Black swan apathy bound to wear off

By Ryk de Klerk Time of article published May 25, 2020

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JOHANNESBURG - Although the markets rebounded strongly after the panic and capitulation, seasoned analysts and investors still do not trust market levels and it is clear that apathy has set in. Speculators and arbitrageurs cause significant swings in individual share prices and even broad stock market indices.

Amid the uncertainties and volatilities, the black swan of the coronavirus is wearing off and the stage is set for a strong bull market in risk assets.

Global economic outlook is improving

The downtrend of Covid-19 cases in the major economic zones is gathering momentum and the reopening of economies is under way. Europe has now joined China with limited new cases, and although the headlines in the US focus on the increasing number of deaths, the curve of the total number of cases is flattening.

Although developed market economies are likely to record downturns in the second quarter of this year, preliminary of Flash purchasing managers (PMI) surveys released by IHS Markit indicate that the looser lockdowns have eased the downturns.

With capacity utilisation in the US and Europe at or near record lows, an improvement in utilisation will undoubtedly be reflected in increases in new orders, employment and new export orders as demand and supply chains are restored after the severe disruptions caused by the lockdowns. The improved outlook is likely to be reflected soon in PMI numbers moving above 50, indicating expansion.

Although the improvement will be off a low base, it will be the first time since 2009 that the developed economies together with China will expand in unison.

The levels and future trends of the purchasing managers’ indexes have pronounced implications for equity markets.

I use Nobel Laureate Robert Shiller’s cyclically adjusted price to earnings ratio (PE10) based on average inflation-adjusted earnings from the previous 10 years, as it eliminates fluctuations caused by the variation of profit margins during business cycles.

The change in the S&P Composite’s PE10 from a year ago, in the past had a remarkable correlation with the variation of the ISM purchasing managers’ index for the manufacturing sector in the US from 50, where a positive number indicates expansion and contraction in the case of a negative number.

Based on Friday’s close, the S&P Composite’s PE10 was about two points lower than at the end of May last year. In light of the relationship between the ISM PMI and the S&P PE10 it infers that the US stock market with the S&P Composite as a proxy, is pricing in a PMI number of around two points below 50 - therefore a contraction in the manufacturing sector.

The expected thawing of the US economy in the coming months will see the ISM PMI move above the 50 level and rising. The S&P 500’s high of nearly 3400 in February can be revisited within the next 12 months.

It will not be all plain sailing though. A number of hurdles lie ahead. Developed economies are probably already experiencing deflation, and with the elections coming up it is likely that President Donald Trump will up the ante to protect the US against cheap imports from China, which had a boon from cheap prices of imported raw materials and intermediate goods.

It does augur well for emerging market assets though. While developing countries are likely to continue to climb the coronavirus curve, they will be under pressure to loosen their lockdowns to facilitate exports of raw materials and intermediate goods to prevent economic and social disaster from worsening.

Deflation in developed economies means zero to negative interest rates. Emerging market assets and especially government bonds, will therefore become increasingly attractive to global funds seeking income. Developing countries should expect foreign direct inflows.

The cycle repeats itself. This bull can fly.

Ryk de Klerk is analyst-at-large. Contact [email protected] His views expressed above are his own. You should consult your broker and/or investment adviser for advice.


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