Friday, 3rd of July 2020
“Progress is impossible without change, and those who cannot change their minds cannot change anything.”
– George Bernard Shaw
Stock markets charged higher again this week, riding the wave of liquidity and positive sentiment around reopening despite coronavirus caseloads spiking right across the Southern US and in many emerging markets. The S&P 500 Index is up +4.0% for the week (with no Friday session due to the Independence Day holiday) and, on Tuesday, capped off the best quarter for the benchmark US index (+20.0%) since 1998. This remarkable rally since the US market troughed in late March has occurred despite analysts estimating that index earnings per share (i.e., EPS) are set to collapse -13.1% for the year as a whole according to FactSet. Across the Atlantic, the Stoxx 600 Index is up +2.8% this week ahead of Friday’s session, and closed the second quarter up an impressive +12.6% on Tuesday. Nevertheless, analysts now expect the EPS of the pan-European benchmark to crater -34.8% this year according to FactSet. And what about emerging markets? The MSCI EM Index is up +2.5% for the week (in USD) as of Friday morning and finished the second quarter up +17.3% (in USD). Great news for EM investors, of course. However, with the virus rampaging across Brazil, Mexico, India, and elsewhere no one expects 2020 earnings to support such a strong recovery in EM indices.
In Fixed Income, meanwhile, US IG and HY corporate bond spreads have narrowed more than 130bps and 270bps, respectively, in the second quarter, and the equivalent figures for Europe are 90bps and 280bps. Given the damage to corporate balance sheets from the closure of business through much of the quarter this spread narrowing is, on the face of it, quite something to behold. Indeed, it seems likely that when the short-term liquidity provided by governments is cut, employment support schemes end, and corporates are told to stand on their own two feet once more, there will be a considerable wave of insolvencies; and many expect defaults to reach levels higher than during the GFC. Clearly, therefore, there is a lot more going on here than a reassessment of corporate fundamentals.
So, what is driving risk assets to rally so strongly? Our answer is the unprecedented fiscal and monetary support provided by governments and central banks globally. Indeed, just this week, another USD 1.5tn in US infrastructure spending was announced, while European leaders edged a little closer to finalising the terms of a pan-European recovery fund to help struggling sectors and regions. This huge stimulus is providing a tailwind for risk assets and is a backstop for markets at this time of acute economic stress. Amid seasonally thin liquidity this summer, some volatility is to be expected and a 10% correction could well be on the cards given the many headline risks to the outlook (not to mention the rocky ride that will be Q2 earnings season). However, with a substantial net short position on the S&P 500, a wall of money (which grows larger every day) propping up indices, and President Trump fretting about the November election, dip buying seems more likely than any momentum-driven sell-off over the next few months. This could change as greater clarity on a possible Biden Presidency emerges by the end of summer, given the risk that he appoints a radical as Treasury Secretary or chooses to reverse the corporate tax cuts passed by the Republican Congress in 2017. Both possibilities are negatives for equities but may not be enough to halt the rally until a Democratic victory – the market is too drunk on stimulus.
The economic data is also starting to improve as most major economies reopen and that is boosting market optimism. For example, on Thursday, the US released its June jobs report which revealed that 4.8m jobs were added during the month (a post-WWII record). Together with robust manufacturing and service sector PMIs and a 60-year record rise in consumer spending, this paints a picture of an economy that is bouncing back faster than many feared it could. That said, even with the record jobs prints of the last two months, the US unemployment rate remains above the peak (~10%) during the GFC. We are a long way yet from having witnessed a full-blown economic revival. China too is proving its economic resilience, even as Beijing is locked down once more to head off a resurgence of the coronavirus. This week, the country’s June services PMI printed at 58.4 (vs. 53.2 expected), which is the highest level recorded since April 2010, and shows that consumers have finally jettisoned their timidity. Perhaps improving fundamentals will finally begin to justify financial market gains early next year. That is, unless the Hong Kong or Xinjiang crisis blows up the phase one US-China trade deal, and the superpowers get back to 2019-style tariff battles on the other side of the US Presidential election.