“Sell in May and go away”: the typical finance adage didn’t work well this time, with stocks around the world rising over the summer, driven by major economies reopening around the world after the covid-19 lockdown. Investors kept buying the rebound as earnings from the first quarter were better than expected. Moreover, Covid-19 cases were slowing during the summer which boosted confidence and led investors to buy stocks, leaving aside the aggressive Mayoshi Son’s bet with call options that it is said have sparked the rebound.
So far, markets have risen but in the past weeks those have been lowering for several reasons, with tech stocks declining the most before rebounding strongly as observed in the picture with the S&P 500 (red), Nikkei 225 (yellow), Euro Stoxx 50 (green) and Shanghai Composite (blue).
There are some risks ahead that might be considered by investors as threats for their holdings such as the upcoming US Election, Covid-19 cases rising, Economic forecasts and retail investors and result in triggers making the market fall in the coming weeks.
US Elections: Trump or Biden?
Voters in the United States will decide on 3 November whether Donald Trump will remain in the White House for another four years. The Democrat challenger is Joe Biden, who served as Vice-President under Obama’s tenure.The upcoming election are featured by a high level of uncertainty, as polls show Biden is currently leading with 51.4%, on the other hand Trump 42.2% (Financial Times), anything can happen.
The second factor of risk is international politics, as a matter of fact, despite Trump being a Republican, he created several tensions in terms of geopolitics and international relations. Since 2017, the target has always been China with some counterparts being hit as collateral damage such as the EU, Canada and so on. The escalation of the trade war appeared to come to an end before the Covid-19 outbreak, but was, somehow, reopened with the ban of Tik Tok and WeChat during the summer.
In case of reelection, it wouldn’t be a surprise to have new disputes arising, which have always created tension on financial markets. On the other side, Biden, more in favor of the so-called working class, has promised to increase corporate tax from 21% to 27%, to raise the minimum wage and has showed his commitment in turning US economy to zero emission by 2050, jumping back to the Paris Agreement on climate change. Other proposals are related to the healthcare system, facilitating the access to it, and work on a better system for student loans, which are becoming a major headache for the US economy having reached $1.6 trillion at the beginning of 2020.
Still, the risk for markets is mainly coming from the increase in corporate taxes, affecting earning and therefore possible reinvestment in new projects, alongside dividends potentially as it is probable that the payout ratio will not change or even decrease pushing down dividends to a lower level.
Covid-19: second wave coming?
As covid-19 cases were getting lower alongside the death rate between May and June, European economies reopened. The safety was kept thanks to facial masks and social distancing, still not all businesses recovered at the same pace. Travel and leisure were affected the most, as measures weighted on restaurants, hotels and the fear of travelling led people to travel inside their own country, fostering national tourism.
Despite the measures, cases are quickly rising in terms of numbers with several countries being above their pick. Moreover, some countries are imposing some new restrictions such as the UK where a curfew at 10 pm have been imposed for bar and restaurants to avoid the virus spreading and urging people to work from home whenever they can. A strong acceleration in cases have also been recorded in Spain and France. Still, the death rate is increasing but remains low compared to the pick of the crisis in March: around 20-30 for Italy while France and the UK are around 70-80 vs 1000 a day.
Despite the viral load seems lower as of now, with autumn approaching with less favorable weather conditions, the situation may get worse. Some countries may be pushed to face the hard decision to keep the economy open or be forced to close again by the worsening of the sanitary conditions. Still, there is the need to acknowledge that the number of tests carried out today are much higher compared to the first outbreak and hence justify partly the numbers: 80k-120k in Italy vs 10k-30k in March while in France the actual number is twice as much. Both cases, although in one in a more significant way, will affect companies and economies, mainly impacting consumption.
Economy: how long to recover?
According to the OECD forecasts, the economy rebounded sharply worldwide as lockdown measures were gradually lifted. Still, the current forecasts show that the economy won’t return to pre-Covid levels until Q3-Q4 2021 in the base case. On the other side, the downside scenario expects very little growth and the upside scenario a better outlook although sensibly below November 2019 previous forecasts as in the figure below.
Moreover, according to the International Monetary Fund (IMF) projections of June, the world GDP should be at -4.9% in 2020 with a recovery of 5.4% in 2021.
It is interesting to notice that Advanced Economies should be the ones more impacted with -8% in 2020 and 4.8% in 2021 while Emerging Markets should resist better in 2020 and bounce back further in 2021.In particular to lead the declines, we can find countries impacted the most by the outbreak, such as Italy and Spain with -12.8% in 2020.
On the other side, Chinese numbers show an impressive 1% for 2020 and 8.2% for 2021 making it the best economy according to IMF forecasts. This data is even more important when related to world trade volumes showing a -11.8% decline in 2020 followed by a recovery of 8% worldwide. This could suggest a very regional if not even national consumption of goods and services, which can, in part, explain the impressive Chinese numbers, given their massive population of 1.4 billion people.
This aspect was also highlighted by companies as those were trying to reconfigure their supply chain to enhance their resilience to supply disruptions as it happened partially. This effect may affect even more exporting countries already heavily penalized and pose a threat to recovery to those.
Finally, one of the major risks highlighted by the IMF outlook is “Fundamental uncertainty around the evolution of the pandemic is a key factor shaping the economic outlook and hinders a characterization of the balance of risks. The downturn could be less severe than forecast if economic normalization proceeds faster than currently expected in areas that have reopened—for example in China, where the recovery in investment and services through May was stronger than anticipated.”
Still, with news regarding a potential vaccine, the IMF is confident that the “Development of a safe, effective vaccine would lift sentiment and could improve growth outcomes in 2021, even if vaccine production is not scaled up fast enough to deliver herd immunity by the end of 2021.”
In addition, economies have been boosted with stimulus packages, such as the United States, supportive central banks policies and buying programs; the European Union have created a massive € 750 billion Recovery fund to help EU member states affected by the Covid-19 outbreak. Despite those massive measures, the economic recovery is fragile with a gloomy outlook looking at Covid cases again on the rise.
Retail investors: broker accounts and leverage to boost volatility?
Last but not least, strictly related to markets, are the brokerage accounts. During the pandemic, those accounts opening boomed in particular, according to the FT due to gamblers not having the usual gambling opportunities, such as sports betting, among others. One element also to consider for those gamblers is that generally, on sports betting they lose everything while on markets, if things go south they can cut their losses.
Moreover, the surge comes at a crucial moment for these companies. Those have been forced into a brutal price war, as brash newcomers such as Robinhood cutting trading fees to zero.
This situation, although quite attractive, has a hidden piece: Robinhood gaining fees on PFOF “payment for order flow” received from electronic market makers for passing on customer orders. Basically, the order sent through the Robinhood app is then sent to a trading firm in a way that both those entities gain a commission from it. Although the practice is not illegal and some claim that it helps retail investors to access better prices. Still, according to the former SEC Commissioner Mary-Jo White the practice can create conflicts of interest, leading brokerages to betray their “best execution” obligations to their customers in favor of higher kickbacks. Retail investors, while working from home, started trading much more and holdings on the platform climbed spectacularly, as observable in the below figure with the pink bars.
This situation started with market lows in March and continued along the rebound. Of course, retail money on brokerage accounts is way smaller than institutional money, such as those of pensions funds, asset managers and so on.
But there is one key difference: those individuals behave as Hedge funds and always try to maximise their gains with leverage. Hence what may seem a trivial sum of money can potentially create a much bigger impact on markets. According to a Yahoo Finance survey, 43% of the responded used leverage using margin, options and a combination of both. Moreover, there has been an average of 28 million options contracts per day, up 45% from last year, according to the Options Clearing Corp.
On the same subject, some of the brokers incurred heavy losses as much as $88 million due to futures on WTI Oil. As a matter of fact, according to those reports, several customers held long positions on cash-settled WTI futures at both CME and ICE Futures Europe, the main exchanges for trading the contracts. The first ever negative settlement price meant customers incurred losses in excess of the equity in their accounts. This situation of course fosters volatility in financial markets, in particular as “If there’s more volatility people like to trade more” according to Steve Sanders, head of product development and marketing for Interactive Brokers. Hence, the volatility this time comes as usual from institutional investors volumes and news but also from retail investors, although there is no way to be sure of how much is attributable to them.
Finally, on the same note, Interactive Brokers is raising clients’ minimum margin requirements by more than a third to protect against market swings anticipated in the run-up to the US election and avoid a rerun of losses. Interactive told its clients that as volatility is expected to pick up both before and around the time of the US election, it was “appropriate to start controlling leverage in a measured fashion in advance” confuting this thesis.
Overall, volatility is expected ahead but it doesn’t mean there won’t be opportunities…
With this article, for sure we observed some risks that might be translated into volatility in financial markets, but it doesn’t present a so-called bearish outlook.
The situations presented here might not realize such as a Covid-19 second wave or can be already priced in the market with the recent decline and decline or be even be better than expected for the economic recovery. Still, it is important to acknowledge the possible risks to better understand the environment in order to position yourself accordingly to eventually profit from one of those with the right instrument and/or timing. One important element will be the beginning of the Q3 earning season that can give indications of companies’ financial health and lead to assumptions for the near term.
Do you feel bullish or bearish with the recent market downturn & rebound and upcoming earning season?
Author: Lorenzo Bracco
(From this website we refer also to the full report, which can be downloaded for free.)