A Reality Check for the Equity Markets

In a market outlook analysis published nearly a month ago, LPL Financial said significant downside risk remained in the U.S. and global equity markets despite the fantastic rebound seen in the month of April, pointing to three main factors behind that risk.

These risks were elevated stock market valuations, Federal Reserve Chairman Jerome Powell’s pessimistic outlook for the economy and the markets, and rising tensions between the United States and China.

Fast-forward to mid-June and those concerns seem to have been validated. After last week’s precipitous drop in the broad U.S. market indices, investors are increasingly skeptical about a smooth, V-shaped recovery. According to Rupert Thompson, chief investment officer at Kingswood, it’s actually in a sense a good thing to see the markets soberly responding to negative news about spiking coronavirus infections and low anticipated growth.  

“What has caused the abrupt turnaround? In good part, the latest falls are just a correction which had been waiting to happen following the exceptionally strong rebound since March,” Thompson says. “That said, the news out last week did highlight the question marks hanging over the market’s apparent rosy assumption of a sharp V-shaped economic recovery. In the United Kingdom, for example, the April GDP data showed in black and white the severity of the hit dealt to the economy by the lockdown. GDP has plummeted a massive 25% since February, swamping the 6.8% peak-to-trough decline seen in the global financial crisis.”

Looking forward, Thompson says, the market outlook clearly continues to hinge on whether a major secondary spike in infections can be prevented. Unfortunately, he says, the latest news on this front confirms this remains a risk.

“Infections have started to pick up in some U.S. states which have been re-opened in recent weeks, and there has also been a renewed outbreak in Beijing,” Thompson observes. “The only good news last week was that the Fed confirmed that there is no danger of it tightening policy prematurely. It is forecasting interest rates to remain close to zero until at least the end of 2022. The Fed is not even thinking about thinking about raising rates.”

Thompson feels the recent volatility has left markets “looking a bit more in touch with the economic reality than they were a week ago.”

“A period of consolidation, while it becomes rather clearer how well economies navigate the difficult months ahead, would make a lot of sense,” he suggests. “However, with the surge in liquidity still in the driving seat for most of the time, hopes for a period of market calm and reflection look likely to prove wishful thinking.”

According to a new survey report published by Natixis Investment Managers—featuring polling conducted between March 16 and April 24—U.S. investment professionals are still forecasting returns in 2020 to look more like 2018 than 2008, by which they mean returns will likely be negative for the year, but not catastrophically so. Of note, the survey analysis suggests the market outlook of respondents is more optimistic in the U.S. than rest of the world. Pessimism is highest in Asia, where financial professionals forecast double-digit losses for the year.

“Advisers in the U.S. seem to be giving an initial vote of confidence to the swift and dramatic actions taken by Fed and Congress in response to the pandemic, as well as the resiliency of the U.S. economy,” says David Giunta, CEO for the U.S. at Natixis Investment Managers.

Interestingly, the survey finds nearly half of financial professionals (46%) felt that markets were overvalued heading into the ongoing period of coronavirus-related market volatility. In fact, nine in ten (92%) believe the prolonged bull market leading into this period of resurgent volatility had made investors generally complacent about risk. Along these lines, the survey shows 76% of financial professionals think individual investors were unprepared for a market downturn; 79% suspect investors forgot that the longevity of the bull market was unprecedented, not the norm, historically; and 85% think individual investors, in general, struggle to understand their own risk tolerance.

Also telling, 81% say individual investors don’t actually recognize risk until it’s been realized—i.e., through losses in their portfolio.

“The market downturn—and expected recovery—serves as a lesson in behavioral finance, even if learned the hard way through real losses and missed goals,” adds Dave Goodsell, executive director of Natixis’ Center for Investor Insight. “Investors got a glimpse of what risk looks like again, and it’s a teachable moment.”