Bonds and equities paint a contrasting picture

Capitulation defines a bottom in markets and for all the recent turmoil, extreme revulsion towards equities has been absent. This also applies to government bonds and the pronounced slide in US Treasury yields and other benchmarks can run further before risk aversion sentiment finally abates.

This backdrop is troubling for investors, particularly the jarring image of a 10-year Treasury yield below 1 per cent, (while a barometer of future growth prospects, the 10-year real yield sits at minus 0.49 per cent) versus an S&P 500 that has only registered a decline in the region of 12.5 per cent from peak to trough in recent weeks.

The risk of a bigger economic hit and deflationary pressure as suggested by government bond yields cannot be ignored by equity and credit investors. S&P Global Ratings now believes the US economy will bump along at a pace of 1 per cent during the first and second quarters of the year, having previously been expected to rebound from April. The rationale for this week’s emergency rate cut from the Federal Reserve is clearer after the latest Beige Book (a record of conversations with local businesses up to February 24) revealed pressure in US manufacturing and tourism.

In that light, Wednesday’s bounce in equities smacks a little of whistling past the graveyard as the economic picture and what that entails for corporate profits remains opaque. The focus on credit strains remains appropriate and for good reason. Oxford Economics note the recent rise in risk premiums for credit and note:

“Declining earnings expectations and tightening credit conditions are likely to raise question marks over companies’ ability to service their debt and could lead to a significant degree of corporate distress in the worst-case scenario.”

For a very good read on credit, the FT’s John Plender has written a superb piece on Wednesday, the seeds of the next debt crisis.

The current backdrop heightens the prospect of rolling bouts of market turmoil and relief until lows are firmly established for equities. At the bare minimum, a test of the recent nadir in leading equity benchmarks beckons, while scope for new lows is not out of the question before the tide finally turns.

Tobias Levkovich and the equity team at Citi note:

“The inability to properly calibrate the Covid-19 effect on investor sentiment and GDP represents more uncertainty, which is something that market participants do not like. We believe that this incalculable factor has left fund managers adrift, but they have not given up hope that the virus is a passing nonrecurring phase. Our sense is that capitulation is a requirement for a sustained rebound in the S&P 500.”

Of note is that among the best S&P 500 sectors on Wednesday are healthcare (Joe Biden’s impressive Super Tuesday performance is a tonic for that group) and the defensive areas of real estate, utilities and consumer staples. The cash-rich tech sector is also finding buyers. Across the pond, utilities and healthcare top the leaderboard for the Euro Stoxx 600. 

Lori Calvasina, head of US equity strategy at RBC Capital Markets, pinpoints the absence of true capitulation by equity investors as Wall Street remains above its late-February low. Lori adds: 

“We haven’t yet seen signs of extreme bearishness among institutional investors or retail investors.”

She advocates watching the American Association of Individual Investors’ sentiment survey, which captures retail investor outlooks and which recently pegged bearish sentiment at 39 per cent, shy of “moves into the 40%–50% area have been common before bearishness tops out”.

At the margin, Joe Biden’s resurrection in the Democratic primary race and expectations of further central bank support (the Bank of Canada on Wednesday cut rates by 50 basis points to 1.25 per cent) are a modest tailwind for equities. That can easily ebb should a deeper economic shock register in the coming weeks.

That will spur another rate cut from the Fed and as BCA Research write:

“If the outbreak continues to worsen after March, then the Fed will be forced to cut rates to zero as a recession will become a near-certainty.”

But other support measures beyond rate cuts are required, namely sustaining credit for small and medium business operations as they face the biggest hit from a supply and demand shock. As Pimco reminds us:

“Small to midsize companies, which account for about 70% of US employment (according to ADP), are particularly sensitive to tighter credit conditions and slower growth.”

Nicholas Colas at DataTrek sums up the current equity mood: 

“Markets understand the Fed is running low on ammunition, so this vector for juicing equity prices is close to its end point; what’s left now is for the Fed to flex bank regulatory policy to ensure adequate capital to businesses temporarily affected by Covid-19.”

Quick Hits — What’s on the markets radar

The ‘Bern’ is moderating and healthcare stocks are relieved. That’s the market upshot after Super Tuesday was a win for Joe Biden versus early frontrunner, Senator Bernie Sanders. With Mike Bloomberg dropping out of the race and backing Biden, the former vice-president’s hopes of securing the Democratic party nomination are looking far more promising. But plenty of primaries beckon, as shown below, and Sanders will fight hard all the way for delegates to the convention in July.

Democratic Primary Race

Capital Economics reminds investors that while Biden is the equity market’s preferred candidate over Sanders, a challenge looms, even from a moderate Democrat:

“While Biden’s platform is much less radical than some of his rivals’ (and he would most likely take a less confrontational approach to trade policy than Trump), he still plans to raise the corporate tax rate, expand public healthcare provision, and strengthen antitrust enforcement. So if he ends up beating Trump in November, that would probably send the stock market down (although by much less than if Sanders won the presidency).”

Among financial market havens, exchange operators such as the CME, ICE (which runs the New York Stock Exchange), Nasdaq and Cboe stand out. Heightened market volatility and surging trading volumes explain their appeal at the moment, and analysts at KBW note that “US exchanges still have some room to outperform” in a risk averse environment. But they caution: 

“The US exchanges (ICE, CBOE, NDAQ, CME) are currently trading at an average premium to the S&P 500 of 40%, which is above their 3-yr historical average of 30%.”

Oil prices are climbing off the canvas ahead of Opec and its allies announcing a hefty cut in supply by another 1m barrels per day at this week’s meeting in Vienna. With Brent crude near $53 a barrel, the crude benchmark remains well adrift of its January closing peak of $69.02. 

Jane Sydenham, investment director at Rathbone Investment Management, says a further reduction in pumping crude “would mean total recent supply cuts of over 3.1 million barrels of oil per day”:

“[That is] equivalent to the production cuts made during the financial crisis in 2008. It’s a significant reduction in oil supply which should help to prevent the price of oil sliding any further.”

Whether that does the trick and keeps crude above $50 a barrel remains the wild card for the oil industry and also for investors trying to gauge signs of a peak in the growth shock from the coronavirus. 

Ole Hansen, head of commodity strategy at Saxo Bank makes this observation: 

“The behaviour of safe-haven metals such as gold and pro-cyclical commodities such as energy, which depends on growth and demand, remain much better guides than the stock market.”