Will the second wave of Covid-19 end the current rally?

It has been one hundred days since the WHO declared the coronavirus outbreak a pandemic. During this time, we experienced the worst sell-off and fastest recovery in stock market history. But the biggest lesson learnt over this period was that old rules no longer apply and many assets became detached from the traditional forces that drive them.

After a violent sell-off in March, governments and central banks came to the rescue led by the US Federal Reserve. Many economies will see their GDP’s shrink by the fastest rate on record in the second quarter, but valuations are near historic highs, particularly in the US. That is simply because market participants believe monetary and fiscal policies are solid enough to fill the gap for growth that has been lost.

The new story making headlines today is fear of a second wave in the coronavirus. Several US states have reported a surge in infection cases with California and Texas hitting a new record.  Meanwhile, millions of people in Beijing are now under lockdown restrictions again after more than 100 cases were reported, which are linked to a wholesale food market.

The belief that the global economy will swiftly recover during the third quarter is now uncertain. The faster economies reopen, the more likely we will see a second wave of infections translate into new lockdowns. Hence the path over the coming months will be murky.

Equity markets began to reflect this risk last week when the S&P 500 plunged 4.8%, but it quickly recovered some of these losses after the Fed announced it would start individual corporate bond purchases in secondary markets, as opposed to buying corporate-credit ETF’s.

Covid-19 and the Fed’s actions are influencing a herd mentality to financial markets where rational risk and reward calculations are no longer in place –  the first sign of trouble sees investors flee to safe havens, and when the Fed plays the put, they take the opposite side of the trade. This kind of environment will keep volatility heightened in the near-term.

In my opinion, the problem that the Fed and other central banks have caused over the past couple of months is that retail investors are bidding up some of the worst performing companies just because they believe the current policies will keep them afloat; the classic example being the car rental group Hertz in the US which declared bankruptcy last month. This is leading to the creation of a big bubble in asset prices and the further it grows, the more damage it will make when it bursts.

No one knows how all this will play out eventually, but we must understand from previous experiences that bubbles tend to grow much bigger before they burst, and there could be a lot of money to be made if the timing of your exit is right. Currently, the two forces in play are a second wave of Covid-19 cases and policy actions. The one which proves to have the stronger influence will lead the next move in markets, but you need a lot of courage to play this game.