Markets are just beginning to get used to the new normalcy

As challenging as things may seem right now, investors with patience and a long-term view will benefit from the eventual revival of economic activity and asset prices. The problem is that the process is likely to come after a series of false reports.

Preliminary signs of peaking the coronavirus epidemic in Europe and approaching it in New York are encouraging. According to optimists, this means that the worst is behind us and that is why markets have bottomed out. Others are waiting for the final vaccine before they get so optimistic.

The glimpses of medical relief, coupled with the overwhelming support of central banks, create an environment where the hardest-hit sectors can enjoy some relaxation, or what is called a bear market uplift. At the same time, some investors are selectively buying assets that have been unfairly affected by the indiscriminate sale that dominated much of March. The result is a rebound of about 20% of the S&P 500 index over several weeks, prompting Citi stock strategists to find that short-term market returns are better than the 12-month average return.

The relief is visible in other key asset classes, including copper and oil, as well as in other economically sensitive sectors, such as shares in the transport sector.

Another important barometer is high yield bonds. As seen in early 2009 and late 2002, the positive development of these securities was an important sign that the next business cycle had begun. But this message came only after experiencing a lot of financial pain.

One of the hallmarks of the market turmoil this year was the rate of decline. But some suspect that the rebound may also be sharp. The magnitude of monetary and fiscal firepower was enormous and rapidly deployed. This means that, although there will be a mass of business failures, a large-scale bankruptcy crisis has been avoided in leading economies. This may mean that a brief and brutal recession will yield a stable recovery.

For Wall Street, this means that the long-term profitability of companies in the S&P 500 will withstand significant damage from the current economic downturn. At about 2,500 points, the index is now trading at 21 times the average profit over the past 10 years, which amounts to 122 USD per share. In 2009, the S&P 500 hit bottom 10 times that profit, with Wall Street’s current sustainability suggesting that the market is confident that structural corporate profits remain stable.

There is also reason to doubt this optimism.

Returning to daily routine and economic activity will take time – a prospect reinforced by secondary waves of contagion that has swept some parts of Asia. The renewal of the blockades will only add to the financial strain for businesses and households.

Belief in incentives can be said to encourage buyers of global equities and high-yield bonds after a sharp fall in prices in March. This is somewhat of a logical answer. However, it is not sustainable in that the stimulus is just mitigation. It is only designed to prevent a deeper shock.

In addition, the sharp rise in stocks and bonds in recent weeks has made them look vulnerable in the lengthy recovery process. Their estimates now downplay the imminent threat of large corporate earnings downturns, while underestimating the long-term effects of the worst pandemic in a century.

Another concern stems from debt. The Institute of International Finance estimates that sovereign debt has risen to a record high of over 2.1 trillion USD in March, which is more than double the 2017-2019 average of 900 billion USD. This will weigh on future economic activity and corporate revenue.

Companies are also facing greater costs associated with disrupting global supply chains after the pandemic is gone.

So any market recovery is likely to be uneven. Assets are divided into those that are actively supported by central bank purchases – and others. This means that stocks, while certainly backed by low yields on government bonds, could easily reach new bottoms before the worst of the earnings revisions. High-yield bonds, too.