There is a view that the latest uptick in COVID-19 cases across several states, including Florida, Arizona and Texas, may dampen confidence. Data that tracks the number of small businesses that are open for business shows momentum stalling out at 20% below pre-COVID-19 levels.
United States, Local Businesses Open, COVID-19 Impact, Median Across All States (%)
Further research shows that this is accounted for by the states where there is a flare-up of new COVID-19 cases. However, mobility data continues to show steady improvement. In our view, these new virus hot spots may be slowing recovery on the margin, but economic recovery is continuing and moving in the right direction.
United States – Mobility, Length of Stay, Whole Country vs. Baseline
Despite the pickup in the hotspots, the slowdown in deaths related to COVID-19 is encouraging. While hospitalizations have picked up, they are well below levels that would cause concern. Outside the U.S., there has been a pickup in cases in Germany and China. China has been quick to respond, and at this point, it seems that the outbreak in China is under control. Meanwhile, Germany has a strong contact tracing mechanism that we believe will allow the country to control the new outbreak without having to implement new closures in the economy. Even with the negative trends in India and Brazil, we don’t believe that the global economic recovery we are seeing will be derailed.
Meanwhile, because of the recent outbreak in some states, we believe that Congress and the administration will agree on fiscal stimulus worth as much as $1.5 trillion. We expect the new stimulus to be passed before July 31 when the additional weekly $600 in federal employment insurance expires. We believe that there will be a compromise between Republicans and Democrats to extend but reduce additional weekly payments, alongside a bonus payout to workers to return to work. Furthermore, we believe Congress could agree on help for state and local governments for as much as $500 billion along with liability protection for companies that could be exposed to legal action if an employee contracts COVID-19.
In addition, there are discussions around revising the Paycheck Protection Program (PPP) – the program that provides loans to small businesses. These loans were designed to cover payroll expenses for eight weeks in addition to some other expenses. As the economic cost has been more severe than when the PPP was passed into law, Congress is discussing an extension to that coverage beyond eight weeks, which would allow businesses to get additional funding. Furthermore, the administration is discussing payroll tax cuts and an infrastructure bill. But, given the time sensitivity of the stimulus plan and lack of consensus between the Republicans and the Democrats on taxes and infrastructure, we don’t believe that these will form part of the next stimulus plan.
Globally, we continue to get stimulus in Europe. France announced another round of stimulus, while Italy and the UK are discussing cuts to the value-added tax to stimulate consumer demand. Data from China shows that it continues to stimulate and are aggressively pushing credit into the economy.
Data released globally suggest that economies in the U.S. and Europe saw the low in April, which could mean we have seen the deepest but shortest recession in history. Data in May has seen a significant bounce back as economies have started to open. Retail sales in May were up 18% month-on-month, and housing has started to recover. Meanwhile, while unemployment claims are still relatively high as compared to pre-COVID-19 levels, they have started to move lower. Furthermore, regional manufacturing indicators and consumer confidence data has been bouncing in May and in early June.
Also, in line with our view that the Fed would not raise interest rates for the noticeable future, Fed Chairman Powell expressed his opinion strongly as he said that “we are not even thinking about thinking about raising rates.”
Dan: In closing, I want to talk about some capital market numbers and how they are reflecting the risk-on activity in the economy and actions from the U.S. central bank. According to research from the JP Morgan and Goldman Sachs, there has been a total equity issuance of $170 billion year to date. In the second quarter alone, there has been total issuance of $130 billion, which is the highest level in 20 years. There has been $1.2 trillion of investment grade issuance and $184 billion in high-yield issuance. Overall, capital markets issuance data is reflecting the risk-on activity in the economy.
The S&P 500 Index is a float-adjusted market capitalization weighted index that measures the large-cap U.S. equity market. The index includes 500 of the top companies in leading industries of the U.S. economy. It is not possible to invest directly in an index.
Past performance is no guarantee of future results. This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through June 22, 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This information is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.
Risk Factors: Investing involves risk and the potential to lose principal. Fixed-income securities are subject to interest rate risk and, as such, the value of such securities may fall as interest rates rise. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets.
The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. In addition, the impact of infectious illnesses in emerging market countries may be greater due to generally less established healthcare systems. Public health crises caused by the COVID-19 outbreak may exacerbate other pre-existing political, social and economic risks in certain countries or globally. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.