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MR. MICHAEL CEMBALEST: Good morning, this is Michael Cembalest with the mid-May “Eye on the Market” podcast.
Around a month ago I wrote in one of the notes that the U.S. might start reopening in the middle of May due to declining infection rates. And that prediction turned out only to be half right because, while states representing almost half of U.S. GDP have announced reopening plans, the U.S. still has one of the highest COVID infection run rates in the world, and one that is declining only very slowly and has not declined more sharply, like we’ve seen in other regions such as in Europe. And given the ample evidence of heightened mortality risk for the elderly, we’re at a moment now where the risk of greater generational sacrifices is about to rise.
We are going to be tracking both the virus consequences of state reopening and also the consumer spending impact of state reopening, drawing in part from information we’re building out from our colleagues at Chase card services. We want to be able to really get an assessment for what reopening means because in different states it may mean different things, and rather than just adding up the GDP of the opened states, I think we need to take a pretty close look at what the responses are, and what the elasticity of different categories of spending are to a reopening.
Now that said, we are already picking up signs of a revived economy pulse at a national level, and we have charts in here looking at hotel occupancy rates, petroleum demand, rail traffic, mortgage applications, new business applications. There’s a decent number of high-frequency U.S. data tracker indicators that are already picking up.
One of the factors that is presumably going into these decisions to reopen is are there any treatments that can be used on a prophylactic basis for health care workers or for sick patients. The news continues to be pretty slow. There was a new antiviral trial result that showed some promise in reducing time to recovery from twelve to seven days but it involved the use of three different antivirals at once: interferon injections, multiple antibiotics and oxygen therapy. And so while the outcomes were okay and the viral load also declined more rapidly in the treated group than the control group, there weren’t that many differences for patients that were treated seven days or more after their symptoms came on. In other words, a highly-intensive hospital domicile, or hospital-only approach, it needs to be used with patients with mild to moderate symptoms, and those two things often don’t go together. In other words, people that are hospitalized with only mild symptoms.
We also had a discussion this week of the latest news on monoclonal antibody therapy, which is basically antibodies manufactured outside the human body that give a temporary immunity boost to sick patients or to health care workers. But again, these are clinical trials that are ongoing. Regeneron and some other companies are going to be taking a look more closely at these trials this summer, and could be available more quickly in a vaccine, but again, more costly, harder to produce at scale, and the impacts are temporary, usually just a few weeks.
Jumping over to the real economy and to corporate profits, last week we took at look at the haves and the have-nots of employment and how layoffs are very highly concentrated in leisure/retail, and how somewhere between 65 and 75 percent of those workers look like they may be receiving, at least for now, state and federal benefits that are equal to or greater than their pretax earnings.
This week we take a look at the high concentration of the earnings hit as well because that’s also very concentrated. It’s kind of remarkable but if you look at around 70 percent of the S&P market cap the projected earnings declines are not that bad: tech, internet retail and media, which is now, after everything that’s happened, around 40 percent of U.S. equity market cap is not expected to have much of a growth hit at all in the second quarter. And non-cyclicals, which is another third of the market, are only expected to have an earnings hit of around 20 percent, which is not that bad, given how much operating leverage a lot of these companies have. It’s the financials, and then obviously the cyclical companies that are expected to have their earnings completely decimated.
But part of the resilience of the equity market so far, and the recovery that we’ve seen is probably a reflection of that fact that more than two-thirds of the S&P market cap is projected to suffer a much smaller earnings hit. Whether that does happen in Q2, and I have my doubts, is another question. So we’re going to be monitoring the Q2 estimates really closely, given how optimistic they are for the non-cyclical stocks, in tech, internet retail and media. But if they can escape from Q2 with flat for tech and down 20 percent for the non-cyclicals, that would be a pretty good outcome.
A lot hinges on two things we don’t know yet, which is how—and I mentioned this earlier—how robust will consumer and manufacturing activity be in partially reopened states, and how large a virus infection spike would be needed to prompt a reimposition of the lockdown by the governors. And to me it feels like with the rally that’s taken place the markets are already pricing in good news on both of those questions. In other words a fairly rapid resumption of some degree of normal activity in partially-reopened states, and then, second, either the virus infection spike won’t be that big, or if it is, that the governors will have so much momentum behind the reopening decision that they would not reimpose any kind of lockdown conditions. It feels premature to me to make both of those judgments, and so, as I mentioned last week, we feel like the markets are kind of fully priced now for what the upside and downside opportunities are going forward.
And one of the remarkable things, to me, is that while 2021 earnings projections for the S&P have come down since the beginning of the year, they’re still around flat to what the actual EPS numbers were through the end of 2019. So that seems a bit optimistic, and we’ll have to see whether that plays out.
There are two final topics that I wanted to talk about in this week’s podcast. The first is a regional equity performance barbell. As many of you are aware, we’ve been following this for a long time, and I joined JPMorgan in 1987 and I have never seen any investment thesis work anywhere as consistently as this one, which is a regional overweight to the United States and emerging markets in equities and underweight Europe and Japan. There’s a chart in here showing that it’s more or less worked on a rolling three-year basis from 1991 until now, with a temporary period of underperformance in those two years of the southern European growth boom in 2005-2006.
But other than that I am actually running out of ways of imagining how this trend would ever change. Particularly this year, compared to the U.S., Europe has had a much more rapid decline in infection rates, and Japan’s infection rate barely registered at all. And yet Europe and Japanese equities are, once again, underperforming the U.S. and emerging markets.
There’s not a lot of things from the 2020 outlook have survived this pandemic but one of the more important discussions from the outlook this year, which came out in January, that’s still very relevant, are the structural advantages of U.S. equity markets compared to Europe and Japan, and specifically, number one, are much higher exposure to tech relative to basic materials, energy and industrials in the U.S. relative to the other regions. And secondly, and I think this one is even more important, within each sector, higher U.S. profitability measured as return on assets and return on equity for U.S. companies, compared to European and Japanese counterparts, within the same sectors.
So if the United States is generally comprised of stocks tilted more toward high-growth sectors, and within each sector they end up being more profitable than counterparts elsewhere, that’s a really strong structural advantage for U.S. equities, and you’d have to have a massive valuation discount in Europe and Japan to offset that and—you know, for a really long time that hasn’t happened.
Last topic: last July we wrote a special “Eye on the Market” on leverage loans because there’s been an absolute collapse in investor protections in terms of covenants. And we went into some detail on this, and there’s some data from Moody’s where they put together an index showing just how weak these covenants have become, and heading into the fourth quarter of last year they were the weakest on record in terms of investor protections. And I’m talking about things like leverage and interest coverage tests, most favored nation provisions, restricted payments clauses, leakage of assets out of the collateral pool, the ability to transfer assets to unrestricted subsidiaries and affiliates. These are the things that investors have been surrendering at a record pace.
So then you come into this year; you have this pandemic, and now we’re going to have a credit crunch and a spike in default rates. This is going to be a problem for the leveraged loan market. Now it already was, right, and almost mirroring exactly what the price action was in 2009 you had almost an immediate upfront 30 percent decline in leveraged loans in March, which is almost the same thing that happened in March 2009. And in March 2009 there was a pretty quick V-shaped recovery. I think it’s going to be a little harder this time, given the erosion of investor—creditor protections and the problems in terms of lockdown, particularly in the states where it’s prolonged, that it’s going to have on cashflow.
So to me, after this recovery, the leverage loan markets recovered around half of what it lost; to me it seems like a pretty decent time to think about shifting out of some of these leveraged loan exposures and taking a closer look at distress debt, given the expected surge in non-performing loans and other distressed assets as we head into the summer and fall of 2020.
So there’s more information on that in the “Eye on the Market” that’s coming out this week; take a close look. We also have a list of some topics that you might have missed over the last couple of weeks in the “Eye on the Markets”: we’ve addressed whether the U.S. fiscal stimulus is enough. We took a close look last time on the COVID impact on underfunded state pension and retiree health care obligations and what that implies for the Chapter 9 debate. We looked at this questionable premise about the BCG vaccine being a driver of COVID severity, and a discussion of some of the more ambitious vaccine time tables and serology results. So take a look.
Thanks for listening and I will talk to you again soon.
ANNOUNCER: Michael Cembalest’s, “Eye on the Market,” offers a unique perspective on the economy, current events, markets, and investment portfolios and is a production of JPMorgan Asset and Wealth Management. Michael Cembalest is the chairman of Market and Investment Strategy for JPMorgan Asset Management and is one of our most renowned and provocative speakers.
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