Are markets out of touch with reality?

Do global tensions, trade risks, bad data and the “new normal” of a COVID-19 world support the rally on equity markets?

30 May 2020 | Shane Oliver, AMP Capital (Image: Jeremy Perkins)

From their March lows global shares are up 32% and Australian shares are up 29%. A common concern I regularly hear now is that the rebound in share markets has left them out of touch with the reality of poor economic data, ongoing risks around coronavirus, the permanently changed world ahead and tensions between the US and China.

Maybe they are and I too have been surprised at the strength of the rebound so far. But then again I have seen this before – notably the rapid recovery seen in 2009 after the GFC and it reminds me of the quotation from John Templeton that “bull markets are born on pessimism, grow on scepticism, mature on optimism and die of euphoria” and this rally has certainly occurred against the backdrop of a lot of pessimism.

After a consolidation of several weeks from late April share markets have now broken to new recovery highs with US shares up 35% from their March low and European, Japanese and Australian shares up by around 30%. The drivers remain a combination of falling new coronavirus cases in developed countries, positive news on the medical front regarding the virus, reopenings, stimulus measures, green shoots of recovery and investors being pessimistic and underweight – meaning that there are more who can be forced to buy shares than sell them.

Many shares in major share markets are very overbought but that is quite common coming off major share market lows and is often a good sign. Technically the breakthrough of resistance around the 3,000 level for the US S&P 500 opens up a run to 3,200. If we are right, and April (or May) proves to be the low point in economic activity then given the massive policy stimulus already seen shares should be higher on a 12-month outlook.

The three big risks remain: a second wave of coronavirus cases (that’s a low risk in Australia, but high in the US); collateral damage from the shutdowns resulting in a delayed or very slow recovery as bankruptcies surge over the next six months and unemployment goes even higher; and a serious escalation in US/China tensions (so far is been relatively mild).

The market rallies

Share markets continued to rally strongly over the past week as economic reopening in developed countries and stimulus measures continued but worries about an escalation in US/China tensions held gains back a bit.

While President Trump further ramped up the war of words on Friday against China his latest actions were relatively mild. For the week US shares gained 3%, Eurozone shares rose 4.7%, Japanese shares rose 8.3% and Chinese shares rose 1.1%.

Despite taking a bit of a hit on Friday from worries about US-China tensions, the Australian share market rose 4.7% for the week making it to a new recovery high with particularly strong gains in banks, property, telecommunications, energy and consumer discretionary stocks through the week as a whole. Bond yields were little changed but they rose in Germany and fell significantly in Italy and Spain. Oil and metal prices rose but iron ore prices were basically flat. The Australian dollar rose to its highest since early March with the US dollar falling.

Easing of lockdowns

Reflecting the downtrend in new cases, lockdowns are continuing to ease in developed countries and so we are continuing to see a migration in countries from severe to intermediate lockdowns.

The reopening is occurring much faster in OECD countries with most now seeing intermediate as opposed to severe lockdowns as they are ahead of the curve in controlling coronavirus relative to emerging countries. This includes Australia which has moved down from a (mildly) severe lockdown in April to an intermediate lockdown (albeit at the high end of intermediate).

Economic activity may have bottomed

Reflecting the progressive reopening, high frequency data continues to indicate that economic activity has likely hit bottom. Our weekly economic activity trackers for the US and Australia based on high frequency data for things like restaurant bookings, confidence, retail foot traffic, box office takings, hotel bookings, credit card data, mobility indexes & jobs data hit bottom in mid-April. In Australia there has been a clear uptrend for six weeks in a row.

Consumer hold on purse strings

As it expected in time of economic uncertainty, spending goes down while savings go up or, as we are seeing now, they surge. Data out of the US and Australia in the past week highlight that the combination of wages and stimulus payments being received but not being able to be spent through the lockdown have led to a huge surge in savings (with the US personal saving rate rising to 33% in April and bank deposits surging in Australia).

Some of this saving may be precautionary but the bulk of it is likely due to people not being able to spend. Which in turn suggests there is a lot of pent up demand with savings to support future spending as the lockdown eases, which providing employment recovers should help offset the risks around a “fiscal cliff” later this year.

The Accord 2020

JobMaker is set to become the next big focus in Australia as the focus shifts to economic recovery…channelling Bob Hawke. The Prime Minister pushed further down the path of its economic reform agenda with a push to fix up skills training and a non-ideological consensus driven approach working with business and unions to fix things that are not working in the industrial relations system.

This is good news – several years of ideological polarisation has not got anywhere in terms of reforming the industrial relations system. It further puts Australia in a good position relative to the US that remains beset by political polarisation.   

Trump v China

US tensions with China continued over the last week – particularly in relation to China’s new Hong Kong security law – but President Trump’s response on Friday was pretty muted and far less disruptive than markets had feared.

While he ramped up the war of words with China and announced that the US would begin a process to revoke Hong Kong’s special trade status and look at various other things, few will take place immediately, they were all relatively mild and there was no tearing up of the Phase One trade deal or anything else that would have a big economic impact.

My view remains it is probable that Trump will want to continue to contrast himself with, Democratic Presidetnial Candidate, Joe Biden by showing that he is tough on China. However, with Trump’s approval around where it normally is, at this stage he does not want to do anything against China that significantly threatens US shares and the US economy.

And China will probably just bide its time and wait. But if it starts to look hopeless for him for the November election then he may conclude he has nothing to lose from ratcheting up the conflict – by say ramping up tariffs on China again – and trying to rally Americans around the flag. This would then hold bigger risks for the economic recovery and shares.

Australia China trades risks are not great

There has been no further escalation in the Australia’s trade tensions with China, with the Chinese commerce minister describing the tariff on barley as cautious and restrained. I remain of the view that any disruption to trade between the two countries will be limited because it’s in both countries economic interest not to mess it up, but it’s a high risk if US/China tensions escalate dramatically.

Dr Shane Oliver is Head of Investment Strategy and Chief Economist, AMP Capital

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