Sentiment congeals in a slow simmer

A more confrontational tone between Washington and Beijing shapes up as another challenge for global equity markets. Wall Street showed some resilience on Monday, with big tech playing its familiar supportive role, but after a strong rebound since late-March, risk sentiment has scope for a broader retreat.

A global pandemic and the extraordinary efforts of governments and central banks have overshadow a tense US-China relationship in recent months. With the easing of lockdowns in big western economies under way, or at least nearing that starting point, market sentiment faces challenges beyond a hotter political temperature among the two leading powers.

Russ Mould at AJ Bell sums up the mood:

“April was a month of recovery for the markets, with several major indices enjoying double-digit gains. The start of May has been less promising and investors will be left pondering if the month will see an acceleration of the recovery, consolidation of the ground won back or capitulation.”

In the near term, much rests on whether Beijing tolerates a weaker renminbi, when the country ends its current holiday. The offshore currency weakened to a six-week low of Rmb7.1555 to the dollar on Monday, before easing back a touch.

Christopher Dembik at Saxo Bank says the Rmb7.15 level “has become a line in the sand for investors all around the world and, if broken, it could signal that China is ready to let go further its currency which would have very negative implications for risk assets”.

During the trade war of 2019, periods of equity weakness proved shortlived as investor sentiment pushed against a damaging confrontation that would hurt both countries (central bank easing also helped). Now more than ever, both the US and China need to nurture their respective economic rebounds from Covid-19.

Christopher Smart, chief global strategist and head of the Barings Investment Institute, downplays the heated rhetoric and thinks:

“Fundamental differences between Washington and Beijing will not disappear, but the rivalry may seem less immediate and consuming as the two governments turn to the task of rebuilding their battered economies.”

Another simmering situation for investors is the divide between rebounding equities (reflecting expectations of a second half economic recovery and also hefty support from central banks and government), and other markets. The message from commodities and government bond yields, alongside still wide credit risk premiums in high yield, suggests less optimism.

A more protracted recovery in economic activity or the rise of secondary infection waves over the summer means that a recent rotation towards cyclicals, value sectors and small-caps (during late-April), may have been a case of jumping a little early.

Lena Komileva at G+ Economics throws some cold water at market expectations of a transitory pandemic shock and a quick recovery in the second half of 2020:

“A persistent recessionary financial tail risk through a surge in corporate credit downgrades, SME defaults and bank losses, once economic visibility is restored after the lockdowns, will necessitate a continuous active interventionist risk-management approach on the part of central banks.”

This comes when Wall Street, buoyed by its extensive tech and healthcare leadership, sits near a crucial level. Analysts at Bank of America note that a rebound of nearly one-third from late March has yet to push the S&P 500 beyond its 200-day moving average at 3,005 points and they observe:

“In theory, a rally toward the 200-day MA from below is a bear market rally.”

Over at BCA Research, it notes the S&P 500, which has benefited from hefty monetary support, would not take kindly to more help from the Federal Reserve:

“The Fed is unlikely to significantly ease policy further, unless the economy deteriorates much more, which would most likely happen if a second wave of infections is severe enough to force greater mass closures. The S&P 500 would not respond well in that scenario.”

Even under a scenario of a slowly reopening economy, backstopped by the Fed’s already hefty support, a more likely outcome says BCA is one where, “over the course of the coming months, equities are more likely to churn than to continue their furious rally as they digest their recent gains”.

Quick Hits — What’s on the markets radar?

The oracle sends a blunt message to airline shareholders. Warren Buffett sticks with companies for the long haul and over the weekend, his announcement that Berkshire Hathaway had sold its entire stakes in four US carriers, was not good news for the sector. American Airlines, Delta and United, led the worst S&P 500 performers, with hefty declines. Hardly soothing, Steven Mnuchin, the US Treasury secretary, said that it was “too hard to tell” if the US would loosen international travel restrictions affecting Asia and Europe this year.

Sales of US Treasury debt are certainly heading higher, with the latest quarterly borrowing announcement due on Wednesday. The Treasury said on Monday that it plans to borrow a record $3tn for the current quarter and $4.5tn for the fiscal year.

At about 0.63 per cent, the US 10-year Treasury yield loiters near the lower-end of its recent range from 0.54 per cent to 0.78 per cent.

Ian Lyngen at BMO Capital Markets argues:

“Ballooning Treasury issuance figures are no cause to assume a sustainable back-up in outright yield levels — if for no other reason than the decided downward skew to the inflation outlook. To say nothing of the medium-term risks to real growth and, of course, the Fed’s participation in the secondary Treasury market via QE purchases.”

Wrightson Icap anticipates a rise of $2bn each month in the gross size “in most Treasury auction cycles” for the rest of this year and beyond. They estimate that while the annualised run rate of gross Treasury coupon issuance will rise “by more than $1tn in CY 2021”, the amount of “net quarterly borrowing totals won’t rise above their 2009 peak until the fourth quarter of this year”.

This week’s Treasury announcement cannot ignore the role of the Federal Reserve and its open-ended policy of buying government debt via quantitative easing.

Here Wrightson note that the Treasury may be mindful of upsizing auction sizes in the coming months towards longer-dated maturities:

“An overly aggressive ramp-up in gross offerings might be self-defeating if it forced the Fed to step up its open market purchases to preserve market liquidity.”

An alternative approach and one that Wrightson flags is that “the authorities could decide that the Treasury might as well take advantage of the Fed’s purchases to boost its offering sizes sooner rather than later. We would put a low probability on that outcome, but we are long past the point of ruling out anything in this environment.”