Since the heavy crash and subsequent rally in global equity markets in the first half of this year, many investment market participants have been asking about the extent and timing of the recovery from the rapid and devastating impact of the fight against the spread of the Covid-19 virus. These questions are often based on shapes – “will it be a V- or a U- or an L-shaped recovery” are some examples. When formulating a response to such questions it is important to know which measure or metric is under scrutiny and to what extent that measure is important or not in formulating investment strategy and making informed investment decisions. The Dynasty Investment Committee has indeed characterised the measures that drive our investment process in this way.
The first rapid response to the Covid-19 pandemic was a dramatic fall in China’s Manufacturing Purchasing Managers Index (PMI) of economic activity. This was followed by a similar plunge in the manufacturing PMIs in the USA and in Europe. A few weeks after the plunge in the China PMI, global equity markets started to tumble as economies were forced into unexpected and draconian states of lockdown.
The recovery in the China PMI was as dramatic as the initial plunge and a V-shaped pattern emerged very clearly in the charts of that measure of economic activity. Global equity markets then responded in a similar fashion and the V-shaped pattern is still very apparent. However, it is important to consider a number of carefully selected measures together, as opposed to viewing each in isolation, since it is important to connect the global equity market to its most important historical driver – corporate earnings. In this case, the shape of the response function is very different. Consensus forecasts for corporate earnings in 2021 initially plunged in concert with global equities in the first quarter of this year, but since then these forecasts have remained very muted and over the first half of this year, the shape of the trend in the corporate earnings outlook is a clear L-shape. At the same time, technology shares in the USA have skyrocketed in a very generous Correct-Tick-shape since the bottom of the market in March, leading to valuations placed on current and future earnings for those companies that are ominously reminiscent of the extreme valuations last seen in during dotcom bubble in the late 1990s.
The most sobering shape at the moment is the recent change in the shape of the China manufacturing PMI from a V-shape to a Square Root-shape as expectations for further gains in economic activity were quickly moderated. This suggests that after a rapid recovery from the extreme lows reached in March of this year, global economic activity may remain very muted for the foreseeable future. In fact, in research seen by the Dynasty Investment Committee, the expectation for a global economic recovery over the next 12 to 18 months is characterized by a Step Function-shape as the world economy emerges slowly and tentatively from the ravages of the Covid-19 virus. This seems to be a very plausible scenario.
The most worrying pair of shapes at the moment is the disconnect between the V-shaped response in global equity markets and the L-shaped trend in the outlook for corporate earnings in 2021. Lessons from history suggest that when equity markets lose sight of poor underlying fundamentals (future earnings), unless the earnings picture improves dramatically in the short term, equity markets must respond. So, either the current V-shaped response in global equity markets turns into a Square Root-shape as equities tread water while waiting for the earnings outlook to recover (the earnings L-shape turns into a U-shape), or the V-shaped response turns into a longer-term W-shaped response as equity markets fall again as the L-shape of the earnings outlook pattern persists in the medium term.
Very accommodative global central banks and heavily-borrowed governments are clearly trying to make sure that support measures and levers are in place to ensure that the V-shape of the global equity market response at best turns into a Square Root-shape but the looming risk is that the ongoing battle to conquer the Covid-19 virus takes much longer, and is much more costly, than expected, thereby putting a damper on the expectations for a global earnings recovery and leading to another fall in global equity markets.
Based on the above scenarios, Dynasty has been positioning its client portfolios for a Square Root-shape outcome but has also introduced strategies to provide for a worst-case W-shape outcome.