Monday Market Review November 23, 2020
Economic data for the week included increases in retail sales, industrial production, and several housing metrics; a pair of regional manufacturing indexes decelerated but remained solidly in expansion.
World equity markets moved in different directions last week, with U.S. stocks declining and foreign stocks rising. Bonds fared well, as interest rates globally declined. Commodities also gained along with higher crude oil and industrial metals prices.
U.S. stocks were mixed to lower last week, as early excitement over more good Covid vaccine news was offset by sharply rising cases across the country, dampening consumer and business activity (a high profile example was the physical shutdown of New York City schools—a close reminder for Wall Street traders). By sector, returns were mixed, with energy leading the pack, up several percent, with oil prices rebounding; this was followed by materials and industrials, which continued to represent the cyclical group. Lagging with negative returns were traditional defensives utilities, health care, and real estate.
As was the case the prior week with Pfizer, positive news of Moderna’s mRNA-based Covid vaccine showed a high efficacy rate (95%) pushed stocks higher to begin the week. Additionally, it appears to be easier to store and transport (in standard refrigerator temperatures) than the Pfizer vaccine (needing far colder conditions, which create complications). The U.S. government has already pre-purchased 100 million doses, in part of an effort of world governments to ‘lock up’ access to vaccines, typically during the development process. Along with this announcement, Pfizer also adjusted their vaccine effectiveness rate upward from 90% to 95%, and applied for FDA emergency use authorization. As expected, the most positively affected stocks were those in the travel and entertainment groups.
Tesla will be added to the S&P 500 stock index, as committee members were hesitant to do for an extended period due to the company’s lack of profitability. Now that some profits have come through, S&P appears more willing to take the next step. It’s important to remember that even ‘passive’ indexes have at least one ‘active’ component—and sometimes several. Inclusion in the S&P series of indexes requires committee approval, after companies have met baseline metrics for profitability and liquidity, making this an ‘active’ decision. This is in contrast to indexes such as the Russell series, where inclusion is dependent on size alone, although original ‘style’ criteria were decided by committee members at some point.
Foreign stocks earned positive returns, bucking the weekly result in the United States—Japan and the emerging market groups led all others. Unsurprisingly, more commodity-oriented nations Brazil and Mexico led the way as hopes for 2021 improvement grew. Conditions in developed markets, such as Europe, appeared driven to a greater degree by vaccine hopes than current lockdowns—perhaps due to these occurring prior to those in the U.S. However, sentiment has been held back by the fact that a Eurozone fiscal aid package is being held up by vetoes by Poland and Hungary. In Asia, optimism followed the signing of the Regional Comprehensive Economic Partnership (RCEP) tariff-reduction trade pact, by 15 countries, from China to Australia.
U.S. bonds earned positive returns as rates ticked lower across the yield curve. Investment-grade corporates outperformed treasuries a bit, as spreads also narrowed during the week. A weaker U.S. dollar helped boost the returns for both developed and emerging market sovereign debt, earnings gains of up to a percent for the week.
Commodities broadly gained on the week in most major groups, led by increases of several percent each in industrial metals and energy, while precious metals declined slightly. Cyclical economic recovery hopes continue to remain high with the arrival of a vaccine. The price of crude oil rose by 5% to around $42.50/barrel, while natural gas declined by over -10%. OPEC and others have delayed a planned production increase in early 2021, which would have added to already high supplies.
(0/-) Retail sales for October rose by 0.3%, decelerating from the prior month, after including revisions upward on net. Overall, this fell short of the consensus expectation of 0.5%. Removing the more volatile components, core/control sales gained only 0.1%. By group, continued gains were seen in the non-store/internet retail category, which was up 3% (likely aided again by Amazon Prime Day), as well as electronics and building materials. On the other hand, department stores, clothing, and sporting goods all fell at least -4% for the month.
(+) Industrial production in October rose 1.1%, which reversed the decline of the prior month and beat expectations by a tenth of a percent. Under the hood, production gained in the manufacturing of business equipment, and especially utilities, while auto production and mining ticked lower. Capacity utilization rose by 0.8% to 72.8%. Overall, it appears industrial production has regained about two-thirds of activity lost due to Covid, so room for improvement continues.
(0) The Empire manufacturing index fell by -4.2 points in November to a still-expansionary 6.3, but in the opposite direction of the 13.5 level expected. Shipments and new orders both declined, but stayed in expansion, per the direction of the overall index. On the other hand, employment increased deeper into expansion, as did prices paid, and expected business conditions six-months-ahead, which remained strongly positive.
(0/+) The Philadelphia Fed manufacturing index also declined, by -6.0 points but still end up with a strongly expansionary 26.3, higher than the 22.5 level expected. In keeping with the broader index, shipments and new orders decelerated, but continued to expand, while employment and prices paid continued to expand further. Business condition expectations for the coming six months fell by nearly -20 points, but continued to show strong expansion.
(0) Import prices declined -0.1% in October, just below expectations calling for no change during the month. Removing petroleum, there was no net change in prices from the prior month, as oil prices fell a percent for the month, offset only a bit by rising food prices. Year-over-year, the broader index of import prices is down -1%, while removing petroleum price decline impacts elevates the core price to nearly 2% from last year.
(+) Existing home sales in October rose 4.3% to 6.85 mil. seasonally-adjusted annualized units in September, surpassing expectations of a -1.1% decline. Both single-family and condos/co-ops showed similar rates of increase. All four national regions saw gains, led by the Midwest and Northeast. This was the strongest single-month in 15 years, prior to the financial crisis, although there appear to be some seasonal ‘catch-up’ components related to recent strength—notably continued strong demand beyond the summer season. This has been seen by the metric of average days on the market, which has fallen almost in half to 21 days, and months’ supply of inventories is down to 2.5, which is the lowest level in two decades.
(+) Housing starts in October rose 4.9% to a seasonally-adjusted level of 1.530 mil., surpassing the 3.2% increase expected. Single-family starts rose 6%, offsetting a flat result in multi-family. Regionally, the South saw a double-digit increase, while the Northeast experienced a -40% decline from the prior month—each perhaps weather-related. Building permits rose to 1.545 mil., about 20k below expectations, with both single-family and multi-family running below their ‘normal’ range. Starts are up 29% on a year-over-year basis, and demonstrate the improving level of housing activity this year.
(+) The NAHB housing market rose by 5 points to 90 for November, surpassing expectations calling for a flat 85 level. Current sales and prospective buyer traffic each gained several points, followed by future sales of a single point. Regionally, the Midwest and South increased by the high single-digits, while the Northeast saw a decline of -5 points. This generally points to stronger homebuilder sentiment, which often translates to strength in housing starts and new home sales going forward—which has been the trend of recent quarters.
(+) The Conference Board’s Index of Leading Economic Indicators rose by 0.7% in October, which matched the increase from the prior month. The figure was helped by ISM new orders and jobless claims, but held back a bit from softer building permits and poorer consumer sentiment. On a trailing six-month basis, which largely coincides with the starting point when Covid sentiment was at its worst, the index has risen 24.7% on an annualized basis, in a reversal from the -24.3% annualized result from the six months prior. The coincident economic index rose by 0.5%, accelerating by a tenth from the prior month. The lagging economic index rose 0.1%, following several months of minor declines. Overall, these continue to tell the story of first V-shaped, and now more gradual economic improvement.
Source: The Conference Board. The shaded areas represent recessions as defined by the NBER.
(0) Initial jobless claims for the Nov. 14 ending week ticked up by 31k to 742k, which was in the opposite direction of the lower 700k expected. Continuing claims for the Nov. 7 week fell by -429k to 6.372 mil., below the 6.400 mil. level expected. The initial claims result was due to a spike of 32k in LA, while the bulk of more populous states saw sharp declines. Concerns continue about the likely negative effects of extended claims programs falling off at year-end, without an updated stimulus plan to provide an addition economic backstop.
In more unusual news, FOMC committee nominee Judy Shelton was initially rejected by the Senate, almost (but not quite, due to a few absent voters) ending a year-long bid by the Trump administration. This was due to several Republican Senators ‘going rogue,’ so to speak, voting against the nomination. She was controversial from the start, with a history of flip-flopping views and promoting unorthodox policies (such as going back to a gold standard), which caused a long list of prominent mainstream economists to lobby against the nomination. While this would have only been a single voice on the FOMC, there appears to be consensus agreement on wanting more conventional monetary thinking, as opposed to adding a sliver of populism to its ranks.
Question of the Week:
Are bonds expensive? Are they in a bubble?
Whether or not an asset class is in a bubble is difficult to answer in real-time, since sentiment can change course as quickly as a few weeks, or take years. In hindsight, these things are always more obvious. The question can be viewed through a few different perspectives:
(1) Bonds are cheap, and have room to run. Unsurprisingly, at current low rates, this camp has relatively few believers. For this story to make sense, it would require an assumption that the economy is perhaps moving toward a second recessionary downturn (where rates would fall again, helping the returns of long-duration bonds), or longer-term deflation, that could drop rates lower than they are now for an extended period. The probability of these scenarios is never zero.
(2) Bonds are expensive, or even in a bubble. This has been the argument made by more bullish economists and investment managers for at least a decade, since the Federal Reserve lowered short-term interest rates down to zero during the Great Recession, and again more recently during the pandemic. Although U.S. treasury bonds are considered ‘risk free’ from a credit default standpoint, they’ve historically offered some premium for other risks: changes in inflation expectations, tying up money for a period of time, and some degree of lessened liquidity (at least compared to cash).
Market interest rates flow from a combination of these factors, pushing up bond prices and pulling down yields when investors have few inflation fears, an appetite for income, and/or a need for safety. On these metrics, a 10-year treasury bond yielding under 1% looks expensive when looked at through past metrics. Using a long-term central bank inflation target of 2%, plus a traditional demanded real yield of at least 2%, we end up with a rate somewhere near 4% looking more historically appropriate. It may not be logical to assume a quick snap-back of rates to that level anytime soon, but through that view, current rates appear low, and bond prices rich. (It’s important to acknowledge that investors have been waiting for this to occur for at least decade, while yields moved in the opposite direction—far lower.)
What could cause a bump up in rates? If truly a coiled spring, theoretically, it may not take a big catalyst—higher realized inflation, rising inflation expectations, or the increased federal deficit and overall debt load causing investors to demand a higher premium over the current rate.
(3) Bonds are fairly valued (status quo). As noted, yields are tied to current or future inflation, which is in turn connected to longer-term economic growth. Real yields can diverge widely from a long-term average, based on monetary regime and investor demand. The buying of treasuries and agency mortgage-backed bonds by the Fed and other global central banks has pushed demand up and yields down, creating artificial market dynamics. But, these persist without any signs of an ending point, especially due to the economic damage caused by Covid. The shift in interest rates downward globally hasn’t helped, especially with the unique situation of the U.S. acting as the world’s safe haven, but, at the same time, also offering higher rates than in alternative regions—notably Japan and Europe. From that perspective, a long-term treasury rate of 1% looks attractive to global buyers relative to yields of 0% or -0.5% seen elsewhere.
Less optimistic economists see low rates inextricably tied to slower labor force growth, low levels of investment, and potentially diminishing productivity, the combination of which has depressed long-term GDP growth. Such a scenario could hold down inflation and future inflation expectations (and actually has held them down, during the entire time it’s been argued about). This perhaps worries the Fed the most. In this scenario, growth setbacks or financial market volatility raising the demand for bonds could pull rates down again to new lows. In a small example, 3-month treasury bill yields have fallen below 0% briefly, as investor demand for short-term safety and liquidity drove prices beyond par—it’s easy to see how this can happen when looking at yields from a simple auction supply/demand perspective.
The debate is ongoing. Status quo is difficult to bet against in the near term. Arguments over rates are perpetual, and have certainly persisted over the past decade, with little clarity as rates have moved in a band of several percent in either direction. Markets themselves provide the right answer, if one believes they’re priced at least moderately efficiently at any given time.
While several foreign regions have moved into policies of negative rates, the U.S. Fed has resisted this, noting the lack of proven effectiveness and negative repercussions on certain segments of the U.S. financial sector (it might render the very large money market mutual fund industry unviable). With little else at their disposal other than lowering policy rates to zero, bond buying, and continued forward guidance about the accommodative low rate stance staying intact for longer, one could see the current environment being in place for a while, absent any upward or downward shocks. In addition to government bonds, corporates of course have their own spread dynamics, offering better rates than treasuries, but also a tighter correlation to equities.
Regardless of opinions about rates and their future direction, bonds have always played an important role in asset allocation portfolios. Taking extreme bets on either outcome over short periods can end up being very correct, or very incorrect, as conditions change. At the very least, large bets raise tracking error and potential volatility relative to one’s target. Most importantly, the stock/bond decision remains among the most critical ones in determining an investor’s risk tolerance. The portfolio risk component is determined almost overwhelmingly by equities, putting bonds in the traditional role of risk mitigation and chief diversifier. (In terms of asset classes, long-term treasuries remain among the lowest-correlated assets to equities, particularly during financial market sell-offs. This is despite their own tendency to be very interest rate sensitive in their own right, particularly when used by themselves.) With low rates, the diversification effectiveness may be lessened along with lower expected returns, but they remain present to at least some degree. In recent years, a quarter- or half-percent has never meant so much.
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.