Does a slowdown in new infections mean the worst is over?
Investors are keenly monitoring the number of new infections around the world to gauge whether the COVID-19 outbreak is under control. A piece of good news is that the number of new infections is coming down in some of the worst hit European countries, including the UK, Italy and Spain, and the U.S. is starting to show signs of stabilization. That said, new infection numbers are rising in a number of emerging market countries, such as India, Brazil and Turkey.
The improvement in these countries is a good sign that social distancing and lockdown policies have worked so far. This has led to some countries, such as Spain, starting to relax its lockdown policy very gradually, and allowing essential businesses and manufacturing activities to resume. That said, governments tend to take a more conservative approach in such re-opening to avoid a second wave of infections. For example, France, UK and India have all extended their lockdown until May. Japan has expanded its state of emergency to the whole country, from Tokyo plus six other prefectures.
The relaxation of these lockdowns would be helpful to indicate the trough of the economic downturn, but the extent of the recovery will be determined by the pace of our daily lives returning to normal, which is likely to take much longer. Manufacturing activities could resume quicker compared to services, especially those consumer services that defy social distancing. People movements across borders could take even longer to return to normal.
The pace of such normalization will be determined by the availability of medical or technological solutions. Developing and deploying a vaccine would be the ultimate medical solution, but this will take time. Rapid and accurate tests would help to identify healthy population to ensure workplace and community safety. Technology in helping to trace those who have been in close contact with the infected, followed by testing, can also help to contain infection clusters in a timely manner. Before these solutions are ready, strict social distancing regulations are likely to remain in place to prevent overburdening the health care system.
This implies that the global economic recovery in the months ahead is likely to be gradual which would be reflected in corporate earnings. The sharp drop in 2Q earnings could take several quarters to return to the pre-pandemic levels. Fiscal and monetary stimulus are helpful to ease the downturn but their effectiveness would decline if the downturn is extended. Overall, investor should consider whether the containment of outbreak is sustainable if social distancing and lockdown policies are relaxed.
EXHIBIT 1: S&P 500 FORWARD PRICE-TO-EARNINGS RATIO
The recent rebound in global equities and risk assets is prompted by aggressive fiscal and monetary stimulus from central banks and governments, and investors’ belief that pandemic is under control with the number of new cases in Europe and the U.S. are stabilizing. However, as we have argued above, it might be too early to conclude that the pandemic is over and normality would soon resume. In the absence of the medical or technology solutions, consumer services and cross border travels are likely to take longer to recover.
Investors are starting to expect weaker 2020 earnings globally, which resulted in a rise in price to forward earnings (forward P/E) ratio. For example, Forward P/E for S&P 500 rose from 13.3 times on March 23 to 19.3 times on April 17, with the index rebounded by 26% during this period. Such downgrade is likely to be reinforced by the latest 1Q corporate earnings season and upcoming April economic data from the U.S. and Europe. This implies that price-to-book valuations are probably a more consistent indicator on equity market valuation compared to forward P/E ratios. Triggers for a more constructive short-term outlook for equities will still depend on the availability of these medical or technology solutions. With this volatility in mind, fixed income can help to manage portfolio volatility, with high quality corporate debt and hard currency Asian government and investment grade corporate bonds generating income to provide returns to investors.