- Volatility has dropped from Q1 2020 but trading volumes stay elevated in many asset classes.
- Tradeweb & MarketAxess trounce the exchange field and the broader market.
- CME is the cheapest of the group I'm willing to own; I continue to avoid CBOE.
- Charts galore!
(Source: Chart Your Trade)
The State of the Market series is a periodic check-in on global market activity and its resulting impact on exchange earnings and stock performance. Trading volumes are a significant driver of exchange stocks, so it's important to follow relevant metrics closely to understand where these stocks are heading.
With the Q2 2020 already more than two-thirds over, the prevailing narrative in the exchange world today focuses on the challenge of tepid trading volumes & activity in the months following a blowout Q1. With coronavirus-related volatility causing an explosion of volumes in March and early April across virtually all asset classes, investors are following how exchanges have adapted to the new trading landscape and what markets have been most affected. I'll run through the major asset classes at a high level below, then wrap up with individual impacts to the exchanges & the outlook for their stocks.
Q1 2020 was one for the ages in the energy sector. A demand shock coupled with an OPEC-induced supply shock sent crude oil prices plummeting in March, sparking the now infamous negative $40 print on front month futures at one point as storage reached capacity and tankers were left waiting on the open seas to unload oil.
Q2 so far has been a story of recovery, both in prices and volatility. With both the Chinese and broader global economies slowly re-opening, we're beginning to see a recovery in air travel, auto activity and industrial production, all of which have a positive impact on oil demand:
While markets have calmed down since March, there remains a great deal of uncertainty and potential for additional volatility as we move through the year. Just the other day, Bloomberg came out with a piece arguing the same factors that brought about negative WTI prices are starting to build in natural gas:
Just because energy prices have rebounded off historic lows doesn't mean another bout of volatility isn't around the corner - the outlook for energy volumes among the relevant exchanges (mainly CME) continues to show promise.
Agriculture & Metals
In the ags & metals world, the spotlight has shifted rapidly towards the metals side of the house and away from the ag markets, where relatively stable prices - coupled with high supply & uncertainty around the US-China trade war - have kept volatility muted as traders search for direction:
The real action so far this quarter has been in metals; unprecedented Federal Reserve money printing has pushed bullish sentiment on gold & silver to new heights:
(Source: St. Louis Federal Reserve)
Speaking of the Federal Reserve, one can't talk about financial assets (let alone any part of this market) without highlighting the truly mind-boggling dovish policy moves taken by Jerome Powell since the start of the crisis. So far in Q2, the equity market has chosen to accept the comforting message Powell has given to the public - "money printer go brrr" - along with the assurance that interest rates will be near-zero (even potentially negative) for the foreseeable future. Unfortunately this assurance on the future path of interest rates takes the air out of rates trading activity - if I know rates are going to be zero for a long time, why hedge my position in the futures markets?
A related trend impacting the rate markets has been the extreme levels of debt issuance we're seeing through the 1st half of 2020. Companies are using low interest rates as an opportunity to raise cash and shore up the balance sheet - with added assurance that the Fed can step in and be lender of last resort if needed. In general, more debt circulating in the marketplace means more interest and trading activity in both the cash & futures markets (benefiting CME (CME), Tradeweb (TW) and MarketAxess (MKTX)).
Exchange Performance Review & Outlook
With a quick summary of markets through Q2, let's run through the impact to each exchange stock - the S&P 500 is up ~27% through the first 2 months of Q2, with Tradeweb & MarketAxess trouncing the broader markets, Nasdaq (NDAQ) holding strong, and CBOE (CBOE) & CME relatively underperforming:
MarketAxess: After dropping amid the larger market selloff, MKTX has swiftly reversed course and punched through new all-time highs towards the end of April. The company has been a huge beneficiary of not only rates volatility & high debt issuance, but the rapid work from home shift forced by COVID-19. Electronic evolution of corporate bond markets is the main narrative that drives MarketAxess higher, and with most of the market trading from home amid nationwide lockdowns, the thought is participants may accelerate their move to electronic trading given the ease & speed advantage over using a legacy dealer. The company's recent results back this claim up - electronic market share ticked up amid the crisis, and has hit an all-time high of 21.2% in May:
(Source: MarketAxess Investor Relations)
As I echoed in a past article, the only downside for MarketAxess is its already lofty valuation, trading at over 75x forward earnings as of the end of May. Investors will have to pay handsomely for a company that's succeeding at the level MarketAxess is achieving today - while I wouldn't sell the stock, I do think the run-up has kept shares in "fully valued" territory and would not be buying at current levels.
Tradeweb: Similar to MarketAxess, Tradeweb has had a stellar run since the March bottom, rallying over 75% since March 18th. Federal Reserve intervention in the credit markets has coincided with unprecedented market interest and activity, which bolsters Tradeweb's results across treasuries, swaps, and international bonds:
(Source: Tradeweb Investor Relations)
I think MarketAxess and Tradeweb are being treated largely the same by the market today given their lockstep stock performance - returns have been strong, but the valuation keeps expectations high for the remainder of the year. A key narrative-changer for me comes from owner banks - the main customers of Tradeweb accounting for ~45% of revenue - selling additional stock in April:
(Source: Seeking Alpha)
If the bank stockholders keep selling, it adds to the medium-term risk that a competing platform takes market share (like MarkteAxess's LiquidityEdge or CME's BrokerTec in Treasuries). Like MKTX, I would not be buying Tradeweb at these levels, but I can't argue with the stellar performance of late for both the company and the stock.
Nasdaq: Nasdaq's share price has stayed resilient amid the coronavirus meltdown (and subsequent melt-up) due to:
- a transition to subscription-based market data & technology revenue paying off, and
- higher cash equity and options volumes.
As can be seen below, Nasdaq's EPS estimates didn't drop with the broader market, setting up a stronger snap-back in late March as investors realized Nasdaq's business was insulated from short-term swings in performance:
Defense in March switched to offense in April & May as EPS estimates went up on higher industry volumes:
Going forward, I believe Nasdaq can continue to outpace the market if its data segment doesn't show signs of weakness amid COVID-19. As volatility normalizes and trading segment results return to normal, investors will need to see Market Technology projects signed and new customers gained for Nasdaq's multiple to remain at current levels. If we see customers cut back on market data spend amid a recessionary environment, I think Nasdaq will begin to underperform. In the meantime, trading volumes continue to show strength and the stock is benefiting as a result.
CBOE: Whereas most exchanges have benefited from the March market chaos, CBOE is an outlier; market health looks to have been materially damaged - particularly in the Futures and Index Options segments - as too much volatility pushed traders out of the market:
I believe CBOE is on the right track in diversifying towards market data businesses - the company recently purchased Trade Alert to add to its Information Solutions offering - but in the short term, struggling volumes will keep the stock lagging the other exchanges. ~40% of its revenue comes from transaction businesses where volumes are down substantially year-over-year in Q2, and this will keep returns muted no matter the success we may see from the data segments. I continue to avoid CBOE at this time.
CME: Finally, CME has had a mixed Q2 as its diversified futures businesses face a deluge of impacts, both positive and negative:
(Source: CME Investor Relations)
While energy volumes have held up well, ag volumes have weakened with the trade war outlook uncertain, and interest rate activity - the company's largest asset class - has started to fade amid the Fed's zero rate guidance and massive stimulus. Although a spike in debt issuance and the potential for negative rates provide some cause for positivity, CME's stock has started to come under pressure as the new normal begins to sink in.
However - with an uncertain narrative comes a cheaper valuation - CME's forward multiple has dropped to ~24x from a pre-COVID-19 range closer to 28-29x:
I continue to believe CME provides the cheapest exposure to future volatility of the group, and am willing to stay positive on the stock long term despite a murky picture in the short term.
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