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As the first half of 2020 has drawn to a close, we can only be amazed by the developments that have taken place at such a breakneck pace in a matter of just six months. Boundaries have been broken on the monetary front on both sides of the Atlantic, gargantuan fiscal policies have been put in place and are still in the pipeline, the European project has been put to great tests, half of the world’s inhabitants have been confined to their homes at some point during the last months… but above all, the human death toll due to origin of these developments, i.e. COVID19, has surpassed 500,000 and continues to increase. Stock market behavior has rarely been so erratic. Indeed, one of the biggest market decline in a couple of weeks’ time during Q1 2020 was followed by the steepest market advance in just 50 days. Bear and bull markets compressed in a timeframe of a couple of months. S&P500 Index had its best quarter since Q4 1998 with a gain of 20%, curiously enough while at the same time the US daily COVID19 patients continue to accelerate and have now surpassed 50,000 (see chart 1). Thus, the dichotomy we referred to in our last update between economic reality and the stock market has certainly not decreased, although one might point to the improving Purchasing Managers Index (PMI) figures, better retail sales data in Germany or the encouraging unemployment figures in the US. We would caution against extrapolating these figures for the next coming months/quarters and thus assume a full V-shaped recovery as a base scenario. Monthly figures such as PMI’s or employment data lose relevance as these data points are released after the ‘Great lockdown’ with near-zero activity in many sectors. The two successive strong monthly US unemployment figures are certainly encouraging but need to be put in the right perspective: Only 7.5 million jobs of the total 22 million jobs lost since March have been clawed back, while last month figures indicate a surge in permanent job losses to 2.9 million. With the recent spike in infections in several US Southern states and ensuing partial lockdowns of some labor intensive sectors such as leisure or hospitality (which saw 2.1 million additions in the last monthly employment data but the survey was done before the recent spike in daily infections), unemployment figures will be less stellar for August.
In our view the single biggest reason for the resilient stock markets relates to market participants’ gradual realization that no government in developed markets will ever resort to shutting down its entire economy, even if a second bigger wave of the coronavirus hits our shores. But at the moment, in countries like the US, the first wave of COVID19 is not yet under control, prohibiting a full 100% re-opening of the economy. Hence some subsectors (for example the ones relying on crowds) will continue to suffer and will need to adapt to this 90% recovery reality (until a vaccine is widely available) by reining in capital and operating expenditures. We expect more companies to revert to layoffs of personnel (where possible taking into account the legal aspects of the Kurzarbeit schemes in EU or Payroll Protection Programs in the US). Therefore, we would be wary in assuming the strong retail figures we have seen in some countries will be sustained beyond a short period where pent-up demand was satisfied. With Q2 results at our doorstep, we will be closely scrutinizing what managements have in store with regard to cost containment measures.
Chart 1: US daily new infection rate
Source: John Hopkins University&Medicine
The start of the second half of 2020, also coincides with Germany taking over the EU’s rotating presidency. Normally we would not dwell on any EU country taking over the presidency and its potential political or fiscal ramifications. But this time is different, as negotiations on the EUR 750 billion Next Generation EU plan are still ongoing with the frugal four states still reluctant to commit to the EUR 500 billion grants. A politically-reinvigorated German Chancellor Merkel will be eager to leave a final mark on the European political scene before retiring in September 2021. Therefore, we would expect substantial progress in the coming weeks, with perhaps already some ‘white smoke’ at the next EU Council meeting mid-July. Funds from the Next Generation EU deal will be dedicated to decarbonizing and digitalizing the EU economy, similarly to the EUR 130 billion German stimulus package that was announced at the beginning of June. Roughly 30% of that budget will go to environmentally-focused spending, and to the surprise of many (and the strong German auto OEM lobbying powers first), no incentive scheme for traditional combustion engine cars was announced. This will be also the direction of travel for the EU recovery plan: to go “all-in” to make our economies greener and hence innovative companies tackling the climate change challenge should be at the core of any long term-oriented portfolio. Besides digitalization, strengthening local supply chains or investing in innovation and education to improve EU intellectual capital, EU political leaders should also rethink the competition regulatory framework as it puts EU companies in a large swath of sectors at a major disadvantage versus US or Chinese peers. The example of the EU (investment) banking sector is well-known, but in a sector like telecoms, the substantial fragmented EU landscape (see chart 2) and thus lack of scale for EU telecom operators (around 100 operators versus 3 in the US) has in part delayed the roll-out of 5G networks. The appointment of Thierry Breton six months ago as commissioner for Internal Market could be a positive for the telco sector and other sectors to facilitate the creation of more EU champions.
Chart 2: POPs – Points of Presence per mobile operator
Source: Morgan Stanley Research estimates
Staying in Germany for a while, the demise of Wirecard is obviously a painful reminder that accounting fraud can unfortunately not be eradicated, even though the Financial Times, with its investigation over the last 2 years went at great lengths in raising some key issues. Observing some rules of thumbs such as being wary of companies deriving a significant percentage of their sales from a selected number of small emerging countries (e.g. L&H), having an unusual mix of cash and gross debt (e.g. Parmalat), over-complex holding structures or owning a local bank, can help to avoid huge investment mistakes. M&A deal making should also be closely scrutinized (and we expect M&A activity to increase) especially if substantial goodwill is involved (with a high risk of impairment if the cycle turns) or lingering liabilities are not properly taken into account by management teams. Bayer for instance is trying to put to rest its more than 100,000 Roundup litigation claims it inherited from its pursuit of Monsanto. It settled on most of the cases for USD 9 billion during the last month but future liabilities remain as some claimants have not settled and Roundup is still widely available without any warning label and hence more claims will be filed over the next 10-15 years (due to latency effect). Bayer is the textbook example of the necessity to integrate qualitative Environmental, Social and Governance (ESG) analysis into the fundamental assessment of a company.
To sum up, as said in previous updates we remain of the opinion that equity markets have already discounted a fair bit of normalization, while in some Emerging Markets or in the US, authorities have not been able to bend off the curve of daily COVID infected people. Expect news flow on case numbers to worsen in some of these countries, which could cause some renewed bouts of market volatility. A full 100% re-opening of the economy can only be considered with an effective vaccine widely available. In the meantime, progress on the EU recovery fund and a better containment of COVID 19 on our continent are hopeful developments in Europe.