Fueled by improving activity data and central bankers being strongly committed to backstop the market, the month of June continued the streak of stellar risk asset performance, bringing one of the best quarters (+20% price return in the S&P 500) in terms equity performance to a close.
Markets seem willing to look through near-term earnings volatility as long as activity momentum remains positive. Besides that, 84 central banks have cut interest rates in 2020. This is by far the easiest monetary policy the world has ever seen. However, it seems to us that markets are already signaling that further policy accommodation may be required, especially on the fiscal side.
- Regionally, Europe outperformed U.S. stocks throughout June, as several U.S. states’ efforts to contain the coronavirus pandemic faced setbacks. The Eurostoxx 50 (+6,5% in EUR) outperformed the Nasdaq100 (+6,4% in USD) on a total return basis. EM Indices (MSCI EM +7,4% TR in USD and CSI 300 +8,5% TR in CNY) had an even better month which remained largely unnoticed by financial media.
- The Nasdaq 100 is now trading 16% above its 200 day-moving average, the last time it got that extended was in February 2020.
- Volatility levels still indicate that we remain in a stressed market environment. The VIX briefly spiked to 44 in June.
Recent Market Developments:
- Quality equities – US mega caps in particular – have regained the leadership, after the rally in cyclical stocks lost steam in mid-June due to fears of rising infection rates in the US.
- Historically, after strong quarters (quarters with returns of +15% and more), future S&P500 returns tend to show continued strength, with a +9.5% return on average in the next quarter. However, the historical data set is limited to 8 observations which again highlights how exceptionally strong the second quarter was.
- Remember that buybacks were the most important single source of demand for the US stock market since the financial crisis? Buybacks are down -44% compared to last year for the first 6 months of 2020 which marks the lowest level in 8 years. How this will impact equity markets going forward remains to be seen.
- Uncertainty remains extremely high. 400 of the S&P 500 companies have not given forward-guidance over the past 3 months. Thus, it is very difficult to make predictions in such an environment. S&P 500 year-end price targets among Wall Street strategists exhibit a 250-point standard deviation. This is more than twice as large as the average standard deviation over the past 20 years, according to SentimenTrader.
Recent Macro Developments:
On the activity front, incoming data is tracking better than expected in most regions, with the latest PMIs moving back into, or close to, expansion territory in Europe and the US. While the loss of output due to COVID-19 is forecasted to be without precedent in the recent history, it seems fair to say that the post-lockdown recovery is so far beating (very poor) expectations. The US economic surprise index is now strongly positive, and Europe’s is rising fast.
- The latest German IFO and French INSEE indices also rebounded more than expected, as did consumer sentiment. In the US, the recent ADP report showed companies added 2.4 million positions in June. In addition, the May release was changed to a 3.1 million gain from a 2.8 million loss.
- Geopolitical tensions between the US and China are elevated and will likely remain so for the foreseeable future. The U.S. House passed a bill imposing sanctions on banks that do business with Chinese officials who are involved in cracking down on protesters in Hong Kong. Furthermore, the US Federal Communications Commission designated China’s Huawei & ZTE as “companies posing a national security threat to the United States”.
Source: Bloomberg
Chart: While still lower in absolute terms, inflation expectations in the Eurozone are showing a more promising dynamic than their US counterpart. Interestingly, they seem to be rising in tandem with the price of copper.
Is this a reflection of better crisis management in Europe and the expectation of significant fiscal stimulus coming to the Eurozone?
Some analysts argue that green and digital stimulus programs could create the conditions for a boom in copper demand — electric vehicles, 5G networks and renewable power generation all require large amounts of the red metal.
Recent Pandemic Developments:
- The US is not doing well. California and New York are backtracking on reopening the economy. California banned indoor dining in certain areas, including Los Angeles, after a day of record infections. New York delayed the restart of such services. Arizona had record cases and visits to emergency rooms, while Houston-area hospitals saw ICU rooms reach 102% of capacity.
- While new widespread lockdowns in the US are unlikely, the effect of the viral resurgence on consumer sentiment and spending could be very negative. That said, markets don’t seem too concerned at the moment as mortality have remained relatively low so far.
- In regards of medical treatments, an early trial of an experimental vaccine from Pfizer and BioNtech showed promising results, winning praise from Wall Street analysts and showing the industry remains on track for having a potential vaccine by the first half of 2021.
Developed Market Politics:
- With Donald Trump lagging significantly in the polls, US equities may remain bumpy over the next few months as Biden has repeatedly stated his intention to roll back Trump’s 2017 tax cut.
“I’m going to get rid of the bulk of Trump’s $2 trillion tax cut and a lot of you may not like that but I’m going to close loopholes like capital gains and stepped up basis.” (Joe Biden during a virtual campaign fundraiser in June 2020) - On the other hand, political consensus seems to be improving in Europe in the wake of the pandemic. Improved co-ordination is evident in the form of the joint EU recovery fund proposal. Although a deal has yet to be made, we believe that political risks are turning more in favor of Europe compared to the US.
Market Commentary:
Stocks have been priced for perfection, but things remain far from perfect. We see signs of rising instability after an historic rally off the lows. Investors remain torn between their fears of the economic damage a second coronavirus wave could wreak, and the assurance gained from the huge stimulus efforts of central banks, governments and politicians who are eager to ensure that shutdowns are no longer an option.
We see potential for Europe to grow more over the next few years than the U.S. because Europe is ahead in terms of virus control and reopening of the economy. The region’s planned reconstruction fund of 750 billion euros as well as the French and German fiscal policy incentives could finally bring back foreign investors into Europe’s equity market. This is, however, more likely a story for 2021 when a sustainable global recovery is expected to take hold.
In the short-term, equities have had a strong run, good news are priced in but VIX remains elevated, all of which makes markets vulnerable to a correction. That said, the lack of widespread participation in the rally and systematic strategies now being much more deleveraged speak for reduced tail risks.
Positioning: We are neutral in our tactical equity market assessment. Our selection remains strongly focused on quality stocks with sound balance sheets and strong business models.
- We favor companies with high credit ratings and keep a preference for tech, health care and consumer staples. Although we note that defensive quality is a crowded trade by now, we believe it would be premature to move out of this positioning.
- On a broad portfolio level, we emphasize diversification, good liquidity, and high quality in our risk assets. We stay away from strategies with return prospects inherently based on leverage.
- As yields are extremely low globally, long duration sovereign bonds cannot be expected to provide the desired hedging mechanism going forward. They lack the desired convexity.
- We view gold as the primary portfolio diversifier, given the huge increase in money supply and surge in sovereign deficits. Negative real yields for many years seem the most sensible outcome to us.
