Thinking over relief, regret and satisfaction

Relief, regret and satisfaction define the range of emotions among equity investors at the moment. Global equities, led by the S&P 500, which on Monday entered positive territory for the year, have now climbed more than 40 per cent from their nadir in March.

As Tobias Levkovich at Citigroup explains:

“Those who held on to their equity assets have ridden the stock market rollercoaster and are almost back where they started, while those who sold are feeling upset and the ones who bought in the eye of the storm are richer.”

Massive stimulus and the gradual restoration of economic activity across many countries, leaves risk appetite relishing a “sweet spot” at the moment. This is highlighted by the recent leadership from small-cap stocks, cyclical value stocks, and emerging market equities and Northern Trust Wealth Management’s Katie Nixon says:

“It is important for investors to see confirmation across risk assets, commodities and credit spreads — all of these areas have repriced the possibility of a faster recovery.”

Falling coronavirus infection rates and incoming economic data that validate a rebound will only nourish current market sentiment and spur more investors to chase the rally in both equities and credit. This raises the prospect of a mutually beneficial dynamic for risk assets, with tighter credit risk premiums encouraging broader equity gains.

This type of price action does raise the prospect of markets further outrunning an improving underlying macro economy.

Rupert Thompson at Kingswood, the wealth management group in London, notes:

“Fear of missing out — and quite a few investors have missed out as the sharpness of this rally has caught most people by surprise — could yet carry equities higher near-term. But, with markets now well ahead of the economic reality, a correction remains on the cards over coming months.”

Many economist believe that a full recovery in terms of economies returning to their pre-Covid-19 levels remains a long journey. In contrast, upbeat market sentiment reflects the stimulus efforts of central banks plugging that gap for equities and credit. BlackRock compares lost national income across big economies with policy measures announced to date, via the following chart and they note:

“Once we factor in the spillover to the full economy, the fiscal policy response (dark yellow) globally falls short. Yet the situation improves when monetary policies (light yellow) are accounted for. This is especially striking in the US.”

Stimulus clearly counts a lot for current market sentiment and while this has driven a strong rebound in asset prices, Paul O’Connor at Janus Henderson highlights a couple of developments that in his view, “raise questions about the sustainability of the recent market surge”.

For example, there has been a sharp climb in the purchase of call options on equities. These derivatives become profitable when prices keep climbing and Paul adds:

“That looks like speculative froth, as does the sharp rise in US retail participation in equities in recent months.”

A notable jump in the activity of US retail investors has occurred during the shutdown of economies — which included casinos and sporting events. Citi links speculative trading with a surge in share volumes at the Nasdaq relative to Wall Street as shown here:

Another cautionary indicator is the level of equity market indices relative to analysts’ share price targets. This chart showing the MSCI World index divided by Bloomberg consensus analyst 12-month share price targets, sits at a new peak since the data began in 2004, according to Janus Henderson.

This means a strong recovery in earnings over the coming 12 months is essential for equities. And true enough, a V-shaped recovery is expected in earnings over the next four quarters when looking at what analysts expect for the S&P 500.

Analyst estimates for S&P 500 earnings for the third quarter ($32.01/share) and the final three months of the year ($36.72) “mirror 2017 and early 2018 S&P earnings power”, says Nicholas Colas at DataTrek.

Citi’s Tobias Levkovich says the present level of valuations — with a forward P/E at 20x for the S&P 500 — “leaves little to chance”. Expectations of a solid earnings rebound in 2021 also “assumes corporate tax rates do not move higher, which is dependent on the elections, not to mention easy sailing on Covid-19 containment plus vaccines that are ready to go”, he adds.

A deluge of corporate debt sales by companies raising cash to bridge the gap beyond Covid-19 also raises the importance of a robust earnings recovery. Analysts at Bank of America calculate that rising corporate borrowing this year will “add about 1.3x and 0.9x to gross and net leverage for IG companies, respectively, at the peak in 4Q20 compared with 4Q19”.

BofA expects companies will have scope to improve their credit quality once Covid-19 fades, but they do concede:

“There is substantial downside risk to balance sheets in the scenario where no vaccine is forthcoming for years and the economy has difficulties getting up to speed, in which case we expect companies to again scramble for liquidity at times and increase indebtedness.”

In the near term, robust equity and credit sentiment may soon be tested by rising long-dated government bond yields. Earnings multiples are flattered by low bond yields, but this relationship cuts both ways. There is plenty of attention on whether the US 10-year Treasury yield breaks above 1 per cent. This week’s meeting of the Federal Reserve may well decide the matter for the bond market.

To some degree, a further rise in the 10-year yield would likely accelerate the current rotation towards cyclicals and global equities versus an S&P 500 that is weighted a lot more towards tech and healthcare. A sharp rise in 10-year yields has in the past trimmed appetite for tech and other growth sector shares and as BCA Research remind us:

“The market heavyweight, the tech sector, is very sensitive to higher yields due to its valuation premium.”

The equity team at Morgan Stanley note that the 10-year Treasury yield remains well below their cyclical/defensive equity ratio and add there is scope for a sharp rise from here in the benchmark yield. Such a move would likely knock equity sentiment in the near term, but Morgan Stanley’s analysts think there is a silver lining from an upward adjustment in the 10-year yield, namely affirmation that the economy is rebounding and the pace will surprise to the upside.

“Equity markets have been telling us growth is going to surprise on the upside. Rates markets have lagged but could catch up quickly.”

And any correction in equities in their view represents “an opportunity to add to risk, especially in the more economically sensitive areas that have been leading”.

So that may provide those nursing a sense of regret with an opportunity to broaden their exposure to equities.

Quick Hits — What’s on the markets radar?

Oil prices are retreating, although Brent crude is holding above $40 a barrel after this weekend’s meeting of big producers.

Helima Croft at RBC Capital Markets says there remains unresolved issues for the market.

“While the errant producers such as Iraq and Nigeria have vowed to reach 100 per cent conformity and compensate for prior underperformance, we still think they will probably continue to have some commitment issues over the course of the summer. The potential return of Libyan output could also cause considerable challenges for the Opec leadership.”