Although risk assets have rebounded rapidly alongside an abundance of liquidity and a resumption in activity post lockdown, there is a growing fault line between reality and market pricing. The scars of the global pandemic that leave realities of persistently high unemployment with permanent job losses mounting, prolonged social distancing measures and other restrictions impinging business margins, and resounding uncertainties that weigh on business and consumer confidence are yet to be felt. Governments and central banks have stepped in quickly in response to the global pandemic, with liquidity taps turned in full force to cushion the impact the sudden economic stop. This liquidity has papered over the cracks for now, but the new “liquid insolvent” business model will eventually wear thin as these actions buy time, not solvency and fundamentals eventually trump liquidity. This alongside the growing COVID-19 case count globally, with many countries still battling the virus into Q3, the lifting of restrictions is pausing and high frequency data shows consumers are becoming more cautious with confidence, mobility, footfall, and restaurant bookings dropping off. Beyond the initial bounce back following a period of pent up demand, it seems the recovery is now plateauing and caution remains which means the speed of the initial bounce back will not be maintained. The resurgence of the virus within Australia where community transmission has taken off in Victoria has seen Melbourne once more in lockdown and we will soon find if the contact testing and tracing strategy has worked in NSW with cases beginning to creep higher. With consumers becoming more cautious, the marginal propensity to spend declines thus weighing on both the speed and shape of the nascent recovery. Covid-19 may have started as a health crisis, but it quickly morphed into an economic and social one. However, the problem with the root cause of this crisis being a global pandemic, there remains a huge amount of uncertainty as no one, not even the epidemiologists can tell us definitively how this plays out, and some experts are on record saying it could be 2 years before a vaccine can be successfully implemented.
So far, the concerns above have mattered little with respect to price action and risk assets have managed to shrug off the prospect of a stalling economic recovery in favour of a broad based melt up with global equities rebounding close to 40% since March lows. The underlying support from central banks, who incipient bubble or not, have pledged to continue to do whatever is necessary in order to detach asset prices from fundamentals puts a floor under risk assets for now, but does not prevent corrective moves. Investors who have for years been conditioned by the central bank put to buy dips have set aside the economic realities in favour of momentum and speculative stimulus driven markets. However, given current extended positioning and sentiment, there is plenty of opportunity for more two-way price action.
With this dynamic in the play, the dissonance between market pricing and reality grows, leading to bumps along the road. This fault line will become more visible as a failure to flatten the first wave of the virus prevents activity from normalising in 2H. For both businesses and consumers, the uncertainty is pervasive. Investors have been looking through the earnings hit, to the recovery, but the realities of a plateauing recovery and failure to return to pre-crisis levels of output that sees businesses operating revenues and cash flows squeezed for a prolonged period will eventually catch up.
With risk assets oscillating between the prospect of continued government and central bank support matched with a stalling global recovery, price action could remain range bound with volatility elevated for some time. When we look at volatility, the VIX remains elevated, currently at 32 and well above the 22 level, which is generally considered the long-term equilibrium in the term structure. With respect to this signal, it is fair to say volatility has failed to settle back within a lower range and has not given investors the signal that the “bear market” is over, in many ways this is not a “normal” bull market and confirms the speculative flavour of the current environment. Perhaps unsurprising when the only real bull market is in intervention.