by David Ruff
CFA, Global Portfolio Manager
With COVID-19, ongoing trade issues, and now riots, many equity investors are asking if equities worldwide have disconnected from reality. The U.S. and Europe, hardest hit by the pandemic, are still dealing with ongoing economic challenges. Investors also worry as tensions between the U.S. and China, the world’s two largest economies, have flared again, and riots trouble both countries. Yet, meanwhile, almost incomprehensibly, equities continue to march higher. Some characterize the climb as ethereal, calling it a Teflon market where bad news doesn’t stick. We believe, however, there are fundamental forces driving the equity market’s advance as well as its ultimate sustainability.
The impact of the riots on sentiment and investment can have significant economic repercussions, but these are likely to be outweighed by even larger changes already underway. True, business owners will not rebuild where they don’t feel safe. Companies may defer capital spending projects. Moreover, it may take years for the hardest hit areas to return to pre-riot levels of economic activity. What we expect, however, is not a permanent step down in general economic performance, but an acceleration of trends already set in place by the pandemic. As my colleague Randall Coleman wrote recently, trends toward homeworkers and home sanctuary thinking will accelerate. The importance of densely populated central business district downtowns will diminish. Renewed suburbanization in the U.S. will replace urbanization. But businesses will adjust and relocate to serve their customers, so economic activity will recover.
Regarding the pandemic, yes, it is still with us. Deaths continue, and we don’t yet have a vaccine. However, my colleague David Lieberman offers valuable insight. David has tracked, monitored, and sagely projected the spread of the disease on a worldwide basis since its inception. David observes that although case counts have risen recently in the two worst performing states – California and Virginia – they, along with most states, have experienced flat to declining numbers in deaths and hospitalizations. He suggests true case counts continue to head lower in most states even as the officially reported cases rise due to increased testing.
This is also true in Europe, where reopening is broadly happening. Sweden is an interesting case, because it did not lockdown. Businesses remained open, although social distancing was largely practiced. The disease numbers in terms of deaths per million are higher than the European average, but lower than the U.K., Spain, and Belgium, countries that locked down. Sweden’s domestic economy also held up much better. April retail sales slid 1.3% year over year, much better than hard stop shutdown countries like the U.K. (-22.6%), Italy (-26.3%), and France (-31.1%). The Swedish experience suggests the disease can be managed without bringing economies to a hard stop, which is critical insight as the U.S. moves towards a broader reopening on the economy.
Finally, market naysayers point to the U.S. potentially removing Hong Kong’s special trade status with the U.S. They argue this will hurt Hong Kong and China equities because risk premiums will increase. True, the action jeopardizes the Island’s reputation as a place of stability, and clearly, this SAR (Special Administrative Region) of China is losing its U.K.-based political and judicial system, and disturbingly, individual freedoms. However, more importantly from an economic perspective, its sea gate function to China and the rest of Asia ensures Hong Kong will retain its economic vibrancy for some time to come.
Currently, Hong Kong is relatively immune to the trade war, since it is treated as a separate customs territory. It serves as an essential entrepot trade port between mainland China, the U.S. and other countries. The Island has attracted tens of billions in investment from the U.S., the U.K., and others. For example, 278 U.S. companies have headquarters and branches in Hong Kong, including nearly every major financial firm. Paradoxically, Hong Kong is one of the rare U.S. trade partners where the U.S. has a goods trade surplus and Hong Kong applies a zero tariff on U.S. imports. Revoking its special status may send a message to China, but the action hurts U.S. economic interests more, mainland China and Hong Kong less. Over 57% of Hong Kong exports flow to China with another 20% destined for other parts of Asia. Europe accounts for 11%. The U.S. amounts to only 7.5%. Most exports in Hong Kong are entrepot trade. That is, not Hong Kong origin exports. Top Hong Kong exports to China are advanced goods, including electromechanical products, specialized metals, medical equipment, and optics. If U.S. firms move out, others will move in, especially European, Japanese, and new economy Chinese firms looking for opportunities to station in Hong Kong’s premier business districts.
After an initial selloff from Secretary Pompeo’s announcement, Hong Kong equities quickly recovered, moving past pre-announcement levels, even though the threat remains. China has passed the worst of the epidemic and is well into recovery, and Chinese company earnings estimates have moved higher, especially over the last four weeks. With approximately two-thirds of Hong Kong Exchange listings being mainland China-based companies, it’s easy to understand the rally. Trade friction will continue and we’ll probably see new announcements like last week’s flight ban of Chinese airlines into the U.S., but the U.S. revocation of Hong Kong’s special trade status, even if fully executed, will not have the desired political impact. U.S. policy makers may have come to this conclusion and equity markets have correctly discerned this. Certainly, trade conflicts between the U.S. and China will continue. We look for the world to trend away from dependency on trade between these two powers. Increasingly, there will more regionalization with three trade blocks — the Americas (anchored by the U.S.), Europe (driven by Germany), and Asia (dominated by China). U.S. and China trade may be stymied, but this will be replaced by increased trade between Europe and Asia, as well as more regional trade.
Finally, the G20 governments and central banks have used an extensive set of tools to restart economies stifled by the virus. This stimulus will lift economic performance and earnings as the world learns to cope with COVID-19. The riots will not stall the recovery in the U.S. and Europe. Asia, propelled by China, will continue to lead the world in economic performance.
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