A strong tailwind from central banks certainly puffs the sails of risk appetite. It also spurs plenty of scepticism about the trajectory of equity prices that mirrors the general view that prevailed among investors during the recovery after the financial crisis.
Bullish sentiment at the moment is being supported by the US administration pushing for a $1tn infrastructure spending programme (only one measly trillion dollars, you say), while a promising drug treatment for patients with coronavirus is also good news. In the US, headline retail sales for May rebounded at a record pace of 17.7 per cent and arrived well ahead of expectations. One caveat: over the past 12 months, retail sales were still down 6.1 per cent in May.
Alan Ruskin at Deutsche Bank says the rise in retail sales suggests “US policy is indeed ‘building at least a short-term bridge’ between the March/April collapse and the attempts at economic reopening”.
Wall Street retained the bulk of its early gains spurred by the data which also helped Europe to build on its already solid performance. After the Federal Reserve indicated it would start buying individual corporate bonds on Monday, another important central bank is whistling a similar refrain. An official at the European Central Bank says it will consider buying “fallen angel” bonds, or debt from companies that have recently lost their investment-grade rating.
The two big central banks are doing all they can to support corporate borrowing, but this also highlights just how worried they are about indebted companies and the prospect of a prolonged recovery accompanied by high levels of small business failures and unemployed workers.
“The longer the downturn lasts, the greater the potential for longer-term damage from permanent job loss and business closures.”
But the Fed chairman also reminded investors of a possible future wind shift by saying that the pace of corporate bond buying was linked to financial conditions and preventing a deeper economic shock:
“If the market function continues to improve, then we are happy to slow or even stop the purchases. If it goes the other way, we will increase.”
Mr Powell gamely told the Senate banking committee:
“I don’t see us as wanting to run through the bond market like an elephant or snuff out price signals.”
I think the herd has already done a pretty good job and it also raises a valid question as to why the Fed is upping its presence in credit when the market has rallied handily since March. Shown here (courtesy of Capital Economics) is the extent of the recovery in the option-adjusted spreads for US investment grade and high yield credit:
While the Fed expands its support, there are long-term consequences from outsized central bank action. An overly indebted financial system will weigh on long-term growth prospects. It also reinforces the feedback loop between central banks and asset prices. Anyone thinking that central banks can step back from their massive presence in financial markets without spurring a volatile reaction should look at the taper tantrum of 2013 and the Fed tightening of policy in late 2018 as simply a taste of what beckons down the road.
Marc Ostwald at ADM Investor Services says the latest corporate bond buying initiative from the Fed sends a worrying message “that financial markets are not functioning, and that it sees the need to bailout USA Inc — in other words offering a dire signal on the outlook”.
True, the Fed is worried about “significant financial-sector vulnerabilities” via its latest monetary policy report to Congress, but its bond buying distorts risk premiums and isolates companies from market forces. It also compels investors to chase markets and for all the scepticism over asset prices, the latest survey of fund managers from Bank of America highlights a nascent shift in tone:
True, four out of five fund managers reckon equities are over valued, but in the space of a month they are sounding a little less bearish on the economy and equities. More than a third of investors now believe stocks are in a bull market, up from a quarter during the May survey. And now a fifth expect a “V-shaped” economic recovery, up from a 10th in the previous month.
Sure, investors say a second wave of Covid-19 remains the biggest tail risk, but they are also worried about getting left behind in performance terms as central banks push asset prices higher. The amount of cash held by fund managers declined at its fastest pace (from May to June) since August 2009 noted BofA.
So where does this leave investors?
Nick Colas at DataTrek highlights a remarkable pattern that links the lows of March 2009 and of 2020 for the S&P 500 index. After a period of 58 days, the S&P was up 39 per cent in 2009, while this year the benchmark has climbed 37 per cent from its low of March 23.
Nick makes some interesting points for those trying to make sense of what the rest of this year entails. If the pattern holds, then Wall Street faces a seven-week period of “volatile stagnancy” which is DataTrek’s “base case” before ending the year at 3,588 points, for a gain of 11 per cent.
Playing a key role here is the fact that the technology sector has expanded from a weighting of 18.4 per cent in the S&P 500 since 2009 to around one-third when you include Google and Facebook (now in the consumer discretionary group) with the tech sector. Unlike 2009, when the S&P 500 was trading at 10.4 times trailing peak earnings of $91 a share, today, the benchmark sits at 19.6 times its recent peak earnings of $155 a share. The current confidence in earnings returning fairly quickly to their recent peak is a function of tech companies retaining their earnings prowess.
Nick leans towards a repeat of 2009 for the S&P 500 because the large weighting in tech companies should help to offset the uncertainties of a post-Covid-19 recovery that appears a lot tougher than cleaning up the banks in 2009.
Indeed, the “fantasy” of returning to normal life in South Korea after Covid-19 is certainly an eye-opening read from FT reporters. They write “governments need a persistent state of vigilance and a willingness to change tack as they attempt to reopen their societies”.
Notably, the BofA survey of fund managers discloses that the biggest structural shifts after Covid-19 passes are supply chain reshoring, protectionism and higher taxation. In turn, 67 per cent of fund managers “think the next decade will have annualised global equity return of 0-5 per cent (weighted average is 3.4 per cent)”, adds BofA.
At least some investors acknowledge that a far greater challenge looms for portfolios, once the current tailwind ebbs.
Quick Hits — What’s on the markets radar?
The US administration is considering a hefty infrastructure stimulus package and Paul Donovan at UBS has a blunt message for investors cheering such a prospect:
“Most fiscal spending so far has been about a scramble to set up a temporary, European-style social safety net. That is more antidepressant than stimulant. The risk with infrastructure is that it can be backwards looking — more about the second industrial revolution of the 1920s, not the fourth industrial revolution of the 2020s.”
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