Waiting for a catalyst to break the limits

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Ahead of long weekends for the UK and US, several market barometers suggest limits have been established for now.

The current state of play is highlighted by the S&P 500 index unable to push beyond 3,000 points, while the 10-year Treasury yield sits below a ceiling at 0.75 per cent. The euro has retreated from $1.10 versus the US dollar after a brief foray above that level.

The market debate playing out against the long-term consequences of Covid-19 is framed by central bank and government support versus a pronounced decline in earnings this year.

Or as Robert Buckland at Citi notes, the bid for risk assets nurtured by $6tn of global monetary expansion versus the offer side of global earnings per share that Citi expects will contract by some 50 per cent this year:

For now equity markets, notably the S&P 500, reflect a view of a recovery in earnings growth in 2021, but much rests on what kind of recovery beckons from here. Yes, a bounce during the third quarter has scope for being eye-popping given the comparison point from a steep decline in economic activity during the spring. In conjunction with a smooth reopening of economies and minimal second waves of Covid-19, market ceilings should crack.

Firmer stocks, higher long-term yields and a weaker dollar are likely outcomes from better economic tidings. But it remains to be seen just how long activity takes before returning to pre-coronavirus levels and what the ultimate recovery path looks like for earnings, a long driver of equity performance. Many look at late 2021 as the best-case scenario for closing output gaps.

Against that backdrop, some worry that equities and credit are poised for a more testing time during the summer and Stuart Rumble at Fidelity International highlights the narrow leadership that has led the rebound in major share markets:

“Equity market performance is now at its narrowest since the 2008 financial crisis, with the rally riding on a dwindling number of large-cap growth stocks.”

Indeed, Bank of America provides this eye-popping figure:

“2,215 out of 3,042 global stocks remain in bear markets or 20 per cent below their all-time highs” at the moment.

Narrow leadership also troubles John Betteridge at Rowan Dartington:

“A sustainable recovery needs to be more broadly based, and ideally led by the cyclical sectors of the economy such as financials, consumer discretionary and industrials. Without a broad-based recovery in cyclical stocks, it is difficult to see anything sustainable in the recent recovery in stock markets.”

One counter to this view is summed up by Chris Iggo at Axa Investors Management:

“There is no easy answer to the question of what equity indices are at the right level given the economic outlook. I would argue that, as an asset class, I would rather hold a basket of US equities that had companies at the forefront of trends such as digitalisation and innovation in healthcare, than a basket of European equities with a large exposure to a challenged financial sector.”

Clearly the global economy needs all the help it can get at the moment and there’s a worrying tone from China and India.

China has abandoned a formal economic growth target for the first time, while the outlines of its stimulus suggests Beijing remains focused on curtailing excessive leverage in its economy and shoring up domestic activity. Not so good for the broader region.

Now many analysts have long noted that China’s rigid target for gross domestic product has encouraged a wasteful allocation of resources in order to meet such an objective. Given the massive growth in China’s economy in recent decades, there is less need for trying to hit a high target, which many economists doubt has actually been met in recent years. Focusing on quality long-term investment projects is ultimately a far better outcome for the country, particularly given the challenges that reflect the costs of the pandemic and its past efforts in boosting growth through debt.

Li Keqiang, the Chinese premier, did not sugar coat the task facing policymakers:

“Pressure on employment has risen significantly. Enterprises, especially micro, small and medium businesses, face growing difficulties. There are increasing risks in the financial sector and other areas.”

Mitul Kotecha at TD Securities writes that China’s focus on stimulating its domestic economy is not good news for the broader region:

“The implication is that the rest of Asia will not benefit much. The lack of a growth target also implies more flexibility for China’s authorities to accommodate a weaker growth path, which in turn suggests limited support for Asia.”

Economists at Citi noted that the scale of fiscal stimulus disappointed market expectations and they highlight less “central government special bond issuance, and the absence of new and stronger measures to cut value added tax and social security contributions permanently”.

In an unscheduled meeting, the Reserve Bank of India cut its benchmark interest rate by 0.4 points to 4 per cent and extended a loan moratorium by another three months. Such action from the RBI comes ahead of next week’s first-quarter GDP report, which is expected to show a weakening economy before the full force of the recent shutdown arrived.

Vishnu Varathan at Mizuho notes that an expected slide in the first quarter (to about 1.2 per cent year-over-year from a fourth quarter pace of 4.7 per cent) “reflects ongoing confidence, capital and credit deficit issues, which predated the coronavirus pandemic”.

Vishnu concludes:

“A much deeper contraction is likely in Q2, with economic gloom expected to persist for longer into 2020 as the seizure [of] economic activity compounds pre-existing fragilities.”

Quick Hits — What’s on the markets radar?

A little more market volatility was on display across Asia to end the week, led by Hong Kong equities sliding 5.6 per cent in the wake of China looking to take a firmer hand in the territory. That marked the worst one-day performance in almost five years for the Hang Seng index:

Line chart of  showing Hong Kong stocks dive on worries over China's new security law

Emerging market currencies are broadly weaker, with the US dollar benefiting from risk aversion. The renminbi remains shy of Rmb7.20 to the dollar for now, a level that matters for market sentiment and one to watch next week.

The winning streak for money market funds since late February has ended and EPFR notes some $1.2tn poured into the sector during the past 12 weeks:

Flows are still running into credit and BofA notes that $30bn of new money has entered high-yield credit funds during the past eight weeks, “reversing a $20bn outflow in February-March”.

When the Federal Reserve steps in and supports the market, buyers will return, while the prospect of more corporate zombies — companies running interest cover ratios below 1 — also grows.

Programming note

Market Forces will return on Tuesday. Thanks for your feedback this week and enjoy the weekend.

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