Why shares will rally in a second wave

There are three potential economic outcomes from a new outbreak of virus infections, but all point to gains for the equity market. The difference will be in the composition of returns.

The threat of a COVID-19 second wave has shortened the focus for investors and they are increasingly relying on a potent mix of tea leaves – daily case numbers and political signals for a return to lockdown – to navigate the markets.But investors must not forget the powerful policy support driving markets and should be on alert for a second wave of stimulus to accompany more infections.

Highly complex and unpredictable, a second wave effect is likely to lead to one of three outcomes:

1. The virus takes hold and economic conditions deteriorate.
2. Governments alternate between opening and closing economies.
   
3. The virus is contained, driving a strong economic recovery.
   

Each of these economic outcomes support a bull market view of equities in financial year 2021 but the composition of market returns will be markedly different with each outcome.

If second wave fears materialise, central banks will continue to provide stimulus, driving technology, defensive and income stocks higher, yield curves will flatten and interest rates will decrease. Risk currencies and emerging markets will underperform.

If the coronavirus is contained, cyclical companies, particularly financials and value stocks, will rally and those inflated by easy money will fall. Interest rates and yield curves will rise and risk currencies and emerging markets will rally.

The movement of case numbers in the next few weeks, either peaking or continuing to rise, will provide an indication of the likely path. The current uncertainty, inherent in stop-start policy-making from governments, provides investment opportunities.

While much has been made of the disconnect between rising asset prices and the economic impacts of the coronavirus, the fact is that sharemarkets predict future economic conditions and not the other way round.

In only a few weeks after the March economic downturn, big central banks had increased the size of their balance sheets ranging from 7 per cent to 16 per cent of gross domestic product to bolster financial markets. Governments have injected about $US11 trillion ($15.6 trillion) fiscal support into the global economy to replace lost income.

Accommodative

As economic conditions improve, the impetus for easy policy will diminish. However, we believe authorities will remain highly accommodative for some time and favourable policy settings will continue in the first half of financial year 2021 regardless of the outcome of the current second wave uncertainty.

Australia also stands to benefit from the strength of China, its largest trading partner. Reporting a 3.2 per cent increase in gross domestic product growth amid a global recession, the Chinese government’s ability to contain the virus, stimulate economic demand and inflate asset prices, is second to none.

Already we have seen an increase in demand from China for iron ore, sending the commodity’s price to 12-month highs and driving share price rallies in BHP Group, Rio Tinto and Fortescue Metals Group.

In addition, Australia’s “safe haven” status from coronavirus in contrast to many advanced economies, such as the US, Europe and the UK, will encourage Chinese investment in property, education, tourism and commodities.

Buoyed by an economic recovery on one hand, or further stimulus on the other, the picture for equities appears positive in financial year 2021. However, investors will need to remain nimble and position according to the progression of the coronavirus.

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