Negotiating demand shocks

A bounce in crude oil prices has bolstered risk sentiment on Wednesday, but the scale of the demand shock hitting the global economy is highlighted by the bleak message from commodity prices in general.

A benchmark of raw material prices (via the CRB index) plumbing fresh lows this week, chimes with falling expectations of inflation and long-dated Treasury yields. Combined with the recent strength of the dollar, the message is one of intensifying global disinflationary pressure. Unless these barometers reverse fairly soon, pressure on risk sentiment will steadily tighten and challenge profuse central bank liquidity.

The bottom line here is that a delicate balance remains the story for investors and markets until a clearer assessment of the world beyond Covid-19 fully materialises.

Paul O’Connor at Janus Henderson makes the point that risk assets are protected to some extent from testing their lows of March by “cautious investor positioning and the extraordinary liquidity support from central banks”.

The trouble is that a stronger recovery in markets, led by economically sensitive sectors, commodities, transports and industrials among others, requires compelling evidence that global activity will accelerate in the coming months and not become derailed by another wave of infections or bouts of financial turmoil. Central bank liquidity has tempered financial markets to a degree, but official support will not prevent a wave of downgrades and business failures. Ultimately, not good news for the taxpayer and the prospects of a future recovery. 

Among the doubters, TS Lombard observes:

“Equities remain short of pre-Covid levels for good reason — even the most optimistic investors are more uncertain than they were before the crisis. And with current valuations unsustainably high, the market will drop sharply yet again, irrespective of Fed actions.”

The case for optimism rests on the view that current deflationary pressure is shortlived. The lows in commodity prices reflect a pretty hard landing and there is scope for considerable upside should demand return ahead of expectations. Plenty rests on signs of Chinese appetite for raw materials picking up, but not only are there signs of a reticence among China’s consumers, global demand has collapsed too. 

Still, analysts at BCA Research argue: 

“China is aggressively easing monetary, credit and fiscal conditions, which will prop up domestic demand. Moreover, the strength in the USD should ebb this summer. As a result, deflationary bets, such as lower commodity prices or bond yields are long in the tooth.”

The signal to watch, they argue, is when gains in the CRB index outpace those of gold as “stimulus seeps through to the real economy”.

That’s what the equity market needs to see, or a test of last month’s lows will eventually arrive. Notably implied volatility for the S&P 500, still remains above 40, double the long-term average of the Vix. 

Quick Hits — What’s on the markets radar?

Another important factor influencing market sentiment is whether the meeting of EU leaders on Thursday starts to close the spread, or arrest rising yields for Italy and other non-core eurozone countries versus German Bunds. Italy’s 10-year yield has risen north of 2.7 percentage points over the Bund this week (not far from last month’s peak of 2.8 percentage points). Spain’s 10-year sits 1.51 percentage points above that of Germany, its widest closing point since June 2016 according to Tradeweb.

This reflects worries about the long-term sustainability of debt among the weaker economies in the region. True, Italy and Spain have both sold long-dated bonds in recent days and attracted record demand, but the high cost of their debt (within the eurozone) is problematic for each country.

In the case of heavily indebted countries such as Italy, facing a deep contraction in activity (and likely to see debt to GDP rise beyond 150 per cent), bond investors clearly want some long-term assurance from EU leaders. Servicing hefty debt requires very low yields and that is not the case for Italy and others at the moment as this chart from Morgan Stanley highlights:

This higher premium being sought from investors for certain eurozone debt constitutes an early warning sign that cuts across the European Central Bank’s Pandemic Emergency Purchase Programme. The PEPP has a €750bn limit and that is likely to be increased at some point. But like any emergency policy it will expire and leave debt markets for the likes of Italy at the risk of serious turmoil. 

There is also the prospect of Italy receiving a sovereign rating downgrade from S&P on Friday. After a meeting of the governing council late on Wednesday, the ECB opened the door to accepting lower-quality or non-investment grade debt. But a step closer to a speculative rating for Italy stands to exclude some investors from buying the country’s debt.

Nothing concrete is really expected from tomorrow’s EU meeting and the question is really whether soothing words can paper over the schism between north and south, with France trying to resolve matters.

Analysts at Morgan Stanley note that the EU council meeting “is also discussing the EU’s medium-term budget” and they add:

“It would not be surprising if the recovery fund becomes part of this discussion by asking the Commission to create some room in its budget to launch it and even granting the Commission modest room for issuance of euro bonds. This would not be as ambitious as proposals by France and Spain, but a modest start is at least a start.”

Shareholders of UK banks need little reminder about how badly the sector has performed this year. As shown here via AJ Bell, the FTSE All-Share Banks sector is down more than 40 per cent versus a 35 per cent decline for a global measure of lenders.

AJ Bell’s Russ Mould says UK banks face the “risk of increased losses on their lending at a time of great economic uncertainty” as the government pushes the sector to lend and roll over existing loans to companies and individuals. 

In turn, little surprise that leading UK lenders trade very cheaply and at a discount to their price to book. Russ adds:

“Investors have real doubts as to whether banks’ return on equity will ever consistently exceeds their cost of capital. This is understandable in a zero interest rate world where regulators are dictating who can pay dividends, customers are being given interest payment holidays, the IMF is recommending debt forgiveness for emerging markets and governments are urging them to offer cheap loans to keep the economy going.”

Value investors likely sense an opportunity, but a prolonged recovery process from shutdowns will contain any share price bounce in beaten down banks. As will an extended cycle of low yields capped by central bank policy.