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Should equity market bulls be worried?

News Team, 19/05/2020

Given last month’s global recovery in equity markets and despite a slight slip last week seems to be in full flow given yesterday’s closing, is it time to cheer for those holding risk assets? Research shows that this may be a tad premature.

Gaurav Saroliya, director of macro strategy at Oxford Economics said: “We think a sufficient discount for stimulus is in the price but not an adequate risk premium for a weak recovery, not to mention the risk that the virus incidence flares up again.”

Other issues Mr Saroliva highlights include markets being unresponsive to risks such as growth weakness / uncertainty for instance the inability of many firms to provide earnings guidance, risk of fresh US-China trade tensions and a slower rate of stimulus, something that markets heavily depend on.

 Laterally, there are risks such as another flare-up of the pandemic, a pick-up in corporate defaults and credit stress and a back-up in core yields – be it because of issuance indigestion or a market narrative surrounding possible inflation risks. Any bond tantrum will eventually turn on itself but it will still bring a discount rate shock, a risk assets look ill-prepared for.

Meanwhile valuations, especially in US equities, have become ever more divorced from the underlying macro dynamics. Not only are equity investors choosing to ignore dire earnings and a widespread lack of earnings guidance, they seem to have a very different take on the combination of risks from highly correlated markets such as high-yield credit.

“let’s consider a small number of drivers, beginning with the bedrock of the current crisis, namely the COVID-19 pandemic. It is evidently the case that the intensity of the COVID-19 pandemic has eased which has paved the way for lower market risk premia,” stated Mr Saroliya.

One simple workaround he proposed is just to look at the evolution of the number of countries around the world where new cases are growing fast (he defines as a daily growth rate in excess of 5 percent).

The VIX (a measure of volatility) peaked earlier in March in response to stimulus measures. Mr Saroliva said: “the COVID pandemic risk premium has surfaced until now in terms of how rapidly it is spreading around the world and much less in terms of the immediate and long-term economic fall-out of the crisis.”

Finally There is also scope for a renewed flare-up in trade tensions between the US and China which could exacerbate the downside risks. Recent weeks have seen a rise in anti-China rhetoric from the US administration and these tensions are unlikely to dissipate easily ahead of the Presidential election in November. Equities do not appear to be priced for this risk, and consensus earnings expectations do not yet reflect the expected collapse in trade volumes.

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