US economy

Seeking a glimmer of light 

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Brace for the worst outcome but hope for some better news, has defined equity market sentiment since late March. A sense of guarded optimism helped stocks on Monday, buoyed by nascent signs that the pandemic was steadying in some countries.

At the margins, risk sentiment was also helped by expectations that the meeting of European leaders on Tuesday would outline support for the region’s hardest hit member’s (Italy and Spain), while hope of an oil production deal later this week flickered in the background.

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Any developments that suggest a light beckons at the end of the tunnel is welcomed by investors.

Capital Economics argue a lasting rebound in global equities requires signs of the virus “being contained in much of the world” and, on that score, “the latest data have only been moving in the right direction for a few days”.

A lengthy journey still remains before the pandemic and its economic constraints finally abate. A hard stop in economic activity from lockdowns entails a lengthy process of restoration, with the ever-present risk of secondary waves (as seen in Japan and China at the moment). Changes in social behaviour will probably remain in place for some time, limiting the ability of a broad recovery in service sector activity. 

That will not, however, prevent financial markets from rallying sharply (with the S&P closing up 7 per cent), as seen on Monday, neither does it rule out a potential test of recent lows in prices for equities and credit. Playing an important role at the moment is the sharp decline of interest-rate volatility. This is what central banks want to see after their massive efforts. The idea is that other volatility markets will now follow the path set by interest rates from here. 

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Mandy Xu at Credit Suisse notes that: 

“Interest-rate volatility is the first to completely retrace its March jump, now back to near one-year average levels after unprecedented Federal Reserve liquidity.”

Asset class implied volumes (one-year percentile)

Markets will, of course, remain volatile and sensitive to medical and economic developments. S&P 500 implied volatility is extending its decline below a reading of 50, but the Vix still remains well above its average or red line at 20. 

Longer term, the direction of equity and credit markets comes down to the scale of the hit looming for earnings over the coming quarters. Now it goes without saying that assessing the current damage to the corporate bottom line belongs in the realm of art rather than science.

Marija Veitmane at State Street Global Markets notes:

“The dispersion of analysts’ forecasts is just shy of an all-time high that was reached at the peak of the 2008 global financial crisis. Optimism on the direction of equity markets will be difficult to maintain until we see more clarity on the corporate earnings outlook and until the dispersion of analysts’ forecasts subsides.”

The longer this plays out, so the risk of solvency issues intensifies for companies and sectors. 

The Institute of International Finance notes how there has been a divergence in downward earnings revisions across mature markets in terms of corporate earnings estimates, “sharper in Canada (13 per cent) and the euro area (12 per cent) than in the US (8 per cent) and Japan (7 per cent)”. The IIF argues “cyclically adjusted price-to-earnings (Cape — chart 1) may be a better reflection of long-term valuation trends”, as shown below:

Among the observations from these Cape measures is that US equities are below their 2005-19 average, but hold well above their nadir seen during the financial crisis.

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The IIF adds: 

“European stocks at a 40 per cent discount to US peers, with multiples for many euro area firms now at or near the lows of the 2008-09 global crisis and the 2011-12 euro area debt crisis.”

As for emerging markets, their fortunes are more gloomy, reflecting the sharp rise in dollar-denominated debt over the past decade across the region and the recent hammering of commodity prices. The IIF observes:

“Emerging market stocks on average currently trade far below historical averages and at the biggest discount ever compared to US stocks (some 65 per cent).”

US equities have led the rest of the world by a fair margin over the past decade and such leadership continues. Over the past 12 months and well before the current pandemic, a number of investors advocated selling US stock and switching into cheaper areas of global equities. The upshot to date is that cheap can get cheaper while quality in the S&P 500, led by the tech titans, remains prized.

This resilience of Wall Street depends on whether its long-term earnings prowess is not significantly damaged by the current health crisis, or that economic pain today does not trigger a financial crunch tomorrow. On that score, Jamie Dimon at JPMorgan Chase warned in his annual letter to shareholders that a dividend cut was not out of the question:

“We don’t know exactly what the future will hold — but at a minimum, we assume that it will include a bad recession combined with some kind of financial stress similar to the global financial crisis of 2008.”

The largest US bank is also exposing itself to “billions of dollars of additional credit losses” as it lends to businesses and individuals in need, added Mr Dimon. 

Such a warning from Mr Dimon helps explain why investors have hammered US financials this year (as has the steep drop in Treasury bond yields) and it also chips away at the idea that Wall Street has seen the worst of the selling pressure in 2020. Financials are an important barometer for the economy and the broader equity market. The mood music is not comforting in this regard.

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There is little room for error with the S&P 500 around 2,500 points, or 21 times the benchmark’s trailing 10-year average of $122 share in earnings. That, says DataTrek’s Nick Colas, suggests a market confident “that structural corporate earnings power remains solid”. 

In 2009, the S&P bottomed at 10 times trailing earnings. For now, a glimmer of light at the end of the tunnel is enough for Wall Street to prevent a repeat of that, at least for now.

Quick Hits — What’s on the markets radar?

The pound fell a cent this evening on the news that Boris Johnson was moved to intensive care after his condition worsened. The prime minister has been battling the coronavirus for the past two weeks and entered hospital on Sunday. 

An important week for European leaders as they meet on Tuesday to discuss how to support the single-currency region. Hopes for a comprehensive package, let alone common eurobonds, are not high as the FT writes here

Erik Nielsen at UniCredit Bank in London thinks:

“We are heading for an agreement on a combination of European measures” and these include “additional capital for the European Investment Bank to boost guarantees by more than €200bn”, while the European “Commission’s €100bn unemployment fund will be approved”.

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