My view on what's going on in the financial markets and the global economy, and a few other things that might interest me from time to time.

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  • tim@emorningcoffee.com

Week Ended July 24th and the Week Ahead

Summary

  • The EU-27 agreed a €750 billion fiscal stimulus plan for the union, a milestone in its history. In the U.S., Congress has not yet agreed a plan for a fourth round of fiscal stimulus as features of the CARES Act are set to expire this week.

  • Sentiment soured towards the end of the week as S&P 500 earnings had a few negative surprises and CV19 rages on in the U.S. passing 4 million cases, threatening the robustness of the increasingly fragile U.S. economic recovery.

  • Gold passed $1,900/ounce for the first time since 2011, and silver rallied to narrow the historic relationship with gold. As these safe haven metals increased in price, the U.S. yield curve flattened further, perhaps signalling more economic troubles ahead in the U.S. The U.S. Dollar also weakened further last week.

  • Credit continues on a roll as corporate credit spreads tighten across the credit spectrum ranging from the strongest AA credits to the weakest CCC credits, even as economic concerns increase and the day of reckoning as far as a swell of defaults grows nearer. For this, we can thank the printing presses of the Federal Reserve, which is buying corporate bonds in the primary and secondary markets.

  • CV19 continues to rage with increasing fears in some parts of the developed world, especially in Europe, as countries focus on curtailing a second wave before it gathers momentum. Nearly 16 million cases have been confirmed around the world, and there have been over 640,000 deaths reported that have been caused by the virus. The U.S. continues to lead in number of cases and deaths, followed by Brazil and India.

 

Equity Markets


Having closed above the 2019 year-end level (3,230.78) on Monday, the S&P 500 eked up the following two days before finally capitulating on Thursday. The last two days of the week were more difficult as the S&P 500 gave up its weekly gains and then some. I will discuss potential catalysts more below but I would say the pivot point was a combination of several earnings reports (MSFT, TSLA, LVS, INTC amongst others), disappointing U.S. employment data on Thursday, the ratcheting up of China-U.S. tensions, and just a general realisation that CV19 is getting worse day-by-day in much of the United States, threatening to slow the economic recovery. Th FTSE 100 and the STOXX Eur 600 also faded towards the end of the  

week, with the holiday-shortened week in Japan saving the Nikkei 225 from a similar fate. The table to the left shows how the indices fared last week.

Credit Markets


The ICE BofA US corporate spread indices from FRED (Federal Reserve Economic Data) do not include Fridays’ data each week until the following week, so I can only write about what occurs with corporate spreads through Thursday the prior week. I am especially curious to know which direction spreads moved on Friday since global equity markets wobbled that day, carrying on with the more negative tone from Thursday. Having said this, the corporate bond market rallied through Thursday with spreads grinding tighter every day. BBB corporate spreads were about 10bps tighter on the week, closing Thursday at +182bps (2020 range +130bps to +488bps). However, the real spread tightening occurred in the non-investment grade (i.e. high yield) corporate arena across all ratings categories, with the U.S. aggregate high yield market tightening 48bps during the week to close Thursday at +526bps (2020 range +338bps to +1,087bps). The European high yield aggregate index also tightened during the week, ending Thursday 21bps tighter to close that day at a spread of +475bps. As you might have expected, spreads in the corporate bond market have reached their lowest levels since the March CV19-induced sell-off in risk assets.


The tightening in spreads of U.S. corporate bonds continued to gain steam even though risk sentiment soured towards the latter half of the week. The ongoing spread tightening is occurring even though equity markets at times feel fragile, a looser correlation than is normally the case. In my opinion, this is occurring for two reasons. Firstly, the Federal Reserve is an active buyer of corporate bonds in the primary and secondary markets, in line with the broad mandate of its asset purchase programme which – as you might recall – includes investment grade rated corporate bonds, fallen angels and high yield ETF’s. Secondly, the harsh reality is that there are fewer and fewer investment alternatives which offer anything other than meagre cash-on-cash returns, so if investors are willing to accept corporate credit risk, then the returns – especially in the high yield arena – look compelling. The spread tightening in the corporate bond market is occurring even as the likelihood of a growing wave of defaults is also increasing, so buyers beware!


Although this section is on corporate bonds, I want to drift quickly into the Eurozone sovereign arena for those of you that follow Eurozone sovereign bonds. The benchmark Eurozone sovereign is of course Germany, and the German 10-year bond is currently yielding -0.45% (and yes, that is a negative yield, meaning you pay the German government to hold their bonds!). At the other end of the spectrum is troubled sovereign Italy, which also happens to be one of the European countries most badly affected early on by CV19. The yield on Italy’s 10-year sovereign bond is currently 1.06%. However, the yield on the Italian 10-year bond blew out to 2.65% in March, and at its widest was 276bps wider than the yield on the German 10-year sovereign bond even though the countries are “joined at the hip” by virtue of the common currency. The spread difference bounced around a bit but remained

stubbornly stuck around +175bps until July 9th. From that point onwards, the spread differential began to narrow as the European fiscal stimulus plan began to crystallise, finally becoming a reality early last week. As a result, the difference between the yields on the 10-year Eurobonds for Germany and Italy narrowed to +151bps on Friday, the tightest level since February, as illustrated in the graph to the right. I discuss the European

fiscal plan further below in this update.


Safe Haven Assets


Gold edged above $1,900/ounce last week for the first time since 2011, and the spread on the 10-year US Treasury drifted below 0.60%, both suggesting a tilt towards “risk off” as far as sentiment amongst investors. Although gold and U.S. Treasuries rallied, another safe haven asset – the U.S. Dollar – weakened, suggesting that investors could be increasingly concerned about several things, including the on-going increase in CV19 cases in the States or the relatively high valuation of U.S. equity markets, or perhaps both!


It is also worth pointing out that the 2-10 year U.S. Treasury differential narrowed (meaning the slope of the yield curve flattened). This could be a signal that investors are lowering their expectations as far as the robustness of the U.S. economic recovery, one of many indicators that suggest more volatility could surface in financial markets in the weeks ahead.


Silver and the Euro


As far as precious metals, silver has gotten a lot of attention during the last few days as it rallied to close at $22.77/ounce on Friday, an increase in price of 17.7% in the past week. This rally is not surprising and is arguably long overdue, at least according to those investors that focus on the historical relationship between the price of gold and the price of silver. According to Seeking Alpha, this ratio of gold price-to-silver price has been around 47:1 during the 20th century, and 60:1 over the last 20 years. As gold hovered in the $1,800-$1,850/ounce area from mid-April to mid-June, silver seemed stuck in a rut between $15/ounce and $18/ounce, a ratio of the price of gold-to-the price of silver of over 100:1. Silver bugs were insisting it were only a matter of time before investors caught on, and this has now come to pass. The increase in the price of silver last week means that the ratio has narrowed to 83:1, although there still appears to be plenty of room for the price of silver to increase further. The graph below shows the ratio of gold price-to-silver price since 1990, and also shows U.S. recessions (source: macrotrends.net).



Although I do not actively cover currencies, the combination of the U.S. Dollar falling more and more from favour and Europe finally delivering a fiscal stimulus package led to the Euro rallying to close the weak at $1.1656/€1.000, its highest level since September 2018, which you can see in the graph below.

Sterling also strengthened, certainly more attributable to the U.S. Dollar weakening that any good economic news from the U.K.


Earnings


128 companies in the S&P 500 have now reported earnings, and on average, a higher percentage of earnings have beat consensus than usual. You can find the complete weekly report from Refinitiv here. Tesla (TSLA) delivered its fourth consecutive quarter of positive net income relying on the sale of carbon credits, qualifying the company for the S&P 500. Microsoft (MSFT) exceeded analysts’ expectations but provided mixed guidance, so the stock got hammered. Twitter (TWTR) had strong numbers, whilst both Las Vegas Sands (LVS) and Intel (INTC) disappointed towards the end of the week, adding fuel to the fire regarding concerns about equity market valuations overall.


As an aside, I wrote an article entitled “My (Bad) Experience with Momentum Stocks” mid-week last week, including some commentary on Tesla, Netflix and Zoom Communications.


This week, 189 S&P 500 companies report earnings, the most active week of the campaign. Some of the more interesting companies worth monitoring are payment services companies PayPal, Visa and Mastercard; large restaurant chains McDonalds and Starbucks; consumer products companies P&G, Colgate, Kraft Heinz and Kellogg; US automotive companies Ford and GM; industrials Boeing and Berkshire Hathaway; and the remaining members of the infamous “FAANG gang” (Google, Apple, Amazon and Facebook).


Economics & Politics


The most relevant economic news last week involved the European stimulus package and a fourth round of U.S. fiscal stimulus. After several weeks of negotiation, Europe finally approved a €750 billion stimulus package – named “Next Generation EU” – split between grants (€390 bln) and loans (€360 bln), to assist those E.U countries most badly affected by the pandemic, mainly in southern Europe. This was a difficult negotiation because the member countries will be effectively jointly & severally liable for the debt programme to fund the programme, which will be undertaken by the European Commission on behalf of the EU-27. I understand that the plan will be funded by having the European Commission used bonds as long as 30 years in maturity. The mutualisation of debt across member countries is a milestone in that this approach was resisted by the more conservative and fiscally sound members of the union even during the darkest days of the Euro crisis of 2012. The fact that this approach was finally agreed amongst EU-27 member states provided good ammunition for the Euro to rally, and perhaps to signal an inflection point favouring a shift towards European equities at the expense of U.S. equities, since stock market valuations are more attractive in Europe (than in the U.S.).


In the U.S., Congress is yet to agree a fourth round of fiscal stimulus as many features of the CARES Act, most importantly perhaps the supplemental $600/week from the federal government for unemployed workers, expires this week. Once a plan is agreed by the House and the Senate, it will need sign-off from President Trump, which is an election year should be easy. However, as I noted last week, the range of the fourth stimulus package remains large between the more conservative Republicans ($1 trillion) and the Democrats ($3 trillion+), and this difference will need to be narrowed quickly this week for a package to emerge.


One final piece of economic news that soured sentiment on Thursday was first time unemployment claims (1.4 million) for the week ended July 17th, which increased for the first time in 13 weeks and was above consensus expectations of 1.3 million. You can see this 

trend in the graph to the left. With CV19 running wild in many parts of the U.S., there is growing fear that large swaths of the U.S. economy might have to be closed again, damaging the economic recovery that is clearly underway. Currently, 31.8 million Americans are collecting some form of unemployment insurance, which is one in five Americans in the workforce.




COVID-19


As you can see from this table, the news is getting worse with respect to reported cases of 

and deaths from CV19. The U.S. continues to be one of the only developed countries that has failed to flatten the R-curve on CV19, as confirmed cases crossed the 4 million threshold last week and over 146,000 Americans have died from the virus. President Trump seemed to finally acknowledge the severity of CV19, giving a speech during which he stuck to his script, noting that wearing masks – after all – might be advisable. He has also reversed course on other CV19 policies, finally falling in line with many of the recommendations of his medical team as his polling numbers weaken.


Away from the U.S., Brazil now has over 2.3 million cases, and India now has over 1.3 million cases. Parts of Europe are fearing a second wave, with the Spanish region of Catalonia being the latest area to reverse steps taken to normalise the economy as CV19 cases spike. In both France and the U.K., wearing masks in retail stores is now mandatory, as Europe seeks to avoid further increases in cases of CV19 as restrictions loosen and Europeans head off for holidays.

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