Major stock markets in the US & Asia have been climbing higher again this week, recording gains of 0-5% while European markets lagged behind, closing slightly lower for the week. The current trajectory of this market rally feels unsustainable when you combine it with the economic reality around us.
There's clearly a lot going on beneath the surface, so we want to spend some time in this newsletter breaking down how we're thinking about the world right now.
Winners & Losers
There are a lot of moves happening every day on the single stock level, industry level and broader financial market level. While we can't possibly break all of that down in this newsletter, here's how we're thinking about the likely winners & losers coming out of all this.
We think it makes sense to break the economy up into 3 "buckets": digital economy, financial economy & real economy. Each one of these segments of the global economy will experience very different trajectories back to a normal(ish) world.
These buckets are by no means perfect, but we find they help us to understand the messy world with a little more clarity, and we hope they help you too!
Winners: Digital economy
- In this context, we think of the digital economy containing brands which us millennials know and love - "tech stocks". These companies have primarily software driven business models, which makes it relatively easy for them to continue operating (and in many cases, thriving) during this period.
- We think these companies as a group will experience the least damage to their revenues. They will be the fastest to return to "normal". Those with strong balance sheets (read: lots of spare 💸 to spend) and astute management teams will be best positioned to capture even more of the economic growth that eventually lies ahead over the next few years, whether that's by making acquisitions or investing extra into their own research and development programmes.
- It's worth noting, however, that many digital economy stocks have been leading the market rally over the past few weeks
- As an example, Netflix now has a higher market cap than Exxon Mobil while Amazon is trading near all-time highs. FAANG stocks in general have seen almost 2 straight weeks of share price gains while Tesla racked up an almost 30% gain this past week alone, rounding out an impressive 11 straight days of gains.
- It's clear that market prices are now reflecting an expectation for digital economy companies to outperform going forward, so while we think these companies will be long term winners coming out of all this, we would recommend paying attention to the fact that they have already rallied quite a lot - approach your investment decisions carefully, following the right strategy for you.
TBC: Financial economy
- As a whole, the financial economy has transitioned fairly seamlessly to the work-from-home world and has had limited disruptions to operations so far.
- Banks are generally doing okay - Q1 2020 earnings reports and commentary from management teams has been broadly disaster free, for now.
- On one hand, heightened market volatility over the past 2 months has helped banks post strong growth in trading revenues, and capital raising activity should help stabilise the corporate & investment banking side too.
- On the other hand, banks are actively bracing themselves for likely write-downs on the loans they have made as the recession starts to bite over the next 3-6 months.
- This has been reflected in bank valuations - major US banks as a group are trading at around 0.8x their book value which is lower than usual but still well above the 0.45x book value they traded at during the financial crisis.
- In terms of news flow, it seems likely that the worst is yet to come for banks.
- Elsewhere in the financial economy, it's also a mixed bag for insurance. Life insurance companies are starting to experience the burden of a larger number of payouts while non-life insurance (i.e. everything else) has been broadly insulated, for now.
- Finally, as the recession starts to affect the spending power of the average consumer, we think credit card companies may also start to experience some headwinds for their earnings.
- The future remains relatively uncertain for the financial economy, and it's something we'll be keeping an eye on over the coming months!
Messy: Real economy
- For our purposes, the real economy contains everything else outside of the digital and financial worlds. This ranges from supermarkets to fashion to healthcare to oil & gas to manufacturing and everything else in between - a messy picture with many winners and losers. For this reason, we think it makes sense to consider any investments here on a case-by-case basis in the context of the company's financial position, the state of it's industry and future outlook.
- Well capitalised real economy stocks - i.e. those which are likely to survive without too much of an impact on their revenues (consumer staple names including supermarkets and pharmacy chains as an example) have performed relatively well. These "defensive" areas of the stock market tend to perform well during downturns - at the risk of stating the obvious, we all need to eat and need our medicines regardless of what's going on with the economy. But while they're relatively safe bets, these companies tend to have limited prospects for growth which means they tend to underperform the more "cyclical" areas of the stock market coming out of a downturn.
- Elsewhere, "stay-at-home" winners might also be experiencing a short term boost during this period (think of all the home fitness gear you've already purchased but probably won't ever really use), but just how sustainable is this? Once we go back to "normal", will these companies continue experiencing strong revenue and earnings growth? We're not so sure, but again it depends on a case-by-case basis.
- On the other end of the spectrum, we have the consumer discretionary sector - travel, leisure, entertainment, fashion are prime examples. We either physically can't, or are simply unwilling to, spend money on these types of things right now. This is inevitably crippling many companies. It's a riskier space because the future looks relatively brighter or bleaker depending on how long we are in lockdown or quasi-lockdown mode for, how long it takes for supply chains to recover and who is actually still left standing when we're back to "normal".
A caveat: it's worth noting there are some companies which fit into more than one of our buckets - we think they will experience a hybrid mix of the above depending on how their particular business is positioned (as an example, Fintech companies could fit into both financial and digital economy while eCommerce companies fit into the digital and real economy buckets).
Q1 2020 Earnings Season
We've also this week seen the start of Q1 earnings season - expect a barrage of earnings updates over the next 4 weeks covering business performance between Jan 1 - Mar 31 2020. We've seen some relatively neutral-to-positive reporting from the big US banks so far (as mentioned above) - the rest of the earnings drama is yet to come.
It's worth paying even more attention to these earnings updates than usual, in particular to the management press conferences which accompany the financial results. This is because Q1 2020 financial performance from many companies won't incorporate most of the economic malaise - that's reserved for the Q2 earnings season which will come in July.
While this makes Q1 results less relevant than usual - investors are focussed on gleaning insights into company performance during Q2, in the lockdown world, in order to gauge likely future performance. Expect stocks to move strongly higher or lower based on positive or negative outlooks presented by management.
It wouldn't be a Q2 2020 What's Going On newsletter without the latest dismal economic data readings. This week's highlights included:
- 6.8% contraction in Chinese GDP for Q1 2020 - biggest downturn since 1992, when official Chinese quarterly GDP data was first published
- Over 5.2 million new jobless claims in the US, taking the total having filed over the past few weeks north of 22 million
- Eurozone industrial production & UK retail sales both experiencing a contraction
Financial markets seem to be content overlooking the poor economic data for now in light of all the various monetary and fiscal policy bazookas we've seen recently, but we think the reality of mass unemployment and economic slowdown - if sustained - will eventually hit hard. As always, we'll be watching! 🍿🥤