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The good news for Europe keeps flowing with 10-year Italian bond yields falling below 1 per cent for the first time since early March.

A week ago, the Italian 10-year benchmark yielded 1.18 per cent and clearly this week’s EU fiscal deal has registered with bond investors.

Line chart of  showing Italian 10-year yield recedes back below 1%

Once the 10-year falls towards the 0.9 per cent lows seen in February, the next step is whether the prospect of greater EU fiscal unity triggers a further decline in long-term Italian borrowing costs. A point of reference is that both 10-year Spanish and Portuguese paper yields around 0.3 per cent.

Ultimately, this boils down to how much the European Central Bank wants to close the bond yield spread? Not since 2015 and the initial round of ECB bond purchases has the Italian 10-year yielded less than 1 percentage point above that of the German Bund.

Line chart of 10-year government bond yield spread, Italian over German (basis points) showing The Italian spread over bunds hasn't been below 1 per cent since 2015

Indeed, some argue that the European markets trade from here is less about equities, and rather that investors should favour the euro and fixed income.

Dhaval Joshi at BCA Research argues that unlike sector-dominated equities, currencies “have a much stronger connection with domestic economics and politics”. That favours sticking with a basket of the euro, Swiss franc and Swedish krona versus the US dollar.

As for equities, BCA highlight that despite all the positive developments in Europe regarding stimulus and the smooth reopening of economies, the tilt towards financials, energy and industrials in regional share markets explains why the Stoxx 600 is not outpacing the S&P 500.

A big question for European equity sentiment is whether foreign and domestic investors return.

Goldman Sachs writes that based on mutual fund flows — including exchange traded funds — “foreign investors have not shown a clear turn into European equities and have been sellers since 2018”.

Domestic investors have also stayed away, as have other non-traditional equity funds. But the further bond yields are crushed by central banks, the more there is a silver lining in the shape of higher dividend yields.

Goldman note: “The gap between the yield on equity and bonds remains substantial” as shown here.

Across the Atlantic, the S&P 500 has stalled about 4 per cent shy of its record close on February 19, with Wall Street under pressure today from weaker than expected weekly jobs data (see Quick Hits), with tech shares leading the selling.

In the near-term, equity sentiment awaits Congress and the White House striking a deal that extends current unemployment benefits. Helping matters here is the likelihood of more Federal Reserve support that keeps real yields heading deeper into negative territory.

Brown Brothers Harriman sums up the mood noting:

“A deal will be struck, but it will likely be seen at the eleventh hour after contentious negotiations.”

They add:

“The optics of [Congress] going on vacation in August with no deal and unemployment benefits running out would be truly bad.”

So where does this leave the equity market beyond July?

Over at Longview Economics, they remain “optimistic about the outlook for equities” over the coming weeks and potentially months and cite supporting factors that include “liquidity, momentum, and an absence of greediness”. They also note the AAII retail sentiment index remains at low, or what are deemed “contrarian buy” levels, as shown here.

Once vacation season ends, and schools hopefully return in September, one hurdle for the equity market are US elections for Congress and the White House. This year is far from done in many ways for markets.

Quick Hits — What’s on the markets radar?

The debate over how to measure inflation has only intensified amid the pandemic. A measure from State Street Associates and PriceStats, shown below, “estimates that the actual inflation rate adjusting for the new Covid consumption basket is already much higher, at 1.4 per cent”.

State Street’s Michael Metcalfe explains:

“Spending may be recovering sharply, but the uneven nature of that recovery means the basket of goods that consumers are buying is still significantly altered, thus distorting measured inflation. Consumers continue to spend less than normal on items such as entertainment, recreation and transport. As a result of this, inflation indices are putting too much weight on the prices of these goods based on past consumption patterns.”

After the deluge, US corporate debt sales are drying up. Bank of America notes investment grade sales of $43bn so far this month, marking “the slowest July so far in the primary markets since 2014”. The result is a further compression in risk premiums for credit given a solid pace of daily inflows to US IG bond funds and ETFs adds BofA.

Equity market sentiment was ruffled after the latest US weekly jobless claims rose to 1.416m, up from 1.307m the previous week and above a forecast 1.3m rise. It was the first weekly increase since March. Rising lay-offs may reduce costs for companies, but that does not bode well for a broader economic recovery down the road.

Joshua Shapiro at MFE says a claims figure running above 1.4m this long after the start of the downturn, along with elevated continuing claims, illustrates “the time it will take to heal a labour market thrown into turmoil by unprecedented circumstances”.

Programming note

Market Forces returns next week. A good weekend to all readers.

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