Equity markets rallied this quarter. Risk appetite increasing as more and more economies start to reopen. Major equity indices have now recouped much of their losses from their Covid-19 driven lows seen in March. The tables below highlight the performance of selected markets for the past quarter and the year to date. The second quarter was one of the strongest for global financial markets in decades. The complete inverse of the first quarter.
Source: MSCI, Datastream, Morgan Stanley Research, Bloomberg and Visio
Is the market taking the view that the worst is over? Certainly, the outlook is better than it was one quarter ago. Unprecedented monetary and fiscal stimulus has provided the necessary support. Global GDP growth will bounce back, driven in part by delayed or pent-up demand as well as enforced savings, but the level of GDP is not likely to return to where it was in 2019 for some considerable time. Before the pandemic, growth was moderate, inflation and interest rates were low and corporate profits high. We know that this year global GDP will contract, and earnings will be weak. Earnings expectations have been revised materially for the next two years. The chart below highlights that valuations of the US equity market, taking currently earnings expectations into account, are not that compelling.
The reset brought about by the pandemic has changed how we live. The longer-term impact on investment decisions will be material. What products and services will be bought as new products are needed in the new environment? Supply chains have become a key focus, as reliance on a few sources or geographic concentration disrupted continuity of stock. Domestic security of supply of food and medical supplies was highlighted during the pandemic, which could lead to more reliance on localisation and increased investment in health care. How will investments be made in these agile and competitive conditions? Opportunities are created but return criteria will need to be disciplined. Business models will need to change. The strength of the management teams, including entrepreneurial flair, now more crucial than ever.
These changes and disruptions will impact on profitability and growth. Corporate investing and household spending patterns may sustain a higher precautionary level than before. Currently higher ratings for the market may result in increased volatility. Investors do need to exercise some caution.
At home, the growth environment is frankly quite desperate. Extremely weak conditions this year, and the outlook remains uncertain with rising unemployment and increasing debt. Poor debt dynamics will result in a weak currency on average in the longer term. As with global GDP, the economy will bounce back somewhat, but certain sectors such a tourism will take longer, and many smaller businesses will not re-open. Although a muted growth outlook, the chart below highlights how the domestic equity market has de-rated materially this year. Valuations are relatively attractive, taking the earnings expectations over two years into account.
Valuation metrics are more fluid in this market. Forward looking ratios such as the forward price earnings ratio (PE) are difficult to use, as earnings forecast risk is high. Management are not always able or willing to provide earnings guidance as the outlook is still so uncertain. Clearly there is significant pressure on cash flows and working capital requirements to manage the economic challenges of lockdown and the gradual reopening of the economy. We are seeing pay-out ratios declining as management teams move to conserve cash. Companies that can pay out dividends will be limited, but also provide investment opportunities. A solid and sustainable dividend yield for a well-priced business based on long term fundamentals is compelling, considering the very low interest rate alternative currently available. A robust business model with balance sheet strength that can endure the current market conditions, remains key in providing confidence in an investment decision. This will remain our core focus.
The true power of diversification is demonstrated in times of crisis. We remain well diversified across asset classes, both locally and globally. Each component of the portfolio working to ensure the risk and return characteristics of your assets are maintained. We are pleased to note that returns in these extremely volatile times have remained robust, with volatility kept to a minimum.