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Approaching a moment of truth

July to reveal if the worst is behind us or if the real pain is yet to come.

Increasing concerns with respect to the spread of Covid-19 saw equity markets erase their month-to-date gains during the past week. Over recent days, we have witnessed a steady trend higher with respect to infections in many US states and there is now clear evidence of an acceleration in several large states, including Texas, Florida, Arizona and California.

In hindsight, it appears that the rush to re-open the economy before bringing the contagion under control means that infection rates on a national level are now passing the prior peak in April. This is leading to speculation that restrictions on activity will need to be re-imposed, notwithstanding the message to the contrary which continues to come from the White House.

Indeed, the decision by several states in the northeast to require travellers from states in the ‘hot zone’ to observe a two-week quarantine on arrival is a stark reminder of this. Back in April, it was Florida which led the way on restricting travel from New York; in this way, we are seeing something of a role reversal taking place.

Political concern

Broadly speaking, it has also been interesting to observe the differing attitudes towards the virus in traditionally ‘red’ versus ‘blue’ states, with one poll suggesting that 63% of Democrats are worried by the virus compared to just 33% of Republican voters. In the former grouping, the prevailing attitude appears to be that fear is exaggerated, with the number of infections partly the result of increased testing.

There is also a sense that the average age of those being identified with the virus is falling, demonstrating differing patterns of behaviour between those in lower versus high-risk groups. With death rates low, therapeutic treatments improving and a vaccine on the way, this seems to have created a narrative that locking down does more harm than good and “y’all should calm down and carry on”.

However, the fact that hospital admission rates are rising rapidly and spare ICU capacity is being depleted appears to represent a major flaw in this line of thinking.

Could masks shield the economy?

Arguably, what really matters to financial markets is whether this will end up meaning a fresh wave of lockdowns are imposed, given the seeming strength of opposition.

In answering this, we have tended to think that lockdown becomes a necessary step if it appears that the health system is at the point of becoming overwhelmed – as we saw in TV pictures from China, Italy and Spain earlier in the year.

Analysis highlights how rates of infection are falling in states where wearing face masks has been made mandatory and is rising rapidly where it has not. Consequently, one wonders whether it may be possible to combat the rise in infections and hospitalisations through increased mask wearing and some low-level measures, such as restricting large gatherings and the like, without needing to take more draconian steps to shutter the economy.

It seems that we may see the answer to this question played out in places like Texas, Florida and Arizona over the course of the next few weeks and the outcome here may be important in terms of defining the investment landscape for much of the remainder of the year.

Hopes for H2 hang in the balance

If the muddle-through approach is seen to work, then fears with respect to a second wave of infections may start to fade and it is possible to imagine risk appetite continuing to strengthen in the second half of the year against the backdrop of highly accommodative fiscal and monetary policies. However, should this strategy fail, then it seems highly likely that the prospects of growth and investor confidence are destined to take a hit.

In our assessment, markets may already have adopted an overly constructive forecast for the second half of the year based on several data series bouncing from their lows.

This week’s bounce in PMI data raised hopes of a ‘V’ shaped recovery in some quarters, yet the reality is that these data points only really seem to be giving a message that things were no worse in June than they were the month before.

It appears that many are prepared to argue that even in the bearish scenario, there is not too much to worry about in financial markets because the Fed (and other central banks) have got your back.

We would not disagree that central banks will do more should the need arise. However, we would continue to draw a distinction between those assets which central banks will purchase, versus those they will not, and in many regards it seems this distinction has gone largely forgotten in the rally during the past quarter. We would also observe that while this Covid recession may be very different to past recessions, we are witnessing a material contraction in output nonetheless and don’t expect to have recovered fully before late into 2022.

Central action could normalise valuations

With valuations on many assets having recovered most of their year-to-date losses in recent weeks, we would argue that valuations are far from compelling and it may be wrong to think that central banks won’t allow asset prices to move in line with their fundamentals – as those purchasing stock in a bankrupt company like Hertz a couple of weeks ago have been quick to find out.

Over the past week, a flight to quality has pulled Treasury and Bund yields to their lows of the last months, while Gilts have recorded new record-low yield levels, with those who have been short forced to square positions. Credit spreads have moved wider, with CDS indices back to their levels at the start of the month as investors seek hedges for long positions.

Supply indigestion has also seen cash corporate bonds move wider at an index level during the past week, but they remain materially tighter since the start of June with the cash-CDS basis closing in the wake of the earlier Fed announcement on cash corporate bond purchases.

Spreads in the periphery and in emerging markets also trended softer in line with moves in other markets.

Meanwhile, the dollar rallied in the flight to quality, notwithstanding the US-specific nature of the headlines which are driving price action. Elsewhere, steps to apply US tariffs on some US goods was taken as a negative development, though the total of USD3bn which this applied to is largely immaterial in our eyes.

Much to play for in the second half 

As described above, we are starting to think that what happens in markets in the wake of the spread of the virus in the next few weeks could hold the key to understanding the remainder of the year.

Generally speaking, we doubt that the abundance of liquidity is going to disappear as a support to financial markets any time soon, and we remain moderately constructive with respect to IG credit on both sides of the Atlantic, as well as the Eurozone periphery, given central bank support to purchase these assets in the month ahead.

At the same time, valuations are much less compelling than was the case when we ramped up exposure in late March and early April in the wake of central bank intervention. Meanwhile, we are worried that there is complacency with respect to the economic trajectory and also with respect to the spread of the virus and the scope for this to create further downward revisions to growth forecasts.

In the last several weeks it seems like the predominant fear that has existed in financial markets has been the ‘fear of missing out’.

Yet in the real world, fears related to the virus, to losing a job and making ends meet are what many individuals are experiencing.

It almost feels as if the two worlds have been disconnected in the past couple of months, but it is possible that by the end of July we should either be able to conclude that the worst is now behind us, or whether the real pain is yet to come.

It seems like we should all be rooting for the Dallas Cowboys and their kin, but as we have already witnessed in Sweden, complacency doesn’t really seem to be a compelling form of defence when it comes to Covid-19. Either way, the moment of truth approaches.