Why patience is a virtue

The recent rally in equity markets has got many people wondering whether the market swoon is behind us. It is indeed tempting to assume that now most countries are in lockdown, the only way ahead is a lifting of restrictions leading to normal activity and hence a proper economic recovery.

Unfortunately, markets do not ‘buy’ into increased economic activity, nor do they ‘buy’ into shutdowns or lack thereof. They ‘buy’ into company earnings, which means when markets can estimate the full extent of the damage to real company earnings, they may be able to move up durably. This is where the crisis has yet to bite however, and the reason why we believe markets may have further to fall before their eventual rebound.

Very little has been priced into corporate earnings yet, to reflect the massive drop in economic activity which has started in western countries. Some firms have begun to estimate a collapse in US GDP of 30% for the current quarter, and similar numbers for European countries. If that is the case, then earnings could fall by 20-50% for at least a couple of quarters. The lifting of government containment orders is widely estimated to happen in the next four to six weeks, possibly leading to a full resumption of economic activity, but the ‘V’-shaped bounceback afterwards that is expected by some is highly optimistic.

Our concern is that, even when governments allow us to do what we want again, there will be a natural reluctance to expose ourselves to any remnants of the virus and to spend like before, given how hard the shutdowns will have hit many people financially and how many businesses will have suffered to the point of no return.

China is a case in point. Arguably, following the most effective containment process in the world, China has now lifted most restrictions and the government is actively encouraging its citizens to go out to restaurants, theatres and other venues of discretionary consumption. Yet the population is wary of embracing that newfound freedom.

When will we see the impact of coronavirus in corporate earnings?

Corporate earnings will start to get revised from next week and we are likely to see market movements that reflect the new reality. Although we don’t recommend comparing two bear markets that were caused by totally different things, it is useful to look at what happened during the financial crisis. In 2008, equities fell first on concerns about the economy going into a recession. Later on, after a rally, they fell further again to reflect the drag on corporate earnings in most sectors.

We are therefore continuing to advocate patience in dealing with this potentially open-ended uncertainty. Being able to forecast the peak in infections across the world is not the only condition for markets to make a lasting recovery. We also need to know how much economic damage is being done through corporate earnings and see a possible end to that damage.

The advantage of patience is twofold: first, we may get a lower entry level into most investments and be able to find the really attractive opportunities and second, we will have greater visibility on which sectors, countries and shares are more likely to outperform after the crisis. There are many such ideas on our radar and we are updating our lists every day for a recovery in the shape of the letters ‘V’, ‘U’, ‘W’ or ‘L’. We are mapping out what a recovery discretionary portfolio might look like for each of these potential scenarios, but it is still some way before we would consider pressing that button.

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