A limit to market optimism

Stocks have faltered as we move into the middle of the week, the FTSE 100 is down nearly 1.5%, with a 0.5% decline for the Dax index. Is this a bump in the road to recovery, or are markets right to treat any rally with scepticism? Below we analyse three factors that could determine the next move for risky assets, with equities most in focus. 

1, Technical signals: At the peak of the financial market volatility we said to ignore technical signals, they would be overwhelmed by extreme price movements and historical price action was no indicator for where stocks would go next. Hence signals that suggested that markets were overbought meant nothing. However, we have been taking small steps back into technical analysis in recent days. The main finding from adding technical analysis back into our tool kit for looking at equities, is that the majority of signals are still suggesting that equities are a sell. This is true for the FTSE 100 and other European indices. Regarding individual blue-chip companies, one would assume that the news that Tesco was distributing £900mn in dividends, when other companies have turned away from dividends, would be good news for the Tesco share price. Not so, Tesco is one of the biggest decliners on the FTSE 100 today and is down nearly 5% so far. One of the reasons for the decline is the backlash that Tesco has faced for paying dividends to shareholders while also accepting a business rates holiday from the government. This highlights the “moral” premium attached to stock prices in this environment. Wil investors reward those companies that do the right thing, and punish those that it thinks are excessively greedy or are abusing state benefits? If the moral yardstick is how we now weigh up the prospects for a stock price, then will Tesco have to cancel future dividends on the back of this furore and will people turn away from companies that are seen to be exploiting the Chancellor’s measures to combat the economic damage caused by the coronavirus? As you can see, in the current environment, technical analysis only goes so far, you need to keep up to date with corporate news flow that could ultimately damage the value of a company if they take a misstep for the benefit of shareholders or executives during this sensitive time. Corporate greed and a lack of generosity is likely to be punished in the current environment. 

2, Coronavirus: an update 

There has been a lot of good news stories regarding the pandemic in recent days, which can be lost in the news headlines about surging death rates. According to JP Morgan Cazenove’s healthcare analysts, who do a sterling job analysing the data on new infections, death rates and recovery rates, there are signs that Germany is at its peak, and both Italy and Spain are moving closer to their peaks with their net infection growth rates at 1% each. In Italy, the new infection count reduced to 3k per day on Tuesday from 4-4.5k on average last week. This is encouraging. As we have mentioned in recent notes, Italy needed to see new cases drop well below 5k per day for it to be close to its peak. With the infection rate at this level, then a surge in recovered cases should be around the corner for Italy, potentially as early as next week.

There is also good news in the UK, with the daily infection rate down from 3.8k per day on Monday to 3.6k on Tuesday, which is a further sign that the UK’s lockdown is having an effect. This equates to a growth rate of 6%, which is the lowest daily rate of the outbreak so far. Recovery rates in the UK seem to be slower than elsewhere, however, this could be because only the sickest are getting tests once they are admitted to hospital. In Germany, where testing has been widespread, all patients are recovering in 14 days. If the UK had more widespread testing available, then we believe that the UK recovery rate would be faster than it currently looks. A notable exception to this trend is France, where it does not seem that the lockdown is working. Data in the US is also worrying. 

Good news on the data front for European Covid-19 infection and recovery rates should be welcomed by financial markets, as the light at the end of the tunnel starts to shine brighter. This data suggests that the measures taken by most European governments are starting to pay dividends, and this should be enough to suppress excess market volatility for now. Thus, we believe that the most brutal part of the market sell-off, like the one that we experienced last month, is behind us, and the current recovery in financial markets is more than just a dead cat bounce. Lower levels of volatility should be here to stay, even if we do see down days like we are seeing today. 

*A caveat to this would be if we see the current trend in Covid-19 data start to deteriorate or a second wave of the virus emerge in the coming weeks. 

3, The economic fall out 

By and large the economic fallout from the Covid-19 outbreak looks horrific, and this is the biggest hurdle for equity markets across the globe right now. Economic data points across the US and Europe including global sentiment indicators, employment indicators and measures of construction activity are, unsurprisingly, tumbling. This is to be expected in data since March, when many lockdowns were put into effect. We would expect data for April to be even worse. While we do believe that economic data is important, it is worth noting that we think that its usefulness to trade equities is limited, as we expect most data in the US and Europe to be universally bad in the coming weeks and months. 

Instead we think that more useful data to consider include corporate results and Chinese economic data. Corporate earnings are a key metric for the future direction of equity prices. Tesco’s full year results, released today, were a mixed bag. A dividend will be paid which runs to February 2020 and does not include the period of lockdown and panic buying in the UK. The bad news is that Tesco expects the pandemic to cost them more than £500mn due to excess operating costs including paying for extra staff as more than 50,000 Tesco staff have been either off sick or self-isolating. If normal shopping habits resume by August, then Tesco executives believe that the extra revenues from food sales could make up for the surge in costs, thus it will take a lot of extra items in peoples’ baskets to make up for the costs of this pandemic to a supermarket like Tesco.

The immediate impact from this news is that the Tesco share price is one of the worst performers on the FTSE 100 today and is down nearly 5%. Thus, even some sectors that are considered the big winners from the pandemic could see profit margins squeezed.  

Sectors, including finance and other value-added services are worth watching closely. Since large swathes of these sectors can work effectively from home, the lockdown may not have had such a large impact on their businesses. Businesses that have a physical presence and a limited online presence, such as Primark Owner Associated British Foods, are expected to suffer a deep blow to their earnings, which could hinder their stock price recovery in the long term. Thus, all traders need to look closely at corporate earnings in the coming weeks and months, as the degree of damage done to corporate profitability will be the driver of stocks going forward. 

China appears to be coming out of the other side of its Covid-19 nightmare, thus its economic data is also worth watching closely. While there is some concern about the veracity of Chinese data, both on Covid-19 cases and economic data, it is still worth looking at how a 3-month lockdown of 11mn people in Wuhan effects the overall economy. Inflation in China is expected to have fallen for March. This is released on Friday, and the market expects a 0.7% decline for the month. Lockdown is likely to be deflationary for the global economy in the short term, which is bad news for stock prices. China could give us a steer as to how far prices may drop in the coming weeks, which may help give traders some visibility on the pandemic’s effects on corporate earnings and stock prices elsewhere. 

Overall, the world has changed in recent weeks, and so too have the drivers of global stock markets. We believe that the points above can act as good lead indicators for where stocks may go next.