CROFT FINANCIAL COMMENTARY – Delta Woes
Conventional wisdom tells us that healthy bull markets climb a wall of worry. Ascending to new heights by scaling an abundance of negative factors that are seen as temporary stumbling blocks rather than permanent impediments.
In the current environment, there are plenty of “temporary” stumbling blocks for the bull to scale; the taper timeline, direction of interest rates, elevated valuations, irrational exuberance in sectors (meme stocks), Covid trends, vaccine uptake, inflation, supply chain disruptions, labor shortages, government debt… and the list goes on.
Viewed as a package, the list is problematic. But dig deeper and the one risk that could galvanize bears is the Delta variant. The Delta Variant is the great unknown and has become the scourge of the unvaccinated.
According to the US Center for Disease Control and Prevention (CDC), 99% of Covid related hospitalizations and deaths occurred among the unvaccinated. As of August 30th, over 1.6 million Americans had been hospitalized with COVID-19, only 0.65% of that total, or 10,471 patients, were fully vaccinated.
It is the perfect storm for the highly contagious Delta Variant. The daily case count ebbs and flows, with unexplained spikes and sharp pullbacks. Daily confirmed cases in the US recently topped 300,000 in August. The current seven-day average is just under 100,000. In total, more than 41.5 million Americans have been infected by Covid with 670,644 deaths (as of September 12th, 2021).
Already, we have seen eight Covid variants since September 2020. Delta has emerged as the most virulent strain, but as with any virus, further mutations could challenge its position.
What makes Delta different is that is highly transmissible. In effect, a person infected with Delta can spread to a greater number of people than previous strains. This is why Delta is now globally the predominant strain.
People can also be infected within a shorter period of exposure, which leads to a bigger viral load among infected individuals. Particularly among the unvaccinated.
The other concern specific to Delta is that vaccinated individuals can spread the virus. This is slightly different from what we have seen from previous strains, where it was less likely an asymptomatic vaccinated person had enough of a viral load that could be spread to another person. That is a key reason why Delta has spread so quickly even within countries with high vaccination rates.
Delta is by far the single greatest threat that could derail a return to normal, which we need to remove friction along major supply chains and quell labor shortages. The questions are how bad will Delta’s impact be and is there a risk that other more virulent strains emerge?
Looking at the global implications within developed and emerging markets we get mixed messages, especially in Europe and the United Kingdom (UK), where the news is mostly positive.
The UK is particularly noteworthy as cases and hospital admissions are down sharply despite a full re-opening. As a result, the latest PMI (Purchasing Managers Index) data indicates a reacceleration following the peaking of cases and full reopening.
Economists believe Europe will lag but, in time, will follow the UK trajectory. Throughout most of Europe, we are seeing COVID cases peak. Cases are still rising in France, Italy, and Germany (although from a smaller base) but in some regions exposed to the early onset of Delta (notably Spain and Portugal), we are seeing cases contract. Overall, the news is generally positive.
As for the US, not so much! While at a national level the numbers are manageable (current estimates are 55,000 people in hospitals), there is a significant disparity among individual States. For example, in Florida one individual out of 2,000 is now hospitalized with COVID. That is a staggering statistic when you consider that Vermont’s hospitalization rate is one in 100,000.
More importantly, the negative correlation between vaccination rates and hospitalizations is, as one might expect, significant. For example, the vaccination rate in Alabama is around 43% well below the 90% rate in states like Vermont and Massachusetts. These large discrepancies correlate incredibly well with hospitalization rates.
Aside from the Florida stats, we anticipate that Delta will weigh on economic output throughout the US. Our main concern is “consumer risk aversion” among vaccinated individuals. According to a recent Gallup poll, the share of Americans who feel protected has dropped from 50% to 38%. Interestingly, those who are most fearful are fully vaccinated. Respondents who feel the safest have no plans to get vaccinated.
The Gallup poll is indicative of some interesting dynamics. High virus transmission in Florida or Alabama indirectly weighs on the recovery in high vaccination states because people respond to the national news cycle. What the statistics tell us is that consumer behavior is impacted more by the national virus numbers than the more relevant local data, which is consistent with the downward national GDP revisions we are seeing.
In short, there is a behavioral connection in which bad news out of Florida may affect someone in Vermont, who in turn might be more hesitant to go to a restaurant despite being fully vaccinated in a region where the virus is being contained.
For those reasons, economists have tempered US growth forecasts by one to three percentage points for the second half of 2021. The greatest revisions are in consumer services such as leisure, entertainment, travel, and restaurants.
Globally, there will be wide dispersions across continents, beginning with somewhat positive news in most of Latin America where, aside from Mexico, cases are in decline. Vaccination rates across Latin America are rising, and what is most interesting is that much of the region seems to be closing in on herd immunity resulting from previously high case counts.
That is in sharp contrast to the Asia Pacific basin, where draconian restrictions implemented in 2020 shut down the virus. Unfortunately, because natural immunity rates are lower and vaccination uptake has been sluggish, the virus situation is deteriorating. Accordingly, growth forecasts for India, Asia, Japan, and Australia have been cut drastically.
The main concern is China where, despite low case counts, the more transmissible strain is beginning to surge. Unfortunately, China’s zero Covid policy while admirable, is likely not achievable. The risk is that shutting down operations to thwart outbreaks will have serious and unpredictable repercussions on global supply chains.
Across the board we are witnessing a sharp reversal in global growth forecasts since the emergence of the Delta variant in April. The largest downgrades have been across the Asia Pacific Basin particularly in the Philippines and Thailand, two countries not only suffering from high virus transmissions and restrictions but also from a slower than expected rebound in tourism.
We have also seen significant downward revisions for US growth related to consumer risk aversion as well as bottlenecks in housing, labor markets, and the goods sector.
That said, we are seeing green shoots from regions – notably Europe and the UK – where early exposure to the Delta strain and declining case counts might be a harbinger of good things to come.
As Covid cases begin to roll over, we anticipate upward revisions especially in geographic regions where there is significant room for vaccine-driven reopening. Think in terms of Spain, Southern Europe and perhaps India.
The biggest risk is the emergence of a new more transmissible strain that might penetrate the vaccine firewall. The other risk, indirectly related to the pandemic, is a slower recovery for supply chains and specific to the US, the ability to attract labor.
On the supply chain question, economists believe that inventories will be rebuilt in the coming months. That would be a net positive effect because, earlier this year, inventory drawdowns weighed on growth in the US, Germany, and France. Unfortunately, that effect could take longer than expected as Asia Pacific economies struggle with lower vaccination rates and zero Covid policies.
As for the US labor market, economists are more bullish. Most expect the US unemployment rate to fall from 5.9% to the low 4% this year as generous federal unemployment benefit top-ups expire, and vaccination rates rise.
The challenge is that labor market participation is a complex issue. Covid has resulted in a rethinking of priorities between work, leisure, money, family, and health. It may be a slower recovery than first envisioned and something we will monitor closely over the coming months.
THE RISK OF A CHINA SLOWDOWN
The Chinese economy, once the post-pandemic success story, has been experiencing a bumpy ride of late amid a rash of Covid outbreaks. Economists worried about the contagion effect, wherein slowing growth in China becomes a serious issue for smaller emerging markets.
Most economists expect China’s slowdown to gather speed. Under China’s “zero-Covid” policy, periodic outbreaks are met with draconian shutdowns that hamper supply chains and stunt growth.
Hard to imagine that a year ago China was leading the post-pandemic recovery. Case counts were abating and business was booming. Today is very different – recent PMI surveys are indicating a slowdown in the second half and the country’s biggest property developer, Evergrande, is staring down a potential default that could cost banks and investors billions.
Adding fuel to the crisis fire, the Chinese Communist Party (CCP) has called up a frequently used political blueprint for launching influential legislation during a crisis. This latest avalanche of regulations is intent on limiting the growth and influence of some of its largest tech companies.
Longer term, the CCP strategy is to transition the economy into one that relies more on domestic growth than external trade. That means introducing strategies to curb excess debt and financial imbalances.
Building walls will diminish China’s role in driving the world’s economy, which means that US stimulus programs will have to fill the gap. That is risky as it could lead to higher global interest rates, a stronger US dollar, and lower commodity prices, which is not a good mix for emerging markets.
Certainly, the Chinese economy can weather the storm, but given the country’s outsized 30%+ weight in the MSCI Emerging Market Index (symbol EEM), these domestic challenges could lead to further weakness across emerging markets which are already down 10% year to date (see chart next page).
Despite these rumblings, bulls don’t need to look far for encouragement. According to Bloomberg, stock valuations are near a 20-year low and the hawkish turn by many emerging-market central banks has boosted carry-trade returns. Note in the far right of the chart, MSCI’s stock benchmark has jumped about 7% in three weeks.
FAANG STOCKS DEFY GRAVITY
One of the biggest challenges facing analysts is finding ways to explain current market valuations, which have eclipsed all previous metrics aside from the 1990s dot.com bubble. Is it the rise of passive investment strategies, corporate buybacks or something that is rarely cited: namely, the market’s ability to accurately predict earnings among America’s growth stocks?
Nowhere is this view more prominent than among the FAANG (Facebook, Amazon, Apple, Netflix, and Google) stocks where a buy and hold strategy is being rewarded more than at any other time. Steady profit margins climbing a steep trajectory of revenues has resulted in valuations that were once in nose-bleed territory, but now seem reasonable and justified. Especially when one views outcomes through the lens of multiple years.
FAANG stocks are the poster child as their earnings flight path continues to outstrip their valuation metrics, defying cries from value investors that buying stocks at 30 times earnings is a recipe for disaster. The result is a surge in valuations that, while not at the levels of 1990s hysteria, has matched the dot.com boom in terms of duration. The more bears talk about a major sell-off, the more markets climb to new highs.
In the end, fundamentals matter. FAANG stocks command higher multiples because they are disruptors. They have changed the way people shop, interact socially, transact business and work.
Facebook Inc. is a classic case study. In 2013, a year after the company went public, the shares were trading at 62 times the previous year’s earnings. Expensive by any measure! However, when viewed in the context of earnings over the next twelve months, the stock price looked downright cheap. Same with Amazon.com Inc., which traded at roughly 183 times reported earnings in 2013. When judged by earnings that materialized five years out, it had grown into a multiple of 14.
Bloomberg notes that: “Bubble warnings were again heard when the broader market began to rally off the 2020 pandemic lows. Yet corporate profits have roared higher in such a spectacular fashion that those valuations, when analyzed against the actual earnings reported a year later, were almost 20% cheaper than analysts thought.”
Valuations, while not great market timing tools, still matter. If markets are over-valued – a term that is, at best, subjective – it does play a role in results five years out. According to a study by Deutsche Bank AG, when equity markets had valuations in line with current metrics, on average they produced slightly negative returns over the ensuing five years.
Notes Binky Chadha, Deutsche Bank’s chief strategist: “Current stretched multiples reflect confusion over exactly where the market is in the earnings cycle. With S&P 500 firms exceeding analyst estimates by more than 15% for five quarters in a row, stocks are priced for a prolonged recovery and for large beats to continue. Yet earnings are already 10% above the trend seen in past decades.” It will be difficult for markets to sustain that momentum.
As long-term investors, we are constantly searching for changes in market sentiment. We recognize that FAANG stocks have outperformed post-pandemic, but mostly because they rode a wave of consumer spending through alternative channels. Which is to say, the easy money has been made. The challenge now is to produce a forecast with limited guidance. In recent analyst calls Apple warned about a slowing sales cycle and supply chain challenges, while Alphabet (Google’s parent company) said it was too early to forecast longer-term trends due to uncertainty over the pandemic.
There is also concern about pending regulatory blowback. Apple shares fell 3% on September 10th, after a court order required the company to allow developers to steer consumers to outside payment methods for mobile apps.
On the bullish side, investors have gravitated to FAANG stocks as a defensive strategy citing their earnings stability amid heightened pandemic uncertainty. This is similar in many ways to how investors traditionally rotated into the safety of utilities.
Investors who were undeterred by historical valuation metrics have been rewarded as FAANG stocks have added US $8 trillion in share values since 2013. All on the back of an uninterrupted earnings expansion that endured the 2014-2015 oil shock and last year’s pandemic recession.
What little forward guidance exists appears to support a continuation of that trend. Analysts estimate that FAANG stocks will grow earnings at an 23% annually over the next three to five years. Well above the S&P 500’s expected growth rate. To maintain FAANG positions comes down to a simple mantra: you must be willing to pay above market multiples for disruptors with bulletproof business models.
 The CDC defines fully vaccinated as two weeks after the second dose of a Pfizer or Moderna vaccine or two weeks after Johnson & Johnson’s single-dose jab.
 Data as of September 12, 2021, from John Hopkins University.
 The PMI is based on five major survey areas: new orders, inventory levels, production, supplier deliveries, and employment. The Institute of Supply Management (ISM) weighs each of these survey areas equally. The surveys include questions about business conditions and any changes, whether it be improving, no changes, or deteriorating. The headline PMI is a number from 0 to 100. A PMI above 50 represents an expansion when compared with the previous month. A PMI reading under 50 represents a contraction, and a reading at 50 indicates no change.