• Pierre Fournier

Stock Market Prevision for the Rest of the Year

By: Professor Pierre Fournier

2020 has been a roller coaster of a year so far with a lot of extreme highs and lows. During the second quarter, the stock market bounced back strongly and out of the bear market territory. The economic data has improved and is now indicating that a V-shaped recovery is in the works.

Nevertheless, looking at stock markets right now, it’s difficult for an average person to make sense of them. Bad news seems to make stock market values fall, but worse news makes it go back up. Stocks rise and fall on sketchy “good news”, but don’t seem to worry much about reports of a persistently high unemployment rate.

That was historic. The fastest 40% drawdown in the history of global equities in the first quarter was followed by the largest 50-day advance in market history in the second quarter. Earlier in August, the S&P 500 broke above its late February high and notched a fresh all-time high. The August rally built on the market`s sharp rebound off the March 23 intraday lows. Since then, the Dow and S&P 500 are up 57% and 60% respectively.

Federal Reserve continues to drive up stock prices by committing to keeping interest rates close to zero for a very long time. Consequently, they are fueling the melt-up in stock prices. Earlier this year, the Federal Reserve cut rates to zero and launched an open-ended asset-purchasing program to support the economy through the coronavirus pandemic.

Meanwhile, commentators have been lining up to claim that markets are detached from fundamentals.

I am not so certain that investors have it wrong. For sure, markets seem to be priced for an optimistic outcome of no meaningful second wave of infections as lockdowns are lifted. But record levels of fiscal stimulus sustained low-interest rates, and ongoing low inflation creates a supportive environment for risk-asset outperformance.

One of my previous articles laid out a cautiously optimistic case for riskier assets, such as equities to outperform defensive assets like cash and bonds. Value had improved following the market crash, the outlook turned positive with central banks and governments in “whatever it takes” mode - fiscal and monetary stimulus announcements.

These conditions provided a springboard for risk assets to rebound as the economic impact of the lockdowns turned out less bad than feared and as a possible second wave of infections failed to materialize during summer.

Nevertheless, looking near-term, markets are vulnerable to negative news after a 57% rebound.

Main risks

The main risks come from the potential second wave of virus infections and the approaching U.S. federal elections in November.

  • There is little evidence so far at the end of the summer of a meaningful second wave of virus infections following the easing of lockdowns. COVID-19, however, is highly contagious and has only been contained through the imposition of severe lockdowns. We should know in the next couple of weeks whether a second wave is underway. On the plus side, most countries are now better placed to manage a second wave in terms of healthcare capacity and treatment. Also, the news on vaccine development is promising, although 2021 is the most optimistic timeline.

  • The U.S. federal elections are too close to call. They will become a bigger focus for markets if the Democrat nominee, Joe Biden, takes a decisive lead. Biden plans to at least partially reverse President Donald Trump’s 2017 corporate tax cuts. This could deliver a hit to earnings per share in 2021. One of the key watchpoints will be the election outcome of the Republican-led U.S. Senate. Democrat control of the White House, Senate, and House of Representatives would make a corporate tax hike more likely. It would also create the risk of more corporate regulation.

  • The other risk is a re-escalation of the U.S./China trade war. A recovery in the stock market and the economy provide President Trump with his best chance of re-election. I expect he will not endanger this by re-starting trade hostilities. This calculus could change if Trump’s poll ratings show him in a losing position a couple of weeks from the election. He may conclude that nationalism and China-bashing increase his chance of victory.

Longer-term COVID-19 implications

Here are five likely longer-term impacts of the pandemic.

  1. Low-interest rates for longer. The global economy has taken a huge hit from the pandemic and interest rates are zero or lower at all the major central banks. There is a lot of economic spare capacity which will keep inflation low for the next couple of years at least. This means central banks will keep rates low, which will keep bond yields low. Furthermore, after experiencing zero rates, central banks are likely to keep rates low once inflation rises. They will be reluctant to tighten too quickly.

  2. Less globalization. Globalization was already in reverse before COVID-19. The 2008 financial crisis undermined the trust of western voters in the free-market capitalist model. The backlash continued with Brexit, the rise of Trump, and the U.S./China trade war. The virus is accelerating the anti-globalization trend. Global supply chains are being unwound and the pandemic has created fears about food security and pressure for domestic production of medical supplies.

  3. More government debt and a bigger share of government in the economy. The lockdowns are leading to the largest rise in government debt levels since World War II and higher levels of government support for industries. Eventually, the political debate will turn to how to pay for the lockdown support measures and how to address the inequalities that have been worsened by the pandemic. Well-paid white-collar workers have been able to isolate at home while lower-paid workers have been laid off or had to work in less-safe conditions.

  4. Higher inflation, eventually. Inflation shouldn’t be a problem for the next couple of years due to economic spare capacity caused by the recession. Longer-term, inflation could rise by more than expected. Globalization was deflationary and its reversal will be inflationary. On the supply side, it would be inflationary from higher input costs, less cheap foreign labor, and rising tariffs and protectionism. On the demand side, central banks likely would take a lax approach to rising inflation and governments would see higher inflation as a way of reducing debt burdens.

  5. Pressure on profit margins. Slower trend economic growth, less efficient capital allocation, "just-in-case" instead of "just-in-time" inventory management, higher taxes and higher labor costs will place profit margins under pressure. One potential offset is that the increased use of technology encouraged by the lockdowns will generate cost savings and productivity improvements.

These trends should favor domestic stocks over those exposed to global revenues and supply chains. Mid- and small-cap stocks should do better than large-cap stocks, in a reversal of the trend of the last decade. Developed markets should benefit relative to emerging markets as there will be less technology transfer and less export-led growth. The unwinding of globalization is a headwind for emerging markets. Ongoing low-interest rates favor higher-yielding assets such as stocks, property, and infrastructure over government bonds and cash.

Last week, the U.S. Federal Reserve released the minutes from its July meeting that said the coronavirus pandemic "would weigh heavily on economic activity, employment, and inflation in the near term".

The bottom line: I expect the stock market to continue moving higher, thanks to Fed's ultra-low interest rate policy. Stocks should end the year higher, but there is plenty to keep this roller coaster moving, so investors should brace for volatility. Investors should really pay attention to the positive trends in job gains, coronavirus cases globally, and also any vaccine developments.

Disclaimer: This article is intended to be used and must be used for informational purposes only. It is very important to do your own analysis before making and investment based on your own personal circumstances.

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