The global economic recovery continued, and equity markets have responded favourably to the better economic picture coupled with strong monetary and fiscal support.
Markets were also boosted by potential vaccines preliminary trial results. Recent economic releases showed signs of a rebound from disastrous numbers seen in May and June. The US economy recorded the sharpest drop in Q2 since 1947. However, the 32.9% decline was smaller than forecasted. Eurozone GDP contracted by 12.1% in the second quarter, following a 3.6% contraction in Q1. The drop was also less dramatic than anticipated and the spread between individual countries narrower than assumed. In China, the rebound has been confirmed with a strong second quarter of 3.2% year on year.
Looking at earnings, the Q2 decline for the S&P500 earnings appears huge: -35.7%, but also better than analysts’ estimates. 84% of S&P 500 companies have reported a positive EPS surprise and 69% have reported a positive revenue surprise. In Europe, 60% of the Stoxx600 reported better earnings than forecasted by analysts, but the 40% decline remained spectacular.
Bond yields stayed near record lows as central banks supported markets through corporate and government bond purchases and liquidity conditions improved. The European Union agreement on EUR 750 billion recovery fund in response to Covid-19 also boosted peripheral European government bonds (Italy, Greece, Portugal, Spain). Globally, the combination of lower government bond yields and corporate spreads tightening resulted in positive monthly returns for all corporate bonds. Emerging market bonds performed well with the additional tailwind of a weakening US Dollar.
Global equities extended their gains with four consecutive up months since March. The MSCI World in CHF terms added 1% over the month. US equities rose sharply with the S&P 500 gaining more than 5% in USD, supported by impressive earnings from the Tech giants (Facebook, Amazon, Apple) and a weaker US dollar. Despite European stock markets failed to post positive returns over July.
The sell-off on the USD intensified during July on massive US money supply growth, and due to recent EUR strength supported by the announce of a European recovery fund. The Dollar index fell 4% over the month. A weaker dollar and falling interest rates propelled gold to a new all-time high at $1973. Gold has risen more than 30% this year as investors have sought refuge from weaker currencies, falling interest rates, and increasingly negative real yields.
Despite the recent improvement in economic releases, most economies will not revert to their pre-crisis levels until a year at least. While the exit from economic lockdown will spur a mechanical rebound in the second half of this year, the risk of an increase in Covid cases as economies reopen is leading to a potentially more gradual and geographically differentiated recovery. China appears to be somewhat ahead of most major economies due to its earlier shutdown and reopening. While the worst of the recession appears also to have passed for the US and Europe, activity levels remain far below normal.
The sharp recovery in prices for riskier assets reflected abundant liquidity and hopeful expectations about the coronavirus being a one-off shock. This may prove optimistic given the resurgence of cases in the US and challenges around important emerging market economies from Latin America or India. Though an effective vaccine would clearly be a strong catalyst for a more sustained economic rebound. Bond market appears to be acting rationally to the pandemic, while equity markets behavior has been anything but rational over the past few months, as it appears somewhat disconnected from the global pandemic, supported by extraordinary monetary and fiscal stimulus.
Encouraged by central banks purchases, bond yields are at record lows and the flatness of the yield curve on major government bond markets reflects the ongoing presence of the central banks as a systematic buyer. Real yields are negative, even with current low inflation levels, and drive investors out of government bonds to find some yield in the credit market, where central banks are also large buyers. We continue to focus our fixed income investments on high quality bonds as they still provide a portfolio hedge in case of pandemic resurgence. We believe upside in bond yields is limited as no central banks will be willing to risk an economic double dip in the pursuit of policy normalization.
The danger of premature policy withdrawal seems low, especially when the global economy remains fragile and debt is mounting to unprecedent levels everywhere. We also don’t see any imminent risk of rising inflation in the short term forcing central banks to tighten.
The rally in risky assets has been driven by massive doses of fiscal and monetary stimulus, which has set a fierce battle between ample liquidity and the collapse in earnings. Earnings are expected to fall nearly 20% this year with consensus estimates are for a return to pre-recession levels by the end of 2021. Analysts are revising their earnings forecasts upwards following a better Q2 earnings season than anticipated. The fundamental outlook is still weak but improving, central bank support continues to be beneficial and equity positioning is still light. We are comfortable with the current neutral equity allocation but would not hesitate to reduce it drastically in case of rising volatility for instance or fading equity price momentum. The economic and earnings outlook is solely dependent on the pandemic and a potential vaccine such that the equity rally walks on thin ice. In case of adverse market conditions, we still believe our exposure in gold and a core fixed income allocation towards government bonds should limit the portfolios drawdown.