Stumbling into May after running too fast

The start of May, with a number of countries observing holidays, is being marked by a sharp retreat in global equities. This follows disappointing results from Amazon, Apple’s decision to withhold guidance for the current quarter and frosty US-China relations testing market sentiment.

Political tension between the US and China is flaring anew with President Donald Trump raising the prospect of deploying an old weapon: trade tariffs. The White House has squashed chatter of the US cancelling its debt with China, frankly the last thing the global financial system needs at this point.

Still, one of the ramifications of Covid-19 is an acceleration of the new cold war between the US and China. This year’s US presidential contest will be dominated by a China-bashing contest and upping pressure on companies that manufacture and/or sell goods and services across the Pacific.

For markets, the pressure shows up in the exchange rate. The offshore renminbi on Friday weakened 0.7 per cent to Rmb7.1269, its largest daily move since March (China along with much of Europe is observing May Day), although there are limits to such moves given the current macro backdrop.

Alan Ruskin at Deutsche Bank says “the broader US dollar uptrend has weakened with the Fed’s aggressive actions” and he suggests the renminbi can tag along. Or as he adds:

“It is easier to pursue a quasi-fixed exchange rate when the Fed has an accommodative bias, rather than when the Fed policy is tight.”

The worry is that political temperatures boil over, knocking markets. Under that scenario, a much stronger US dollar via a global risk-off trade, will only inflame White House hawks.

A bout of risk aversion, or at least a period of consolidation, animates the current conversation given the pace of stock market rebounds from March lows.

Mark Dowding at BlueBay Asset Management weighs up the risk-reward environment at the moment:

“Having started April looking for assets to rebound, we believe that selling strength and reducing risk may now be appropriate, on the view that there may be opportunities to add exposure at more attractive levels, should markets suffer a renewed bout of volatility.” 

BlackRock estimates that Fed asset purchases “through year-end will amount to near 28 per cent of the S&P 500 index market capitalisation or 20 per cent of the US Aggregate Bond index”. That’s a hefty backstop. But dire economic news can only be offset by central bank liquidity up to a point.

Thomas Costerg at Pictet Wealth Management says market sentiment is running ahead of the economic damage that lockdowns are inflicting. He thinks the US economy only returns to its late-2019 level by late-2021 or early-2022. Thomas says:

“The Fed is helping but it can’t offset all of the capital destruction.”

Over at Carmignac, the asset manager highlights . . . 

“ . . . the very fragile equilibrium sponsored by policymakers whereby risk assets valuations can remain elevated because there is enough confidence that the medium-term economic outlook will be very slow [and] which will justify enough ongoing monetary supply to support valuations”.

One equity sector that draws plenty of sustenance from a world of weak economic growth and ground-zero government bond yields is technology. Big tech has enjoyed quite a run during the pandemic, none more so than Amazon. A pullback is not surprising and also healthy given the performance of the S&P 500 versus an equally weighted measure of the benchmark, as shown below. This reveals just how the market has been driven by a narrow band of companies, with this year’s hefty rise previously seen in late 1999.

DWS notes that at some point such leadership will retreat, but for now the asset manager thinks tech titans still have scope to maintain their outsized influence, given how the coronavirus is accelerating broader economic and social trends. It notes:

“The triumph of technology stocks is not just a cyclical phenomenon but a trend that we believe is likely to extend over more than a decade.”

Tech also retains another important attribute: “balance-sheet strength”. And until the credit storm — still bearing down — passes with its downgrades, defaults and restructurings, any rotation from quality companies does appear shortlived.

Within the ranks of credit there is a divide between assets with and without a central bank backstop. Investment grade-rated companies are able to borrow (See Quick Hits), whereas others, arguably facing acute cash flow strains, are twisting in the wind.

Daniel Tenengauzer at BNY Mellon, highlights the IMF’s recent financial stability reports and notes a striking aspect about the US economy and the companies classified as “debt at risk” (where either interest payments are below earnings before interest, taxes and amortisation, or debt in companies with a speculative grade credit rating).

Daniel writes:

“In the US, a total of 64 per cent of small- and medium-size enterprise (SME) debt (as a share of GDP) is at risk. In contrast, large firms’ debt at risk is only 10 per cent of GDP. This demonstrates why the US Treasury and the Federal Reserve have been increasing efforts to support SMEs through various programmes.”

NFC debt: Speculative grade debt and debt-at-risk (ICR<1), % of GDP

Quick Hits — What’s on the markets radar?

The cash is piling up on the sidelines, waiting for a test of market lows or ready to power an equity cyclical sector upswing if there is no second wave of infections.

EPFR’s latest flows data reveals:

“Money market funds saw by far the biggest inflows in cash terms, taking in a net $91.5bn that pushed their total year-to-date over the $1.1tn mark.”

EPFR also noted net flows into the bond funds it tracks “exceeded $10bn for the third straight week going into May” and “flows into Europe bond funds hit a 30-week high and both US and global bond funds recorded solid inflows”.

Central banks have certainly encouraged inflows into bonds. Over at Bank of America, its analysts remind us that many are waiting for the Fed to show up, particularly as US investment-grade sales were a record $296.6bn in April, eclipsing March’s tally of $261.4bn. US IG debt sales so far this year are $807.1bn, the fastest start to the year ever, says BofA, which adds:

“Note to Fed . . . a lot of investors (including non-credit ones) have bought IG corporate bonds the past two months on the expectation they can sell to you. So would be helpful if you soon began buying broadly and in size.”

Chris Iggo at Axa Investment Managers outlines the risk-reward stakes for credit investors:

“A return to pre-crisis spreads over the next year in US investment grade would target a total return of about 10 per cent from here. For the European credit market, the same would be around 6 per cent and the UK, between 9 per cent and 10 per cent. This is the super-optimistic case as in reality it may take longer for spreads to narrow and there will be downgrades and defaults that will chip away at total returns in credit markets.”