Markets have priced in present lockdowns, not future difficulties

Market traders have all eyes on the coronavirus present, not the future Picture: AFP

Two related but distinct questions have buffeted financial markets over the past two months: how long will COVID-19 lockdowns last; and how difficult will it be for the economy to recover? Investors are cheering early answers to the first, but shouldn’t forget they remain clueless about the second.

The S&P 500 rose 12 per cent last week, its best weekly gain since 1974. News that Europe is starting to unwind consumer lockdowns as the spread of the coronavirus is contained fuelled investor optimism, as did Thursday’s announcement by the Federal Reserve of a further $US2.3 trillion ($3.6 trillion) in loans.

But visibility about the aftermath of the lockdown period is still severely limited.

Since the coronavirus sell-off started on February 20, the equity market’s gyrations have followed four phases. The first was the violent sell-off that lasted until the S&P 500 bottomed on March 23. As expected, so-called defensive stocks — like utilities, healthcare and consumer staples, whose earnings depend less on economic strength — outperformed.

The second phase was the rebound over the following week, which included the biggest one-day jump since 1933. Remarkably, defensive sectors were still the top performers, and travel and leisure stocks such as airlines and hotels didn’t really bounce back. This suggests that it was a rebalancing bounce: the equity holdings of many funds had fallen so far that many were forced to buy stocks to meet their mandates. Stocks subsequently fell back, in a third phase.

This week’s rally was fundamentally different — and more optimistic. Defensive stocks are now underperforming more “cyclical” ones, even excluding oil and gas shares, which have been boosted by the rebounding oil price. US travel and leisure stocks are racing ahead of the S&P 500.

A massive weight seems to have lifted from the shoulders of investors, who were fretting that lockdowns had no end in sight. A flattening of the COVID-19 infection curve had long been targeted as a crucial turning point.

One reason for caution is that it is still very early to be anticipating the end of lockdowns, particularly in the US. The other is that the longer-term economic fallout is extremely hard to predict. Economists’ forecasts for US output growth this year range from a moderate increase to a flabbergasting 15 per cent drop, according to FactSet data. Analysts are almost as clueless about the second half of the year as they are about the second quarter.

A one-time shock to the economy as a result of the shutdowns will surely be the worst since World War II. But then what? Many of the millions being laid off could reasonably be quickly rehired by their former employers. Alternatively, just a few weeks of unemployment and bankruptcies could be enough to engineer a protracted period of subpar consumer confidence and spending. A second wave of infections is also a plausible scenario.

The S&P 500’s peak-to-trough fall during the COVID-19 sell-off amounted to 34 per cent, far below the previous big drawdowns during the global financial crisis (57 per cent) and dotcom bust (49 per cent). In the past, share­markets have usually tested their bear-market lows at least once. The S&P is now down 18 per cent from its February peak, while the technology-heavy Nasdaq has fallen just 6 per cent.

The defining feature of sharemarkets is that they are forward looking. But the latest rally may have been all about the present — with nothing to say on the future.

The Wall Street Journal