Are markets oblivious to the risks, or keenly aware of them? For today’s note, we offer our take on what is, and isn’t, priced in.

Our Top Market Takeaways for May 22, 2020.


Before we dig in, a quick word on the news overnight in Hong Kong. Beijing introduced legislation at the National People’s Congress that would pave the way for changes to Hong Kong’s Basic Law (the city’s mini-constitution). The so-called “Hong Kong Security Law” would require Hong Kong to pass laws banning “treason, secession, sedition, and subversion” against the Chinese government. The move triggered renewed calls for protests and called into question the city’s autonomy. President Trump chimed in, vowing a response from the United States. The Hang Seng Index plunged -5.6% in the wake of the news. It is still early in assessing the overall impact, but it is likely to instigate tensions between the United States and China, and spur further unrest in Hong Kong. We will be back with updates as we know more.


What’s priced in?


The COVID-19 crisis will go down as the recession that was “no one’s fault,” and by extension, the one that no one really anticipated. However, markets are anticipation machines—virtually all price action can be explained by what investors expect to happen in the future. So with markets continuing to march higher in the wake of an unpredictable global pandemic, it seems logical to question what scenarios the market is, and is not, accounting for. Are markets oblivious to the risks, or keenly aware of them?

For today’s note, we offer our take on what is, and isn’t, priced in.


First, what is priced in:


1. Bad economic data through Q2. The economic data has been horrifyingly bad; in what seems like a blink, more jobs have been lost in this recession than during the last 10 recessions combined. But remember—investors did a lot of portfolio purging in anticipation of this back in February–March, when the S&P 500 plunged -34%. So while the data has been terrible, it wasn’t exactly a surprise to investors. Since late March, and with massive stimulus programs in place, markets have been hard at work sniffing out an eventual recovery. Indeed, we may already be seeing signs of economic data starting to inflect higher (albeit off a very low base).

The line chart shows the U.S. Citi Economic Surprise Index from January 2020 through May 21, 2020. It shows that there was a sharp decline beginning in March 2020, but it has begun to trend upward again since the end of April 2020.

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2. Policy support for as long as necessary. Central banks and governments around the world are having a “whatever it takes” moment. Of 63 central banks we track around the world, 61 saw a rate cut as their last move. Additionally, the Fed has already bought roughly $2 trillion in securities (more than it did in each of the quantitative easing rounds 1, 2 and 3 during the Global Financial Crisis), the U.S. government was quick to top up the PPP when initial funds were exhausted, and it seems like the European Union (EU) is getting closer to a bloc-wide recovery plan. By all indications, it looks like policymakers will continue to act as required to support their respective economies.

3. Earnings weakness through 2020. It should come as no surprise that COVID-19 has had a huge impact on corporations. Even with historic monetary and fiscal policy support, businesses across the world have dramatically lowered their guidance for 2020 profits (or refrained from issuing it at all), as the combined impact of lockdowns, disrupted supply chains and a cliff-drop in consumer demand is taking its toll. Consensus currently expects S&P 500 earnings per share to drop over -20% in 2020 versus the year prior. This, combined with the rally in stock prices, has pushed the S&P 500’s P/E ratio to 21x—its highest level in 19 years.

Earnings expectations for 2021 have also fallen, but only to levels consistent with 2019’s earnings per share.

The line chart shows the S&P 500 earnings per share expectations for 2020 and 2021 compared to the 2019 earnings per share from June 2019 through May 21, 2020. It shows that both 2020 and 2021 were originally projected to be higher than 2019, but now 2020 is projected to be lower and 2021 is projected to converge with 2019 numbers.
4. Prolonged suffering in emerging markets (EMs). With the outbreak mostly contained in East Asia and infection curves flattening in the United States and Europe (for the time being), most EMs (ex-East Asia) are seeing rising new infections, and it’s still unclear if they will be able to bring it under control. But markets seem to be respecting this uncertainty, with 20 out of 26 EM equity markets down -20% or more from their 52-week highs.

The bar chart shows the distance from its 52-week high as a percentage for each member of the MSCI All Country World Index.
5. Some businesses will falter and fail, while others will survive and thrive. There has been a large amount of dispersion between the potential “winners” in the new socially distanced world (e.g., software, pharmaceuticals, home improvements, etc.) and the “losers” (e.g., travel, leisure and hospitality, banks, etc.). Small cap stocks have underperformed large cap stocks by 10% so far this year, and “value” stocks (generally more levered to economic activity) have underperformed “growth” by 20%. Further, neither banks nor commodities are close to pricing in a recovery.

The line chart shows the KBW Bank Index versus the S&P 500 as well as the BCOM Index from 2016 through 2020. The slopes show that both indices followed the same sharp downturn during the COVID-19 crisis.

Now, for what isn’t priced in:


1. A second wave of the virus. There is a very real risk that lifting lockdown measures too early, a large uptick in travel, or a lack of adherence to social distancing practices leads to a surge in new infections. With infection curves flattening and reopening underway across the United States and Europe, the risk of a second wave doesn’t seem to be fully appreciated. However, so far, the data on reopening has been encouraging.

Which leads us to…

2. A stunted reopening of major world economies into the second half of the year. With states or countries representing roughly 92% of U.S. GDP and almost 85% of EU GDP now in the process of reopening or about to reopen, it seems that investors are expecting some semblance of return to the “new normal” this summer. However, if a second wave becomes a reality, and key economies enact policy to delay reopening beyond the summer, it seems markets would need to reprice to account for a slower recovery.

3. On the flip side, we could find a workable vaccine or effective treatment. There are more than 100 projects underway by various companies and research groups, ranging from smaller, private companies to large, publicly traded pharma and biotech companies—with several on fast-tracked timelines for clinical trials. How do we know that the prospects of such treatments becoming a reality aren’t priced in? When headlines have noted progress, shares of such associated companies have popped higher to reflect the news. Should there be a breakthrough, we’d also likely see broader cyclical and pandemic-exposed sectors get a lift.

For more on where key players are in the process, be sure to give Michael Cembalest’s deep dive a read.

4. A Democratic sweep in both the House and the Senate. The U.S. election is only 165 days away, and the landscape has changed dramatically over the last few months. Here, we look at prediction markets, which represent the outcome expected by market participants. According to this gauge, the presidential election now looks like a toss-up, and at the same time, it appears now equally likely that either Republicans or Democrats take the Senate (while a divided Congress still looks the most likely).

Putting all that together, a Biden win and a Democratic sweep of Congress, as well as a Trump win and a Republican sweep of Congress, look to be the least expected outcomes by investors—however, the probability of a Democrat-dominated Congress is notably rising.

The line chart shows four lines showing the odds of a Biden presidency and Blue Congress, Biden presidency and divided Congress, Trump presidency and Red Congress, and a Trump presidency with a divided Congress from January 2020 through May 2020. The chart shows that Biden’s odds have been increasing throughout this crisis.
5. Breakdown of the U.S.-China phase one trade deal. You’ve probably heard that the United States and China are butting heads again, with a war of words exchanged over the source of the virus, a recent renewal in tech competition, and most recently, Hong Kong’s autonomy. However, for all the headline buzz, the average person doesn’t seem too concerned that these developments will lead to a complete renewal in the trade war and a breakdown of the “phase one” deal—Google searches for the phrase “trade war” are as low as they were at the beginning of 2018 before all the tit-for-tat began. If words turn into unexpected action, markets would be forced to digest a real reescalation of tensions.

The line chart shows the Google Trend Index for “trade war” from January 2018 through May 17, 2020. It shows that currently the index is at near 0 levels, after reaching highs in May 2019.

How it all stacks up:


It’s natural to be skeptical of this rally, but we think it is likely that we saw the lows back on March 23. And while the broad index has rallied, over 300 S&P 500 companies are down more than 20% year-to-date. From that perspective, it’s hard to argue that the market is completely disconnected from reality. With uncertainty about reopening still high, we are investing cautiously. All in all, it seems to us that the market is priced for what we know.

The bar chart shows the year-to-date total return of the companies in the S&P 500. It shows that only 23 companies are up 20% or more, while more than 100 companies are down -30% or more.


Happy Memorial Day!


With Memorial Day on Monday, we wanted to take the opportunity to thank the men and women who have sacrificed their lives in service of our country. As we enjoy the first few days of summer this weekend, we’ll take pause for a moment of gratitude for those who have served.

While this Memorial Day may look different from the traditional summer weekend with family, friends and barbecue, the stock market isn’t missing out on celebrating. We call the below the “Memorial Day” basket, comprising home improvement stores, boat makers, cooler purveyors, RV companies and beverage companies. Compared to the Russell 3000, the basket has outperformed by almost +50% since the end of March. With that, we wish you a happy MDW!

The line chart shows the Memorial Day basket relative to the Russell 3000 from December 2018 through May 21, 2020. It shows that the Memorial Day basket is currently outperforming the Russell 3000 Index, despite a sharp decline in relative value in March 2020.

All market and economic data as of May 2020 and sourced from Bloomberg, FactSet and Gavekal unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.


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