Monday Market Review May 18, 2020
Economic data continued to reflect the negative reality of Covid closures, with retail sales and jobless claims continuing to show extreme weakness, as well as a deceleration in inflation. On the other hand, manufacturing sentiment gained a bit—especially in future expectations—while consumer sentiment also improved.
Global equity markets fell back last week, as sentiment soured surrounding economic data, further stimulus, Covid infection rates, and foreign relations. Bonds were flat to higher with interest rates remaining tempered. Commodities rose slightly as crude oil prices continued to recover.
Question of the Week
Have some financial asset prices bounced back too far and too fast?
This is never simple to evaluate, as current prices for rates and risk assets have a behavioral component, and appropriate price levels may only be obvious in hindsight.
In past cycles, equity bear markets and subsequent recoveries have unfolded over months, not weeks. This more recent volatility event was different on that front. Compared to how trading was conducted decades ago, the current flood of news through electronic sources, institutional algorithmic trading systems, and fast (and now largely free) retail trading has generated higher volumes. By adding low-cost market, factor, and thematic exchange-traded funds to the mix, the ease in implementing exposures may also be exacerbating the day-to-day volatility markets experience. This has created a few hiccups more recently in bond markets, where underlying bond holdings are far less liquid, causing the fewer offered exchange-traded products to act as a ‘safety value’ for price discovery and liquidity. This function has also added to volatility, and no doubt was a factor in the Fed’s decision to provide liquidity and buying power to these markets—a validation of their widespread usage and growing importance to financial market health.
In terms of pricing today, many market strategists are in agreement that where we go from here remains heavily dependent on the medical landscape. This makes the situation more fluid and more of a wildcard than we’ve been used to. In normal downturns, even if economic forecasts aren’t perfect, some modeling can be done to provide a rough framework for recovery. In this case, the depth and length of the downturn is likely very much dependent on the spread/waning of the virus. The possible scenarios have been broken down into ‘shapes’ of the expected graph of economic growth:
The general consensus view is that a ‘V-shaped’ recovery (economy re-opening quickly and activity getting back to normal soon) is less feasible as a best-case scenario. China and South Korea have experienced a relatively rapid recovery, but societal differences and technology have played a stronger role in targeted medical tracking that may not be as palatable for Americans or Europeans. In addition, the risk of a second wave remains, as with many prior pandemics.
A ‘U-shape’ appears to be the most common currently-accepted base case—a deep trough which may take a few months or even quarters to plough through to ensure a more thoughtful reopening. This scenario assumes a bottoming in Q2, with a resumption of activity in Q3 and Q4, as well as into 2021.
A trickier set of conditions is the ‘W-shape’, which is a sharp bounceback, followed by a second wave of infections and shutdowns in future months, and, finally an eventual drawn-out recovery. This would no doubt try everyone’s patience from a societal and economic standpoint, but, unfortunately, isn’t an uncommon outcome based on prior pandemics in which a second or even third wave has unfolded. Some compare the current case to the 1918 influenza pandemic. Despite being perhaps useful on the epidemiological front, this period was less relevant from an economic standpoint, as the Fed was only a few years old and untested. That era pre-dated the modern Fed’s usage of monetary policy, economic data was far spottier when available, not to mention other carryover effects from the conclusion of World War I, all of which complicate the analysis.
The dreaded ‘L-shape’ represents a sharp economic downturn, with a permanent loss of some activity and jobs. This is not considered to be a base case by mainstream economists, but if the current shutdowns persist for an extended period, the chances of this scenario rise as businesses shutter and temporary job losses turn permanent. Fears of this outcome have been the force spurring politicians and businesspeople to fight for faster re-openings, even in spite of higher medical risks. It could be said that the Great Depression in the 1930s was an L-shape, although there were policy errors that likely exacerbated its length and depth. Avoiding repeat of those mistakes explains the use of extreme fiscal stimulus today.
Valuations today appear neither extremely cheap nor outrageously expensive, and price in an optimistic economic and earnings recovery next year, which of course is possible. However, an important pitfall to avoid at times like this is pricing for a very narrow and ‘perfect’ path. Last week, a handful of hedge fund managers (many of whom are known to take and could benefit from volatility and negativity) claimed the U.S. equity market was overvalued, while other portfolio managers expressed the opposite sentiment. This reflects the uncertainty and disagreement in possible economic paths going forward. This year’s earnings have been written off completely, with those for 2021 expected to get back to $160-170 on the S&P. Bond yields are anchored by very easy Fed policy, and lower inflation expectations in the mid-term. (The long-term expectations are up for debate, due to the now massive fiscal budget deficits.) As always, starting yields have been a decent indicator of future fixed income returns, which is less inspiring for savers and more conservative investors.
As they were a decade ago after the financial crisis, many bond investors may be pushed to take on more risk to earn higher income in high yield corporates, emerging markets, etc. For equities, only a small proportion of earnings inputs into cash flow models depend on the coming few years, rendering the Covid outbreak hopefully a small blip on the historical chart. However, sentiment in the near term can be powerful, and could well depend on medical news.
U.S. stocks fell back again last week, with sentiment about a faster recovery from Covid waning somewhat, in perhaps an acknowledgement of a ‘V’ turning into more a ‘U’ (as discussed above). Presidential and Senate pushback on a new Congressional $3 tril. relief package also appeared to add to soured sentiment, as did ramped-up rhetoric about a further cutting of economic ties with China. Persistent Covid infection rates, including in some nations with reopened economies, also was of concern due to the ramifications in the U.S. and broader global growth. Large caps have outperformed small caps sharply, due to a continued focus on investors seeking growth and stability where it can be found. By sector, health care stocks led the way, as the only group with positive returns, while cyclically-sensitive energy, industrials, and financials lost -6% or more each, as did real estate. Foreign stocks in the U.K. and Europe fared similar to those in the U.S. in local terms, although a stronger dollar acted as a headwind, resulting in further declines. Stocks in Japan and the emerging markets fared a bit better. Chinese data from an economic activity front continues to show improvement from lows, including industrial activity, as the nation continues to emerge from more widespread lockdowns. U.S. bonds gained a bit, with investors moving away from risk assets, causing yields along the longer end of the yield curve to tick down a few basis points. Front-end yields up to the next several years remain anchored between zero and a quarter-percent, in expectations for continued easy Fed rate policy. Investment-grade credit outperformed government slightly, although high yield bonds suffered losses in keeping with equities. Foreign developed and emerging market bonds were little changed in local terms, but were pulled down by a strong dollar. Commodities ticked higher generally, led by gains in energy and precious metals, while trade-related industrial metals and agriculture fell. The price of crude oil recovered by about 10% on the week to just under $30/barrel, with continued expectations for demand to slowly recover, coupled with planned production cuts.
(-) Retail sales in April fell by -16.4%, twice the magnitude of March’s decline, and surpassed the -12.0% drop expected. On a core/control level, retail sales were just about as bad, down -15.3%, despite expectations for only -5.0%. As expected, declines in retail activity occurred throughout the economy, with especially poor results of -60% or worse declines in clothing, electronics, and furniture. On the other hand, online/non-store sales rose by 8%. With a combination of a furloughed workforce percentage, lack of movement/travel, and locked doors for most physical locations, this was perfect storm for a terrible report. Low levels of activity are expected to continue until lockdowns are eased, and consumers feel comfortable venturing out. Whether this event is a catalyst for a further more toward online shopping remains to be seen. (-) Industrial production fell -11.2% in April, the worst month in history, almost reaching the consensus estimate of -12.0%. However, it’s still up 3.9% on a year over year basis. The headline figure was obviously driven by general declines in the overall economy, led by auto production down over -70%, and other segments down at least -10%. Utilities, however, only fell by -1%, with some offset by home demand. Capacity utilization unsurprisingly fell by -8.3% to 64.9%. (-/0) The New York Empire manufacturing index rose by 29.7 points in April, to a still deep-contractionary -48.5, and better than the -60 level forecast by consensus. Underlying components also improved a bit, with similar readings as the headline for new orders, shipments, and especially employment—despite all remaining deep in contraction. The index of business conditions six months out rose by 22 points to 29, signifying optimism by companies for a light at the end of the tunnel. (-) The producer price index for April fell by -1.3% on a headline level, beyond the -0.5% median forecast. Energy prices falling almost -20% was a key contributor, while when removing food and energy, core PPI fell by a more tempered -0.3%, surpassing the -0.1% expected. Under the hood, most segments declined in price, while medical care services rose by several tenths. Year-over-year, core PPI has decelerated to 1.1%. (-) The consumer price index for April fell by -0.8% on a headline level, and -0.4% for core, removing food and energy prices. Energy commodities, including gasoline, fell by -20% over the single month, offsetting food prices which rose by nearly 2%. While gasoline prices have been related to declines in crude oil, food supply linkages have been more directly hampered by Covid-related disruptions, such as in meat particularly. Apparel and transportation prices were each down -5%, with other categories falling into the negative, such as lodging and airfare, or showing mixed results during a shutdown of commerce. The exceptions were shelter and new cars, which were flat, and medical care services, which rose by 0.5%. The monthly drop for core CPI was four times larger than the worst month of the financial crisis, pointing to the severity, speed, and focus of the current downturn—especially in the service sector. Year-over-year, prices fell sharply to a pace of 0.3% for headline and 1.4% for core. These stats reinforce the demand destruction caused by the unprecedented decline in business and consumer activity. (0) Import prices fell by -2.6% in April, which was less dramatic than the median forecast of -3.2%. The sharp drop in petroleum prices of -33% was the primary driver, with core prices down only -0.5%. In other segments, prices for autos and capital goods rose a bit, offsetting declines in industrial supplies and food. (+) The preliminary May Univ. of Michigan index of consumer sentiment rose by 1.9 points to 73.7, beating median forecasts calling for a drop to 68.0. Assessments of current economic conditions rose by nearly 9 points, while expectations for the future fell by several points. Inflation estimates for the coming year rose dramatically by 0.9% to 3.0%, while those for the coming 5-10 years only ticked up a tenth to 2.6%. It’s possible that consumers expect low oil/gas prices to recover to higher levels, in addition to the assumed long-term impact of monetary stimulus (although having a job and current gasoline prices tend to be the primary drivers of near-term consumer moods). (-) The government JOLTs job openings level fell by -813k to 6.191 mil. for March, just above the 5.800 mil. level expected, with layoffs rising by 11.4 mil., notably in hotels and restaurants. The layoff rate rose to 7.5%, while the quits rate fell -0.5% to 1.8%. The job openings rate fell by -0.5% to 3.9%, and the hiring rate fell by -0.4% to 3.4%. (-) Initial jobless claims for the May 9 ending week fell by -195k to 2.981 mil., which came in above the 2.500 mil. estimate. Continuing claims for the May 2 week only rose by 186k to a level of 22.833 mil.—below expectations of a rise to 25.120 mil. Initial claims rose in several states on the hard-hit east coast (NY and CT), but fell in several states with looser restrictions (TX, OK, NC), while CA also fell. A new element in the report, the Pandemic Unemployment Assistance (PUA) program, which covers self-employed and contract workers, showed an increase to 3.4 mil. continuing claims for the Apr. 25 ending week, with about 1.0 per week added in the subsequent two weeks with not all states reporting data. Due to the sheer numbers, categorization of workers, and various delays in filing due to technology hurdles in some states, the fine details are not as critical as the fact that up to a quarter of the American workforce is at least currently furloughed. Have a good week.
Ryan M. Long, CFA
Director of Investments
FocusPoint Solutions, Inc.
Sources: FocusPoint Solutions, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Citigroup, Deutsche Bank, FactSet, Financial Times, First Trust, Goldman Sachs, Invesco, JPMorgan Asset Management, Marketfield Asset Management, Morgan Stanley, MSCI, Morningstar, Northern Trust, PIMCO, Standard & Poor’s, StockCharts.com, The Conference Board, Thomson Reuters, T. Rowe Price, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wall Street Journal, The Washington Post. Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends. Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.
The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness. All information and opinions expressed are subject to change without notice. Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product. FocusPoint Solutions, Inc. is a registered investment advisor.
Notes key: (+) positive/encouraging development, (0) neutral/inconclusive/no net effect, (-) negative/discouraging development.