Sell in May and go away, not so fast

Normally at this time of the year, as the old adage goes, investors “sell in May, and go away” jetting off to exotic locations to enjoy the summer holidays without having to worry about financial markets. But, with planes grounded, hotels and resorts locked up and a potential market recovery on our hands, we expect this summer to be a very important one for traders and investors as we all try to navigate the opening up of our economies, whilst at the same time being aware of any rise in the rate of new Covid-19 infections that could trigger another round of lockdown and economic suppression. 

The gradual opening up of economies in France, Spain, Italy, Germany, parts of Asia and some states in the US has given the impression that economic data will rebound in the months ahead, which has helped  the FTSE 100 jump past 6,000 (even though the UK remains in lockdown), and the S&P 500 rise to the 2,800 level, which is a 50% retracement of the 18thFeb to 23rdMarch decline. The technical indicators are all pointing in positive directions, the Federal Reserve is likely to re-state its willingness to support the US economy and flood the world with dollars when it concludes its two day meeting later tonight, and investors seem to be happy to look through some dismal earnings reports and historically weak economic data and start buying up equities on the cheap. 

What the stock market recovery looks like 

This is helping to fuel what could become the greatest recovery trade of all time. What this looks like in practice is that stocks that were highly sensitive to Covid-19 are outperforming defensive sectors. In the FTSE 100, Barclays, Carnival and Centrica are the biggest gainers on Wednesday, while Ocado, Morrisons and Reckitt Benckiser Group are the biggest fallers. This rotation out of defensives into “growth” stocks is a sign that markets are starting to function normally once again, and one would expect this type of behaviour at the start of a major stock market recovery. This is benefitting sectors such as airlines (EasyJet is also higher today), retailers, advertisers (WPP is also a top performer on Wednesday) and financial companies (Barclays, St James’ Place and M&G plc are among the risers) have also benefitted as risk seeking returns to the financial markets. We believe that this theme will continue to permeate the markets for the rest of this week, as the Fed meeting and a potential update on the easing of lockdown rules in the UK help to boost investor sentiment. 

But what are the risks? 

There are two main risks which threaten the global equity market rally in our view. The first is another outbreak of Covid-19 in the absence of a vaccine, and the second is a wave of bad debt, as millions of businesses and individuals find that they can’t cling onto the financial lifelines offered by banks and governments around the world. Bad debt hasn’t yet weighed on equity market sentiment, even though the ratings agency Fitch downgraded Italian debt to one notch above junk status. Fitch justified its move by stating that coronavirus will push up Italy’s debt load by 20 percentage points to 156% of GDP this year. Also, the record-breaking $35bn of US treasury 7-year notes on Tuesday, after another large auction on Monday, may reassure investors temporarily, as the US government can borrow huge amounts of money at record low yields, however the reason they are borrowing at all is to help fund the mega US budget deficit bills that are stacking up as a result of the Covid crisis. Government’s all over the world are offering wage furlough schemes, grants and cheap 100% guaranteed loans to keep businesses afloat during this crisis. Eventually, even the US will see bond yields creep up. That may seem very far away, the 10-year US Treasury yield is currently close to a record low at 0.62%, but when the rate rises the burden to pay the money back will start to grow, which will ultimately lead to tax rises and other equity-negative policies as the global economy takes a long time to heal from Covid-19. Barclays, the UK-based bank, may be the top performer on the FTSE 100 today, but it increased its bad loan provision to £2.1bn, as a direct result of the pandemic. Thus, too much debt and any rise in bad debt, is bad news for the global economy. If this starts to dawn on investors, or if we get more rating downgrades, then we may see risk sentiment start to fade and stocks come under pressure. 

The evolution of coronavirus

Another risk factor is the prospect of a second wave of coronavirus, potentially as early as the summer.  Economies are opening up, slowly, around the world. Some parts of Europe and Asia are leading the way as the spread of coronavirus starts to slow and recovery rates rise. In Spain the recovery rate has jumped, and in France the growth rate of new infections is around 0%. It is worth noting that it is not all good news, the recovery rate in Italy remains stubbornly slow, and the growth rate for new infections in the UK continues to hover around the 3% mark each day, which suggests that the peak in infections for the UK is some way off. Germany may have been one of the first European economies to ease lockdown rules, however, the country’s virus reproduction rate has risen back to 1.0 which is the dividing line between growth and decline of the virus. Chancellor Merkel has said that she will implement a second shutdown if Germany sees a corresponding wave of new infections. Thus, the steps out of lockdown are likely to be small, and if a large economy like Germany’s is put back into lockdown, then we would expect a large decline in risky assets like stocks. 

To conclude, after historic declines in economic activity and in stock market prices, there are signs that financial markets are engaging in more normal behaviour. The prospect of a return to economic normality is also being priced into the stock market and is leading to a rotation out of some defensive sectors like supermarkets and household goods’ producers and back into the financial sector and retail. Due to this, selling in May does not seem like a good trading strategy right now. Added to that, we expect there to be plenty more volatility in financial markets in the coming months due to the prospect of a second wave of economic lockdowns and rising bad debt levels. This summer we may not be able to leave our homes or jet off to luxury resorts, but there could be plenty of entertainment in the financial markets.