Jumping into the next cycle

Steady progress on reopening economic activity and central bankers reiterating their resolve for doing “whatever it takes” in terms of stimulus, certainly bolsters the spirits of investors.

But hopes of a medical solution to a pandemic registers a lot higher as seen on Monday, on news that the first US Covid-19 trial for Moderna’s potential vaccine shows promise.

No matter the small scale of the trial, the news triggered a fresh bout of equity market optimism that economic activity is on a smooth upward trajectory.

This is illustrated by signs of a shift in momentum taking place within surging equity markets on Monday that propelled Europe’s Stoxx 600 higher by 4 per cent, while the S&P 500 added 3.2 per cent.

Alongside a firmer oil price, buoyed by expectations of Chinese demand returning to pre-Covid-19 levels, the latest rally is being distinguished by a rotation from recent equity winners, such as technology towards more economically sensitive sectors such as energy, banks, transports and small-caps (the Russell 2000 index was up 6.1 per cent). A virus-sensitive basket created by Citigroup and comprised of the airline, cruise ship and entertainment sectors among others, rose some 9 per cent.

An early run higher in the price of gold also withered and Treasury yields climbed (see Quick Hits) as risk sentiment built impressively during the global trading day.

Whether this marks the start of a sustained rotation within equities is very much a point of conjecture. Plenty needs to go right here. Certainly, a smooth resumption of activity in big countries will play an important factor in terms of ascertaining equity market leadership and breadth. Beyond that, the scale of damage inflicted by missed payments, defaults and bankruptcies still awaits assessment, a prospect for later this year.

Robert Teeter at Silvercrest Asset Management says:

“A key question for investors is whether the winner’s circle will remain largely the same or if winners begin to broaden out — a necessity if the economic outlook is to improve.”

Robert adds that so far this year, “a mere 90 stocks in the S&P 500 have delivered positive returns, while many others have declined significantly”. 

Narrow leadership to date across equity markets chimes with the message from low government bond yields and inflation expectations (Monday’s climb in Treasury yields still leaves benchmarks much lower on the year). These infer a modest and bumpy recovery that entails plenty of time passing before the current negative output gap closes for the global economy.

Under such an outcome, corporate earnings growth may well lag current expectations, but the rebound in price-to-earnings multiples has a powerful friend in low sovereign bond yields staying that way for a while courtesy of central bank policy.

Indeed, concerns from Jay Powell, chair of the Federal Reserve, that a recovery will take time entails a lot more support from the central bank, a prospect that nurtures bullish equity sentiment.

Here’s one interesting comparison of the market outlook for US interest rates from Morgan Stanley; expectations in May of 2009 reflected rates climbing whereas today, the outlook is flat.

For now, a wall of money flowing into the financial system, via central banks transcends the likely aftertaste of Covid-19 that includes rising missed payments, defaults and elevated levels of long-term unemployed workers.

Marc Ostwald at ADM Investor Services International points out that while central banks “may mitigate the worst seizures in terms of financial conditions, above all liquidity”, he adds such policies:

“Do not make companies or consumers any more solvent, and indeed exacerbate the ugliest aspects of corporate zombification and financial engineering that have been so evident since the global financial crisis.”

Plenty of stimulus and hopes for a vaccine are powerful drivers of equity and credit sentiment, but some think some prudence is required.

The last word for now rests with George Lagarias, chief economist at Mazars:

“We may be out of the previous cycle, but we are certainly not in a new one yet. As markets search for a new overarching positive narrative, we expect more bouts of volatility and believe that diversification is still an investor’s best defence against it.”

Quick Hits — What’s on the markets radar?

The prospect of more countries adopting negative interest rates is very much a topic of debate. Officials in the US continue to push back, but in the UK, the pound is under pressure and short-term rates are below zero. Andy Haldane, the Bank of England’s chief economist, said in an interview with the Sunday Telegraph that the central bank was “looking at” the option of cutting its key rate below zero.

Gold failed to sustain its push towards the recent peak of March, once Wall Street opened higher. Still, sentiment for the precious metal highlights concerns from central banks pushing hard on quantitative easing and keeping interest rates low for an extended period.

Or as Neil Shearing at Capital Economics notes:

“Another consequence of the crisis could therefore be that we’re entering an era of more active fiscal policy. And as central bank asset purchases continue to blur the line between fiscal and monetary policy, this could yet mean that deficit monetisation is the next taboo to be broken.”

The US Treasury market faces the first sale of 20-year bonds since 1986 on Wednesday. Ahead of new paper arriving and reflecting the general “risk on” tone, the yield on current 30-year bonds rose 14 basis points to 1.458 per cent, its highest level since March 20. TS Lombard highlight that the US market remains attractive for foreign-based investors. Treasuries are a “high yielder” among sovereign bonds and they also point out:

“Furthermore, for the first time in two years, FX-hedged US yields for Japanese investors have now turned positive, further enhancing the attractiveness of Treasuries.”