May 2020 Market Commentary: Digging Out Of A Deep Hole

Summary

• Global stocks continued their 2nd quarter recovery from the steep 1st quarter sell-off.  Global markets as represented by MSCI All-Country World Index, or ACWI, were up 4.3% in May.
• Despite some early month weakness driven by cautious comments from famed investors (Warren Buffett, Stanley Druckenmiller, David Tepper), global equities rallied over positive COVID-19 vaccine developments.
• Europe and Japanese markets performed well over increased pandemic relief measures.
• U.S. small caps had briefly outperformed large caps up until the last week when the markets had pulled back due to the escalating tensions with China.
• Fixed income posted another positive month,helped by the continued recovery in corporate credit and mortgage-backed/asset-backed sectors.

Data Source: Bloomberg

COVID-19 (Coronavirus) and Digging Out of the Deep Hole

Source: istockphoto.com

"A friend once observed that if you dig yourself a deep hole, and emerge partially, you are still in a deep hole. It will be a while before we are back on level ground." - Northern Trust Weekly Economic Commentary, 6/1/2020

The above quote comes from Northern Trust's economics team, who are adopting a cautious tone when it comes to interpreting recent improvement in economic data and activity as investors look for signs of a recovery from the coronavirus-driven global recession. Whether an uptick in air passenger traffic, improvements in manufacturing/business sentiment, or a slowdown in U.S. jobless claims, such positive 'changes-at-the-margin' need to be soberly viewed within a context of a COVID19-driven deep hole economic contraction with US Q2 GDP expected to decline at an annualized rate of 50% (according to the latest GDPNow forecast) and the U.S. unemployment rate expected to reach 20%. The sudden and sharp decline in economic growth, not seen over the post-World War II period, is a hole that will likely take years to dig out of.

So, where are we seeing improvements at the margin even if these measures still remain deep in the hole? Transportation (air, car, train) activity is picking up both in the U.S. and China. Figure 1 displays an interesting chart that combines Apple (AAPL) mobility signals with gasoline usage as a lagged variable. Such tracking data appears to be pointing towards a recovery, although this will be influenced by the level of shelter-in-place rollbacks at the state level. Similar upticks in activity can also be observed across China, although China is seeing a rise in new COVID-19 cases.

Figure 1 - Tracking Data Points Toward a Recovery in Auto Transportation Usage

U.S. small business sentiment also seems to be improving as the percentage of businesses reporting negative impacts from COVID-19 has been trending lower (again, this begs the question on whether conditions 'worsening' is an actual tangible sign of improvement). The fact that 40% of Paycheck Protection Program (PPP) funds are still available could also be interpreted as a positive sign that fewer businesses are in need of emergency relief (or it could indicate a growing distaste of the conditions attached to the program and frustrations over lengthy delays in loan processing). Unemployment benefits are also clogging up as state employment offices are finding it difficult to process the surge in claims.

Figure 2 - Tracking Data Points Toward a Recovery in Auto Transportation Usage

Finally, Figure 3 displays an improvement in credit card transactions, suggesting we've seen the full extent of the coronavirus pullback in U.S. consumption.

Figure 3 - Credit Card Transactions Indicate Possible Recovery in Consumer Spending

The fact that the world remains in a deep hole (and getting deeper across emerging markets still experiencing a rise in active COVID-19 cases such as Brazil and India - see below), that's not to outright dismiss emerging green shoots of a recovery as 'things getting better' (at least in the U.S. and Europe) is obviously preferred to the opposite. Capital markets have been outright giddy following record amount of fiscal and monetary stimulus to provide stopgap relief for those affected by the coronavirus. In particular, the U.S. stock market has almost dug out of its own bear market hole, helped by megacap momentum darlings epitomized by U.S. technology and communication growth stocks (i.e. FAAMG). The S&P 500 has clawed back almost three-fourths of its 30% bear market drop from mid-March, while the Nasdaq 100 is now up almost 10% YTD through the end of May. As soon as it became clear the U.S. government and monetary authorities would pull out massive bazookas to arrest the mid-March sell-off, investors have been 'buying the panic' but have yet to 'sell the relief'.

Credit goes to the equity markets that were well ahead of commodities and fixed income in betting that the world would not spiral down a deflationary hole. Historically, it's been the other way around as credit markets and commodities sniff out a recovery earlier than the equity markets. Bearish investors believe a deflationary outcome is still possible and too early to dismiss, but this outcome is far from a baseline expectation of a recovery, should it eventually materialize. Equities had buckled earlier in the month over cautious comments from famed investors Warren Buffett, Stanley Druckenmiller and David Tepper.

But assuming economic conditions don't worsen, whether it's a V-shaped recovery or an L-shaped recovery seems to matter little at the moment; investors are glad that economic conditions do not appear to be getting worse and care little whether corporate earnings growth recovers next year or the year after. Global equity market valuations (Figure 4) have surpassed the post-2008 financial crisis levels as investors are increasingly certain that an earnings recovery is just around the corner. At just under 22 times earnings projected over the next 12 months, the S&P 500 seems especially rich, but it's anyone's guess as to what the proper multiple one should pay for a market enjoying high corporate profitability and historically low interest rates.

Figure 4 - Global Market Valuations at or Surpass Post-2008 Highs

Sharp stock rallies have mostly occurred around positive developments concerning potential COVID-19 treatments (Gilead's (GILD) Remdesivir) and vaccines (Moderna (MRNA)). Moderna's possible success in formulating a COVID-19 vaccine could be a game changer for helping the world move past the pandemic and further ease the shutdown. The company's announcement did not come without controversy as its release of early phase one trial data coincided with an equity raise. However, NIAID Director Anthony Fauci expressed cautious optimism at a CNN town hall in the middle of the month. Moderna announced that it entered its phase two trial for the coronavirus vaccine. Travel and leisure-related stocks have seen sharp rallies as they now trade with a high beta to positive COVID-19 developments. Investor spirits were also lifted with the successful launch of SpaceX Dragon carrying NASA astronauts to the International Space Station.

Fixed income and commodity markets have been fixated over issues of 'insolvency,' while equity markets are mostly focused on 'liquidity' figuring that the global fiscal and monetary response to COVID-19 would open up frozen capital markets and provide enough bridge financing for Main Street businesses to traverse the economic chasm. That and the fact that investors are betting on large cap 'winners' (technology growth, stay-at-home beneficiaries) and investment-grade borrowers' abilities to take advantage of the new issue market now backstopped by the Federal Reserve.

As the fixed income market relishes the renewed liquidity support provided by the Fed, the new issue window has turned into a 'haves' versus 'have-nots' as investment grade borrowers were able to raise $50 billion from new bonds sales by the middle of the month. Despite some high-profile bankruptcy filings (Hertz Global, J.C. Penney, Stage Stores, Intelsat) and intramonth weakness in airline bonds, lower quality corporate spreads (Figure 5) continued to narrow from the mid-March highs, although remain well above pre-COVID levels.

Figure 5 - Corporate Credit Continues to Rally as Spreads Narrow Further from Mid-March Highs

However, as investors grow increasingly positive on the economic backdrop, the new issue market is expanding for less credit worthy borrowers. Figure 6 displays an acceleration in below investment-grade new issuance, far exceeding the pace set in 2018 and 2019.

Figure 6 - High Yield (Below Investment-Grade) Borrowers Take Advantage of Fed Support as 2020 Issuance Exceeds Pace Set in 2018 and 2019

Whether corporations will use this as an opportunity to deleverage and raise buffer capital for the next downturn remains to be seen as overall corporate leverage continues to rise (Figure 7). This may turn lower once corporate profitability returns, but corporations may see the low nominal debt cost of capital as too tempting to forego.

Figure 7 - Corporate Financial Leverage Continues to Trend Upward, Not Downward

One thing appears to be certain - the Federal Reserve's tool set appears to be without limit so long as the U.S. dollar remains the reserve currency of choice. Although Fed officials have dismissed the prospect of pursuing negative interest rate policies (unlike their counterparts in Europe and Japan), the Fed's emergency lending and capital market support measures have helped restore capital market liquidity, resulting in higher equity valuations and lower corporate credit spreads to U.S. Treasuries. The Fed's balance sheet (Figure 8) has now surpassed $7 trillion or 30% of U.S. GDP, and this month saw the Fed buying corporate bond exchange-traded funds (ETFs) with its secondary credit funding facility for the first time. There are still some areas that have yet to recover, such as lower grade municipal debt, but fixed income credit spreads have been trending lower throughout the second quarter.

Figure 8 - U.S. Federal Reserve Balance Sheet Has Surpassed $7 Trillion as the Fed Purchases Corporate Bond ETFs for the First Time

Source: Bloomberg

The U.S. is not entirely out of the woods yet. Both the U.S. and Canada are expected to see some of the highest unemployment rates among developed countries (Figure 9).

Figure 9 - U.S. and Canada Expected to See Unemployment Rates Around 20%

And while the credit markets have reopened for corporate hungry borrowers, there are troubling trends emerging among Main Street borrowers as indicated by bill payment delays (Figure 10) and rising U.S. bankruptcy filings (Figure 11) to levels not seen since 2009.

Figure 10 - Consumer Survey Indicates High Likelihood of Bill Payment Delays

Figure 11 - May 2020 Sees Large U.S. Bankruptcy Filings Since 2009

Rising Political Tensions (China, U.S. Protests Over Police Brutality)

Bears may also accuse bullish investors of whistling past some troubling developments as U.S. China relations continue to deteriorate following the COVID-19 outbreak, and several U.S. cities are facing mounting unrest over the police killing of George Floyd's death in Minneapolis, MN, prompting the Trump Administration to formally label ANTIFA as a terrorist organization, whom many blame for the bulk of the rioting and damage.

Overshadowing positive COVID-19 developments is the increased geopolitical tensions highlighted by the deteriorating relations between the U.S. and China. At the annual National People's Congress, the Chinese Communist Party passed national security legislation for Hong Kong, bypassing Hong Kong's legislature, which could threaten to remove local freedoms and lead to renewed protests. Hong Kong's stock market sank on the news amid the uncertainty over the city's future and the potential for more asset outflows. When asked about the legislation, President Trump pledged to respond "very strongly."

And we're starting to see how the administration is responding as Secretary of State Mike Pompeo declared that Hong Kong "is no longer autonomous from China," the key statement headlining the annual assessment of the special trading relationship with Hong Kong. This has set the stage for the Trump Administration to no longer treat Hong Kong as autonomous, which could remove preferential treatments (i.e. lower tariffs on Hong Kong imports versus China) across both travel and trade. The U.S. is also contemplating sanctions on Chinese government officials involved in the security crackdown in Hong King. As of the time of this writing, China's retaliation appears to be measured although it is reported that China reduced their imports of U.S. soybeans. China has also threatened retaliation by targeting U.S. companies that have significant exposure to China (i.e. contracts with Boeing (BA), Apple/Starbucks (SBUX) retail), such as adding them to China's "unreliable entity list" as well as increased regulatory scrutiny.

According to some political analysts, China's political leadership feels "threatened" by the COVID-19 crisis where the Communist Party had to drop economic growth targets for the first time amidst rising unemployment and declining global trade. China would rather crack down on Hong Kong as a potential subversive threat than maintain it as a key financial/trading hub, unconcerned about the political and economic consequences should the U.S. and other industrialized countries retaliate. This latest flareup will likely accelerate the downward in U.S./China trade activity as Chinese percentage of U.S. imports continues to drop (Figure 12).

Figure 12 - China's Share of U.S. Imports on the Decline

Source: Bloomberg and Bear Traps Report

Without jeopardizing the Phase 1 Trade Agreement, the U.S. is trying to squeeze China on other fronts. Additional measures against China will likely affect areas covering technology (restrictions on purchases for security purposes) and capital markets (divestments from the Federal Thrift Savings Plan, delisting of Chinese companies from U.S. exchanges, removal from global benchmarks). The U.S. Commerce Department is seeking to block shipments of semiconductor components to Chinese telecom equipment provider Huawei Technologies. The U.S. is also 'encouraging' device manufacturers to 'decouple' from China and in-source supply production back in the U.S. - Taiwan Semiconductor (TSM), a major supplier to Apple, announced plans to build a plant in Arizona.

Better News Out of Europe and Japan

Europe and Japanese markets performed well over increased pandemic relief measures. Japan led the rally among Asia-Pacific stocks as Prime Minister Shinzo Abe announced that the state of emergency will be lifted in a handful of prefectures, signaling progress in the country's lifting of economic quarantines. Investors are also hopeful over Novavax' (NVAX) vaccine developments on the back of Moderna's efforts. Japan is also expected to see some recovery in trade activity with China following the latter's economic recovery.

In Europe, EC President Ursula von der Leyen proposed an increase in the EU's budget (known as the multi-annual financial framework) of 750 billion financed by jointly issued debt among member countries. All 27 member states need to approve the scheme, but investors are hopeful that this lays the groundwork for increased joint-funded fiscal support for countries hard hit by the coronavirus. Much of this funding will come in the form of grants rather than loans that need to be repaid. It could also lay the groundwork for a fiscal backstop to support the euro. The euro strengthened against the dollar following the announcement (Figure 13).

Figure 13 - The Euro Strengthens Against the U.S. Dollar Following EU Pandemic Relief Plan

COVID-19 Update

Figure 14 displays the worldwide active cases of COVID-19 as of 6/1/2020. Figure 15 displays the share of new cases by region. Note that South America (primarily Brazil) comprises the bulk of new cases, while Europe is experiencing the largest share decline of new cases. Figure 16 presents some positive data on expanded testing within the U.S. coinciding with a decline in net positive case results.

Figure 14 - COVID-19 Cases Worldwide

Figure 14 - Share of New COVID-19 Cases by Region

Figure 15 - Increased Testing Coinciding with a Decline in Positive Results

3D wants to emphasize the importance of aligning client time horizons and risk profiles with the appropriate asset mixes (stocks, bonds, alternatives) and not to be overly swayed by the daily/weekly market moving headlines. There could be more turbulence ahead until the markets get more clarity on coronavirus medical advancements and the timetable for an economic recovery.

May 2020 Market Review

Global stocks continued their recovery from the steep 1st quarter sell-off that saw the S&P 500 enter deep bear market territory for the first time since the 2008 Financial Crisis. Despite some early month weakness driven by cautious comments from famed investors (Warren Buffett, Stanley Druckenmiller, David Tepper), global equities rallied over positive COVID-19 vaccine developments and signs of an early economic recovery. MSCI All-Country World Index or (ACWI) returned 4.3% for the month. MSCI Japan led all major regions (Figure 16) up 5.9% followed by U.S. Stocks (S&P 500) up 4.8% and MSCI Europe up 4.6%. MSCI Emerging Markets (+0.8%) and MSCI Asia ex Japan (-0.3%) were notable laggards as the region suffered from the China's initiative to impose a security crackdown on Hong Kong.

Figure 15 - Japan and U.S. Equities Led the April Recovery While Europe and Japan Lagged

U.S. small caps had briefly outperformed large caps up until the last week when the markets had pulled back due to the escalating tensions with China. S&P 500 returned 4.8%, while the S&P 600 returned 4.3%. Growth stocks continued their outperformance over value stocks as S&P Pure Growth returned 8.3% versus 3.0% for Pure Value (Figure 16).

Figure 16 - U.S. Large and Growth Outperform Small Cap and Value

Energy gave up some of its April outperformance and ended up as the one of the worst performing sectors despite the strong rally in commodities. Overall, growth sectors such as Technology and Communication Services led sectors as did traditional cyclicals such as Materials and Industrials while defensive sectors (Staples) and Financials/Real Estate lagged (Figure 17).

Figure 17 - Growth Sectors (Technology, Comm Services) and Traditional Cyclicals (Industrials, Materials) Led in May

Among factors, Momentum and High Quality outperformed Minimum Volatility, Value and High Dividend (Figure 18). Momentum and High Quality are increasingly overlapping with one another, reflecting investor preference for premium growth stocks.

Figure 18 - High Quality and Momentum Lead Factors While Value and Dividend Lag

Fixed income posted a positive month (Figure 19), helped by the continued recovery in corporate credit and mortgage-backed/asset-backed sectors. The U.S. Bloomberg/Barclays Aggregate Index returned 0.5% for the month as the 10-Year US Treasury Yield has settled in a 0.60-0.70% range (0.65% at month-end), off the March low of 0.50%. The 2-10 Year Term Structure remains positively sloped as fixed income investors do not expect the Fed to raise rates from the zero level anytime soon, while inflation expectations implied by breakeven rates between TIPS and nominal Treasuries have declined despite consumer perceptions of higher prices (primarily groceries due to shelter-in-place) (Figure 20). U.S. High Yield continues to recover from the 1Q20 sell-off, returning 4.4% for the month. Read above for more color on the credit markets.

Figure 19 - U.S. High Yield and Emerging Market Debt Continue to Benefit from the Global Risk Asset Recovery

Figure 20 - 2-10 Year Term Structure Remains Positive but Inflation Expectations Implied by TIPS versus Nominal Treasuries Continue to Decline

Commodities (Figure 21) continue their rally following the plunge in oil prices back in April. The 3-month generic oil price settled at $36/barrel, up from a low of $18/barrel in late April. Industrial metals also advanced as China appears to be increasing its commodity purchases. Real estate continues to lag over concerns on how the coronavirus pandemic will affect occupancy rates.

Figure 21 - Commodities Recovered from the April Sell-Off While REITs Lagged

Figure 22 - Oil Prices and Industrial Metals Continue Their Rally in Anticipation of Some Recovery in Demand

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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