Summer has arrived — yes, even in London — and asset classes are respecting the limits of their recent ranges. Among them, two in particular warrant close observation.
Benchmark 10-year sovereign bond yields and investment grade credit risk premiums explain much about the quarterly bounce in equities and why many think at the very least that a floor has been established for risk assets. As for extended gains, well, the skies look less clear on that front. A case in point is that implied equity volatility for the S&P 500 remains elevated in spite of hefty fiscal and monetary support.
Also, real Treasury yields — a barometer of future economic growth expectations — keep setting new record lows well below zero. That helps explain the solid demand for gold, with the price climbing to a fresh high since 2012 and looking at testing $1,800 an ounce.
Equities may well spend plenty of time trading sideways over the summer and perhaps endure another nasty 5 per cent-plus drop in a session. Yet, barring a big shift in 10-year nominal yields and an eruption of credit turmoil — two outcomes being strongly suppressed by central bank policy at the moment — lasting weakness in equities looks contained.
A test awaits for equity sentiment; namely what kind of earnings recovery beckons during the second half of the year. In the interim, the twin arms of central bank support via narrowing credit risk premiums and subdued sovereign bond yields are certainly encouraging a sense of optimism.
Chris Iggo at Axa Investment Managers sums it up:
“The policy framework — the credit backstop — has provided bondholders with a put option while equity investors are essentially long a call option on future earnings. If companies are going to survive because their credit profile has been strengthened by policy, why not pay 22x times next year’s earnings with a risk that prices go down a bit? You might benefit when earnings eventually do start to rise.”
The policy put option is also being reinforced by signs of economic news arriving better than forecast. Sure, there remains a hefty hole in the economy, but the direction of travel is what matters for those of a bullish inclination.
John Velis at BNY Mellon notes:
“After spending five weeks at 5 per cent, our nowcast is now at -15 per cent, indicating that on an annualised basis the economy is still shrinking, albeit at a slower rate than we witnessed in early April.”
Other forecast models at the Federal Reserve also show an improving tone for the economy, although the hole still remains deep. Indeed, a full recovery in economic activity that takes us back to pre-Covid-19 levels appears a story for 2022.
But it may also require negotiating a deflationary crunch.
Christopher Dembik at Saxo Bank highlights the following chart of an index from the Federal Reserve Bank of St Louis. It measures the probability that the personal consumption expenditures prices index inflation rate over the next 12 months will fall below zero.
At the moment this measure — which includes 104 series such as foreign prices variables, PPI and labour market indicators — shows a probability of 76 per cent that the US will fall into deflation over the next 12 months.
“Clearly, the Fed’s favourite deflation probability indicator is in risk-zone. This is the second highest level ever reached since its creation, after the peak of January 2009 at 0.82. We observe the same worrying trend in many developed countries, but also a drastic fall in inflation forecasts for many emerging countries.”
Deflationary winds will only intensify the earnings pressure on companies that have borrowed heavily lately in order to bridge the gap towards an eventual recovery in the economy and in revenues. True, deflationary pressure will spur lower 10-year yields, but in that context, equities may gain little solace from a new nadir in sovereign benchmarks. Particularly given the renewed pressure on corporate credit in such a scenario.
Oxford Economics estimate that the ratio of aggregate corporate debt to that of the economy in developed countries may climb to 95 per cent “well above the 2009 peak” and “debt service ratios may also rise into risky territory despite low interest rates”.
On the radar screen of equity analysts, a lacklustre recovery does not register much of a blip. This chart via FactSet highlights the trajectory of an anticipated S&P 500 earnings recovery beyond the nadir of the current second quarter. By the first quarter of 2021, expected earnings of $39 per share are forecast versus a figure of $33 per share for this year.
DataTrek believes the current quarter forecast of $33 per share is a “very high floor upon which to build an earnings recovery based on corporate cost cutting, less-bad macro demand, and continued fiscal policy to support the US economy”.
But extended cost-cutting does not bode well for the broader economy if such efforts maintain elevated levels of unemployment, while credit pressure via commercial real estate and other sectors hard hit by shutdowns may well send the worst kind of tidings to equity markets. Policy stimulus can only keep the sun shining for a limited time.
This is certainly an outcome should the expected bounce in economies falter and highlight how recessions tend to play out over several quarters. Rowan Dartington remind us:
“The last recession was priced into equity markets over the course of a year and a half. The dotcom crash took longer still. Why would we expect equity markets to have fully, and accurately, appraised the necessary valuation adjustment to Covid-19 in just over a month?”
A counter view is that the speedy and vast response from central banks such as the Fed, renders such comparisons with the past two recessions a moot point.
Axa’s Chris Iggo veers towards optimism.
“As long as credit distress is controlled to some extent (defaults don’t rise as much as they did in previous recessions, leverage can be controlled, and interest coverage remains high), then equity value won’t be wiped out and the option on future growth will remain a valid and attractive asset . . . Flows into credit will drive yields lower allowing companies issuing new debt at yields and spread levels that will help them control leverage. It’s a positive cycle when it works.”
Quick Hits — What’s on the markets radar?
One expression of rising risk appetite is flagged by currency markets via greater demand in carry trades. Or borrowing cheaply in one currency and buying a higher-yielding asset.
John Velis at BNY Mellon says:
“Appetite for carry, which had been mired in record-low territory between the end of February and beginning of June is rapidly approaching significantly positive levels.”
This time, as shown below, something looks amiss and John highlights: “Strong appetite for carry and simultaneously weak appetite for trend and value is unusual” and prior periods of such a combination, July 2017, December 2018, and August 2019 “were associated with higher FX volatility. We expect this relationship to hold, and expect rising volatility in comings weeks.”
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