Buoyant asset prices highlight a stark divide between current market sentiment and the economic winter engulfing companies and locked-down households.
Leading the way has been large-cap US equities, with the S&P 500 index having now retraced half its decline from its February peak. This marks a striking divergence not just with Main Street (where a stunning 16.8m jobs have been lost inside three weeks), but with US equity benchmarks for smaller companies and global share markets.
It’s difficult at times to make sense of market sentiment downplaying the worst health crisis in a century while that same crisis slams the brakes on economic activity. But, beyond signs of a flattening Covid-19 curve, the truth is pretty simple: waves of money are gushing into the financial system, with more to come, spurring demand for risk assets.
Bullish momentum rests on a view that central banks and fiscal measures will bridge the gap between an economic winter and the eventual arrival of spring for companies and households.
In that vein, the Federal Reserve on Friday announced further stimulus to the tune of $2.3tn, extending support to companies with speculative-grade ratings via exchange traded funds. So the financial system bailout now extends to highly indebted companies, including many that have been overly leveraged via private equity owners.
Jay Powell stressed the role of the central bank contribution in “providing a measure of relief and stability during this period of constrained economic activity”, adding that the “emergency tools” would be retired once a recovery was established and private markets were repaired. Or as the Fed chairman said:
“These are lending powers, not spending powers.”
But, as seen in the wake of the financial crisis, the deeper the Fed enters markets, the harder the exit trade. Remember US quantitative easing in late-2008 was billed as a temporary measure.
From the perspective of the S&P 500, the Fed’s buying of corporate bonds (or QE on steroids) has certainly emboldened risk appetite for the index. And, as the FT’s Richard Henderson highlights, insider buying from chief executives and others at big US public companies hit $1.1bn in March, the biggest total since October 2013, according to data provider Smart Insider.
The speedy stimulus from the Fed and Congress stands in contrast with the response from European finance ministers who are still discussing a comprehensive package to combat coronavirus. Meanwhile, the oil price war has only ramped up the pain for many areas of emerging markets.
While US lawmakers are preparing another round of measures, there is at least progress on European fiscal support. There were also signs of an agreement by the Opec countries and Russia on a sweeping oil production cut, as long as G20 countries agree to reduce their output too, ahead of the long weekend.
Clearly at some stage all the money piling up into the financial system will end up finding a home beyond cash. But buying equities today looks rather brave, given the as-yet-to-be determined hit coming for the economy and profits. As John Normand at JPMorgan notes:
“The general concern is that markets rarely make definitive lows so early in a recession, because a multi-month or multi-quarter period of contracting growth and earnings both exacerbates known stress points and creates new ones, which in turn can drive further investor deleveraging and lower valuations.”
A clear example of this occurred in late-2008 when the S&P 500 rallied 25 per cent after the US Congress passed the troubled asset relief programme, or Tarp. US equities then set new lows in early 2009, before the recovery finally began. The lagging performance of small and medium-sized US companies versus the large-caps of the S&P 500 during this rebound also shows where the real pain looms for Wall Street.
As for the economy, Lena Komileva at G+ Economics argues:
“The best-case scenario is that the global recession of Q2 will give way to a slower pace of contraction on 2019 levels in H2. But growth levels will not return to pre-crisis levels for several years to come. And the key ingredient to a future recovery — an extraordinary process of real economy balance sheet repair, across every sector, industry and economy, has yet to begin.”
“For a global economy that is likely to contract by 2 per cent this year — 6 per cent in US GDP and 10 per cent in Europe — and for company cash flows that are set to see 30-50 per cent declines, it is extraordinary to expect that equity markets will trough at 2016-17 levels.”
Eventually, equities should rally substantially on the back of significant stimulus and evidence of a sustained recovery for the economy. But the current equity market rally just looks well ahead of such an outcome.
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Quick Hits — What’s on the markets radar?
The performance of credit is certainly important, and at some point renewed strains in high-yield corporate debt will wash over equity sentiment. That explains the Fed’s shift on Friday towards buying high-yield ETFs. It’s a sign the central bank is very worried about the financial stress to come.
“Roughly $215bn of US debt and €100bn of European debt is expected to be downgraded to high yield this year.”
In this chart, the group highlights the potential for fallen angels in the US high-yield market:
Martin Dropkin at Fidelity notes how its analysis “reveals that only around 5 per cent of the US investment-grade index is currently trading at spreads equal to or wider than comparable double B-rated bonds”.
When you consider that companies most at risk of a downgrade constitute around 27 per cent of the index (rated as triple B-2 or triple B-3), Martin says investors may be “a little complacent considering the near-instantaneous stop to economic activity in some sectors”.
Tapping an overdraft is very useful when times are tough. The latest announcement from the Bank of England means the UK government has short-term cash to help with its spending though the central bank’s “Ways and Means” facility rather than sell more gilts.
John Wraith at UBS notes:
“The drawings of the W&M facility in April 2020 stood at £0.4bn. During the financial crisis, it peaked at £19.9bn. Any drawings of the facility will need to be repaid by the end of the year.”
Another case of recent buoyancy has typified oil prices, with the market hopeful for a grand bargain over production cuts (seen as a cut of 10m barrels a day, or roughly 10 per cent of pre-crisis demand). Stabilising oil prices matters for many emerging markets and asset classes, notably high-yield debt.
Establishing a floor in the price of oil is important, but the return of demand that uses up excess supplies depends on economic activity resuming soon. It’s not clear that is going to happen swiftly, particularly for trade and the transport sector.
The debate over funding Europe’s response to the pandemic has seen Germany and the Netherlands push back against coronabonds or some form of mutualised debt.
Too late, argues Dhaval Joshi at BCA Research, who notes the process has occurred in stealth form when looking at this measure of eurozone accounting, the Target2 banking imbalance, as shown here:
This shows how Italy has shifted a large amount of bank deposits into German banks, while “Germany is symmetrically owed ‘Italian euros’ via its large effective holding of Italian government bonds”, says Dhaval. It means that in the event of Italy defaulting on it debt, Germany is left picking up the bill.
That doesn’t get much play as policy officials are probably very conscious of not spelling this out to German taxpayers or bringing to light that years of QE by the European Central Bank has created this situation.
It also suggests the euro is here to stay given the chaos any break-up would entail for the region. Or as Dhaval says:
“Because euro area debt is now mutualised, the euro has become irreversible.”
The financial market implication in his view is one of buying Italian bonds versus German Bunds and also favouring the euro currency on a long-term basis, meaning beyond the next two years.