Market Outlook May - Mindful of the market uncertainty

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Despite the positive signals, we are mindful of the uncertainty surrounding the virus as societies gradually reopen. We are therefore maintaining our underweight position in equities and our overweight position in corporate and high-yield bonds. We have not made any changes in our portfolios during the month of April.

In April, the attention of the financial market was still fully focused on the coronavirus. The negative economic effects of the shutdown have begun to emerge, and there is little doubt that they will increase in strength and scope as new macroeconomic numbers are presented. This will of course also be reflected in companies' earnings.

Despite this, the stock market has rebounded strongly since the end of March, recovering around half of the losses seen in March. In other words, we are seeing a clear divergence between macro-economic indicators, corporate earnings and share prices. The explanation is that the market considers the worst to be behind us and believes that the huge stimulus packages will patch up all the holes.

We are less sure about this, and mindful of the high level of uncertainty surrounding the virus and how it will spread once societies begin to reopen and its economic impact.

As we enter the month of May, we are maintaining an underweight position in equities for the following reasons:

1) Macro data is so weak that it’s being ignored by the stock market at the moment and assumed to be temporary. We think the macro figures will get worse before they get better, however. This will also be reflected in company earnings.

2) Things won’t return to normal overnight. Societies and economies are reopening one step at a time. The damage to the economy is being mitigated, but it will still be significant. The likelihood of the market factoring in a more lasting decline increases the longer the macroeconomic indicators remain weak.

3) Regarding the virus, uncertainty prevails: What will happen when economies reopen, before a fully effective treatment and vaccines are in place? It’s still unclear if having been infected makes you immune. Earlier this month, news emerged about the drug Remdesivir which apparently reduces the Covid-19 disease period by a third. However, this medication has only been tested on moderately ill clinical trial subjects, not on those who are severely ill. Nevertheless, this would appear to be a step in the right direction in the medical fight against the virus, although it can hardly be deemed a ‘silver bullet’ just yet.

4) Reduced private consumption is quite likely in times like these. Yet there is still uncertainty relating to consumption. Both now, when society is partially reopening, and after the virus has eventually been consigned to history. The connection between reopening societies and increased private consumption is unlikely to be linear. Households will probably be more cautious about increasing consumption, at least initially in the reopening phase. Bear in mind that private consumption is the most powerful driver in many western economies, accounting for 70 per cent of the GDP in the US, for instance. Government stimuli may be able to cushion the fall, but they will hardly be able to compensate for significantly lower levels of consumption.

5) Finally, it’s worth mentioning that other parts of the financial market are not exactly sharing the stock market’s enthusiasm. We are continuing to see high levels of risk aversion in the foreign exchange market. As a result, the US dollar, the Japanese yen and the Swiss franc have gained in strength significantly. In the credit market, premiums have fallen slightly, but remain at very high levels. In the fixed-income market, long-term government yields have hit record lows and remained there.  The commodity market – the oil market in particular – remains strongly affected by the crisis.

Fixed income: A cautious view on money markets
A well-functioning money market is imperative for several reasons. Partly because this market is the starting point for many loan contracts in different markets, and partly because it’s essential in order for the central bank to be able to exert the desired influence on the economy when setting the key policy rate.

In a crisis, it is not uncommon for the money market to freeze, leading to a painful jump in premiums on liquidity and credit risk. The result is significantly higher money market rates, which offset the stimulating effect of interest rate cuts from the central banks. This has also been the case in this crisis. In the US money market, the premium went from 15 basis points before the crisis to 140 basis points in late March. This is the highest premium since the financial crisis (360 basis points).

The central banks have flooded the market with money

The central banks are prepared to do whatever it takes to make this market work again – more specifically, to get the liquidity flowing once more and premiums back to normal. The Federal Reserve has blazed the trail, injecting huge amounts of dollar liquidity directly into the US money market, but also by offering dollar liquidity to foreign central banks.  These measures, along with other government stimulus packages, have reduced the dollar premium from 140 to around 50 basis points. Be that as it may, this level is still not normal.

The Norwegian money market premium also increased dramatically, from around 25 to 90 basis points, when the situation reached a boiling point in late March and early April. This is due to increased underlying credit and liquidity premiums, but also because of the way the Norwegian money market is designed: This is not a market based on NOK directly; the NOK is provided through US dollar loans which are subsequently converted to NOK. This detour means we import any extraordinary dollar-related premiums from the US money market. The money market premium is now back to normal at around 25 basis points.