Ron Temple

The public health conversation has shifted to focus on when and how public life and economic activity can return to normal around the world. In a note to investors, Ron Temple, Co-Head of Multi-Asset and Head of US Equity, shares his thoughts what to look for on the road to recovery.

Economic update

The US employment report was the most important economic news of the week, propelling the US equity market almost 3% higher on 5 June. Consensus expectations called for the unemployment rate to rise to 19% and nonfarm payrolls to decline by 7.5 million. Instead, the report showed a 2.5 million-person increase in nonfarm payrolls and a decrease in the unemployment rate to 13.3% from 14.7% the prior month.

Forecasters missed this outcome primarily due to the negative story unfolding in the weekly jobless claims data, which showed another 1.9 million people filing claims in the week ended 30 May and a total of 42.7 million such filings in the prior 11 weeks.

The two data series are almost certainly both subject to mismeasurement in light of the unprecedented economic turmoil in the United States. However, there were clues in the weekly report’s continuing claims data that the employment report might not be as bad as feared. Continuing claims for jobless benefits tripled in the four weeks ended 24 April, rising from 7.4 million to 22.4 million. Since that time, the number has fluctuated between 20.8 million and 24.9 million. Backing into the numbers, the relative stabilization of continuing claims indicates that some number of people are finding new jobs or returning to their existing jobs.

The data from the employment report shows a similar story: 7.7 million people went from being unemployed to employed in the month of May, while an additional 5.4 million moved from being “not in the labor force,” defined as having worked or actively sought work in the prior four weeks, to employed. Partially offsetting this progress were 4.9 million people whose status went from employed to unemployed and 4.4 million who moved from employed to not in the labor force. The net of the two is a very positive number.

Overall, while the news certainly surprised us, it is unquestionably positive. We will watch the weekly claims data and June employment report very carefully to see if the positive story continues. We continue to believe data will be erratic for the next six-to-12 months as the economy begins to normalize. The various US states are opening in a largely uncoordinated way, and we believe some will pause or even reverse their reopenings as the number of cases begins to rise locally.

Households and companies are likely to husband their resources until they feel confident the recovery has taken root and is sustainable. That said, we could also see surges in demand for goods and services as people are finally able to return to restaurants, bars, and travel destinations. Our hope is that the reopening will progress smoothly and wisely, giving healthcare experts time to develop a safe, effective vaccine.

Policy response update

The European Central Bank (ECB) announced a €600 billion expansion of the Pandemic Emergency Purchase Programme (PEPP) to a total of €1.35 trillion. The ECB also announced that it would continue reinvesting proceeds from principal and interest payments through at least the end of 2022. The consensus expectation had been for an increase of €500 billion.

The upside surprise was encouraging coming on the back of the European Commission’s proposal of a European Recovery Fund the prior week. We are cautiously optimistic that the European Union might be reaching a turning point where it begins to act more decisively to break the economic stagnation that has afflicted the region since the global financial crisis.

On 5 June, US President Donald Trump signed the Paycheck Protection Program Flexibility Act into law. The bipartisan legislation relaxed the rules for forgivable loans issued to small businesses in the United States. Under the original rules, small businesses were required to spend at least 75% of the funds on payroll over a period of no longer than eight weeks. The requirements did not align with the cost structure of many small businesses, however.

Under the new rules, at least 60% of the funding must be used for payroll, and the company has up to 24 weeks or until 31 December to spend the funds, whichever is earlier. It also allows companies more time to rehire employees, extending the deadline from 30 June 2020 to 31 December. These changes should broaden the appeal of the funding to more small businesses. As of 4 June, 4.4 million borrowers have been approved for PPP loans totaling $510 billion, according to the Small Business Administration.

Investment implications

Markets spiked in response to the 5 June employment report, with the S&P 500 Index closing 5.7% below the record high close of 19 February and the median stock down just 8.9% since that point. Investors were encouraged by the prospect of the US economy reopening faster than previously expected, reviving cash flows into corporate coffers. The job data certainly offers a good reason for such enthusiasm.

We continue to remain more cautious, almost entirely due to our concerns over the pandemic and developments in terms of therapies and vaccines. Throughout the crisis, we have thought that the right call is to remain fully invested with a bias toward quality. We believe that is still the optimal choice, but recognize that lower quality, more cyclical stocks might take the lead temporarily if investor enthusiasm is sustained. We understand that there are always times in a recovery cycle when this is the case, but remain steadfast in our view that firstly, it is very difficult to call the beginning and end of low-quality rallies and secondly, that over a multi-year time horizon, high-quality stocks have sustainably outperformed lower-quality peers.

All told, we are unquestionably happy about the positive economic news, as it means less damage to household, corporate, and government finances. We hope the trend continues. In the interim, we would not chase the rally, but would instead remember that monetary policy is fading in scale relative to the supply of new government debt being issued.

As this net balance of supply and demand adjusts, the real economy will be the key driver of markets, rather than the flood of liquidity that propelled the initial leg of this rebound. The bottom line is that the fundamentals of each company and security are likely to become even more important as we move forward from this point. Security selection will be an increasingly important driver of total return, in our view.

The post Health, economy and markets – What to look for on the road to recovery appeared first on AdviserVoice.

Ron Temple

The global economy requires three key building blocks to ‘exit’ COVID-19 in the safest, most effective way possible, according to Lazard Asset Management.

In a note to investors, Ron Temple, Co-Head of Multi-Asset and Head of US Equity, argued that improvements in healthcare systems, economic implications, and monetary policies, will enable the global economy to effectively leave the COVID-19 pandemic.

1. Healthcare systems

Testing: With more than 550,000 new coronavirus cases, global infections increased to 3.45 million, while deaths exceeded 244,000 as of 3 May. The United States accounted for 33% of the global infections and 27% of deaths. Encouragingly, new infection and death rates continued to decline in Spain, Italy, France, Germany, and in the US states that have restricted mobility the most.

Testing remains a top priority. Very few countries are testing widely enough to identify asymptomatic carriers of the virus. While the UK and France made significant progress in accelerating the pace, the US tested only around 10% more people than in the prior week. Estimates for the number of tests needed in the US to facilitate reopening the economy range widely, anywhere from 3 million per week to 5 million per day. What is easily agreed is that current testing in the US remains far below the lower bound of this range.

Therapies: Gilead’s antiviral drug remdesivir made headlines this past week with a successful clinical trial that accelerated recovery in patients hospitalized with COVID-19. On the back of this development, we adjusted our three scenarios for economic recovery to a more optimistic setting. In our base case, sustained recovery now begins in the third quarter of this year.

We believe that remdesivir, although not a cure for COVID-19, significantly truncates the left-tail, or worst-case, scenarios related to the pandemic.

Vaccines: Although vaccines historically have taken years to develop, in the case of COVID-19, we are optimistic that the timeline will be compressed based on a) the amount of funding and focus on development, with six vaccines already in clinical trials, b) the fact that many steps in the development process are being conducted in parallel rather than in sequence, and c) the breadth of novel and proven modalities currently being evaluated. We are encouraged by the magnitude of research efforts underway by so many firms.

2. Economic implications

Despite the positive therapy news, the pandemic continued to wreak havoc on the economy, with 3.8 million more Americans claiming jobless benefits last week, taking total claims to 30.3 million in only six weeks. In Europe, 10 million workers at 425,000 companies are now covered by special unemployment schemes in France, while 4.6 million are covered in Italy. In Germany, 718,000 companies have applied for the government’s short-term special work program.

Nevertheless, we have revised our three primary scenarios for economic recovery given the positive news on remdesivir. We now think a sustained recovery will begin sooner and unemployment will peak more quickly. However, we remain concerned about the potential for the pandemic to have lasting effects on growth.

Countries and companies are likely to exit the crisis with significantly higher debt, curtailing their ability to invest and innovate. We also expect to see some behavioural changes endure, such as more people working from home. That particular change would reduce the amount of miles car commuters drive every day, decreasing demand for oil and automobiles, as well as for office space in city centres.

Finally, we believe companies and governments around the world are likely to reassess the desirability of complex global supply chains, especially in essential areas such as healthcare and food, in light of the supply challenges that occurred during the crisis.

US-China tensions: Another factor clouding the long-term outlook: more intense US accusations against China regarding the origins of the virus and the transparency of China’s disclosures. The latest accusations by the Trump Administration–speculating that COVID-19 was accidentally released from a Chinese laboratory in Wuhan that has dual military-use purposes–in part resurrected suspicions that had been largely dismissed by experts several months ago. The US also accused China of obstructing the flow of information about the virus in ways that increased the severity of the pandemic. Australia joined the US in supporting a global investigation of China’s response, which only heightened tensions further.

While we do not see an imminent re-escalation in the trade war, the economic recovery would unquestionably be impaired by new tariffs or restrictions on trade that increase uncertainty for companies and consumers.

3. Monetary policy measures

During the week the Fed announced an expansion in the Main Street Liquidity Facility, opening the door further to non-investment grade borrowers tapping its facilities. Under the new terms, companies with fewer than 15,000 employees or revenue of less than $5 billion can apply for loans. Also, while the original guidelines on 9 April limited borrowing to $150 million, the Main Street Expanded Loan Facility now can lend up to $200 million at an interest rate of LIBOR + 300 basis points (bps). Borrowers cannot exceed a debt-to-EBITDA ratio of 6x with the incremental funding and must have a “pass” rating from the Federal Financial Institution Examination Council as of 31 December 2019.

In Europe, the European Central Bank (ECB) disappointed investors by not expanding its Pandemic Emergency Purchase Programme (PEPP) to include debt issued by companies that have been downgraded below investment grade since 7 April. During a press conference, ECB President Christine Lagarde emphasized repeatedly that the ECB has been, and will remain, flexible and will do whatever is required to support the economy and achieve its mandated inflation objective. Nevertheless, the questions during the conference implied that the markets do want more aggressive action from the ECB.

During the week, the Fed added $83 billion to its balance sheet, which stood at $6.66 trillion. This was the smallest increase since the week ended 4 March. The decelerating growth reflects slower purchases of both Treasuries ($62 billion) and mortgage-backed securities (MBS), though the $18 billion drop in its holdings was more than offset by a $38 billion increase in commitments to purchase MBS that have not yet settled. The ECB balance sheet grew by €64 billion to €5.35 trillion with purchases of €26 billion in securities in the PEPP and a net €9 billion under the Public Asset Purchase Programme focused on sovereign debt. The other increases resulted from financial institutions tapping the longer-term refinancing operations facility for €19 billion.

Investor takeaways

For investors, we continue to recommend focusing on security selection and prioritizing quality in issuers’ balance sheets, funding profiles, and ability to generate high returns on capital through the cycle.

For debt investors in particular, we believe that some highly leveraged issuers and structured securities remain unattractive and suggest emphasizing detailed cash flow analysis of all issuers. Of note, spreads on investment grade debt remain substantially above pre-crisis levels, and investors should not feel forced down the quality spectrum to generate income.

In the equity markets, we see excellent franchises trading at significant discounts to fair value and to levels of only a few months ago. While it is critical for investors to assess the near term and ensure that companies are not likely to encounter liquidity-related stress, it is also vital to recognize that the value of a company’s stock is the present value of all future cash flows to which shareholders are entitled. In other words, one or two years of weaker earnings may amount to a short-term reduction in cash flow rather than a permanent change in earnings potential.

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