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 Sept 25th and the Week Ahead

Updated: Nov 2, 2020


Outlook for the Week Ahead

U.S. equity markets closed the week on the front foot surging into the close on Friday. Nonetheless, the combination of CV19 taking a turn for the worse, the failure of Congress and the Trump Administration to agree on a fiscal package, heightened and ongoing political uncertainty (and related sideshows) as the US Presidential election nears, and a lack of progress on a UK-EU post-BREXIT trade deal cast a long shadow over the risk markets. This week, the first of three debates between President Trump and Democratic challenger Biden occurs on Tuesday evening, and economic data for September starts to drift in during the second half of the week. 3Q earnings are just a couple of weeks away, too. Overall, the confluence of factors amounts to increasing uncertainty as we head into the final quarter, causing my risk assessment to be decidedly biased towards the downside.

What Happened Last Week

Global Equity Markets

The global equity indices I track were in the red across the board last week, although the U.S. equity markets surged into the close on Friday. For the week, the STOXX 600 had the worst performance (-3.6%) and the S&P 500 the best (-0.6%).

Even with a positive end to the week, the S&P 500 recorded its fourth consecutive week of losses and is down 5.8% for the month albeit remaining in positive territory for the year. This performance reflects the long-awaited and much-anticipated convergence between economic reality and equity market valuations.  Serious investors cannot possibly be surprised at this.  U.S. equities seem to fortuitously encounter resistance levels from time to time that prevent them from falling off a cliff on bad days, or at least that’s how it has felt to me a few times over the last two or three weeks. It could have been a lot worse but markets have weathered a number of storms and have continued to show resiliency.

In fact, at times the markets feel almost directionless albeit, at the same time, feeling increasingly fragile. I retain a negative bias because the risks on the horizon are asymmetrical, including the biggest unknown of all – the path of CV19 and its effect on global economies as cases start to increase again in several major economies.  But the risks don’t end here. We also have a pending U.S. Presidential election fraught with all sorts of political sideshows, an elusive post-BREXIT trade deal between the U.K. and the E.U., and – lest we forget – 3Q20 earnings which are just around the corner. I believe that earnings have a better chance collectively of disappointing this round, at least in the context of traditional valuations (S&P 500 Shiller CAPE ratio of nearly 30x) which remain elevated given the context. In aggregate, this backdrop just doesn’t give me warm and fuzzy feelings about where equity markets might be heading.

Credit Markets

An article in Bloomberg this week reported that junk bond sales in US Dollars have passed the largest year on record (2012), with $328.9 billion of new bond sales YtD - see “U.S. Junk Bonds Set $329.8 Billion Sales Record Amid Yield Hunt”, by Paula Seglison. Recall that new issues of investment grade bonds reached their largest amount ever in August, so now the US corporate bond primary market is in record territory across the credit spectrum.

Below is a graph from Moody’s that illustrates new issue volume over time of US Dollar-denominated high yield bonds, divided into non-financials (meaning corporates, the traditional HY focus) and financials (generally meaning bank capital). The graph illustrates the significant increase in new high yield bond sales this year.

Companies have shifted their focus from “survival financing” in the second quarter following the lockdown of many global economies, to refinancing existing debt since mid-summer in order to lower their overall cost of debt during this window of record-low interest rates and to extend the average maturity of their debt complex.


However, the party might be about to end, as a Bloomberg article this week (“Investors Flee Junk ETFs as High-Yield Bonds Erase Gain for Year”) reported that investors have been exiting two of the largest junk bond ETF’s – HYG and JNK – the last several weeks. The graph to the left from the FT illustrates that last week, high yield funds (mutual funds and ETFs) suffered their largest outflows since March, a time when investors were fleeing risk assets as the reality of the pandemic set in.

Against this backdrop with funds leaving the asset class, U.S. corporate high yield spreads widened significantly last week (+50bps W-o-W), dragging investment grade credit spreads wider too (+9bps W-o-W, corporate BBB). High yield defaults have risen from 3.1% last year at this time (rolling 12-months) to 8.7% now, and Moody’s expects defaults to increase to 10.6% by the end of this year. However, it appears that investors can better “frame” the default rate ceiling now, and those high yield issuers most likely to default have already done so or are identified as expected to do so. The ease with which many high yield companies, some that were on the brink of trouble, have been able to issue bonds, has undoubtedly both flattened the growth of defaults and “bought” companies more time to reorganise their businesses and adapt to a lower growth scenario.

Safe Haven Assets & Oil

The US Dollar has suddenly found its legs as investors look for safe haven assets, not a surprise given the risks that lay ahead.   Of course, what’s good for the dollar is not good for U.S. multinational companies, perhaps another reason that U.S. equity prices are struggling at the moment.  For the week, the US Dollar increased 1.8% against a basket of currencies, continuing its recent trends toward gradual strengthening. The dollar is up 2.6% so far this month, a significant turnaround in that the dollar lost ground every month since March. US Treasury yields also tightened modestly across the board, even on Friday as the equity markets were rallying, supporting – in my opinion ­– a slow but gradual sentiment shift towards “risk-off”. Further supporting the shift in sentiment, another safe haven currency – the Yen – also was stronger on the week (+0.9%).

The one safe haven asset that bucked the trend last week was gold. Gold broke through the lower bound of the range it had been trading within since late July, closing Friday at $1,861.74/ounce (-4.6% W-o-W).  Why is gold struggling?   The strengthening US Dollar is the most obvious culprit, but I also think that inflationary expectations are being pushed out as the global economy seems likely to suffer from excess capacity for longer than expected.  Until capacity utilisation improves and unemployment decreases significantly, pressure on prices is likely to remain subdued. Having spent much of the week below the important resistance level of $40/bbl, WTI crude oil experienced a modest recovery during the latter half of the week, finding enough support to push the price back up to close at $40.10/bbl, still down 2.1% for the week. I think WTI crude will be stuck around this level for a while as demand softens, with a bias towards the downside as far as prices.

Economics & Politics

Economic growth stagnated in the Eurozone in September according to flash PMI data released by HIS Markit on Wednesday (see here), with modest gains in manufacturing being more than offset by declines in the services sector as the CV19 resurgence gains ground. Flash PMI data for the U.K. released the same day was more concerning, with both the manufacturing and services sectors showing a further slowdown vis-à-vis August. Even more alarming perhaps is the “soft” statement in the first paragraph of the report (here) which says “UK private sector companies also pointed to another drop in business expectations for the year ahead, with the degree of optimism falling to its lowest since May.”

Secretary of the Treasury Steven Mnuchin and Fed Chairman Powell testified before the Senate Banking Committee last week, with no major surprises and both clearly aligned on the need for a new fiscal stimulus plan. However, some pundits believe that a fourth round stimulus plan has now become a lower priority for the Republicans in the Senate as they focus on jamming through a new Supreme Court justice. Nonetheless, Speaker of the House Pelosi is pushing a smaller $2.4 trillion fourth-round stimulus package through the Democratic-controlled House, and the Trump Administration has shown an interest in negotiating although it has been clear from the onset that the Administration is not interested in a fiscal package anywhere near this size. I still suspect we will see something this side of the Presidential election because it benefits both parties.

Sticking with the U.S. a moment more, the political news last week revolved mainly around two issues, one of which is the “rushed” replacement of Justice Ruth Bader Ginsberg on the Supreme Court, and the other of which is the willingness of President Trump to step aside should he be defeated in the upcoming Presidential election. You can read about the Supreme Court matter in a blog post I published Thursday that is here. On the second issue, although President Trump could not say he would necessarily concede if he lost the election, Senate Republicans weighed in an said that there would be a peaceful transition of power no matter what the outcome of the election is. (Having said this, some of these are the same Republican Senators which said in 2016 that they would not replace a Supreme Court justice in an election year, so time will tell.)

In the U.K., Chancellor Rishi Sunak announced that the jobs furlough programme in the U.K. would end as scheduled on October 31st, and a new scheme – the Jobs Support Scheme – in which workers that are working at least one-third of their normal hours would be subsidised. There are other ongoing features of the new relief plan including lower VAT for some businesses and a continuation of Bounce Back Loans for SME’s. You can read more about the plan on the U.K. government website here. The intention is for the U.K. government to navigate the tricky area between maintaining viable businesses during this difficult period and “throwing good money after bad” to support businesses that would ultimately fail most likely anyhow. The plan seems to have been well received.

COVID-19

We have passed 32 million cases globally of CV19 and are knocking on the door of 1 million reported deaths, according to the Johns Hopkins Coronavirus Research Center. Of course, these are reported cases and deaths only so most likely understate both. The Financial Times provided a very good update on Thursday on where we stand with respect to the CV19 pandemic globally, which I believe you can access for free – see “Coronavirus tracked: the latest figures as countries fight Covid-19 resurgence | Free to read”. It confirms what you have been reading as far as resurgence in several countries in Europe, with both the U.K. and France taking new measures to lessen the spread before something more dire (economically) is required. Let’s hope that people listen and that these measures resonate, as the expectation for the spread of the virus is moving in the wrong direction as winter approaches in the northern hemisphere. The article also discusses the concept of excess deaths vs the normal level of deaths by country, to provide a better feel for what might be the true number of deaths from CV19 by country (suggesting that deaths attributable to CV19 might be understated by as much as 100%).

The two illustrations below, one each for the U.S. and Europe (extracted from the FT article referenced above), show deaths by state (US) and country (Europe), and are very much worth studying as they provide a good synopsis of what areas have been hit the hardest by CV19.



Conclusion

Batten down the hatches as October approaches because I fear we are in for more volatility and sentiment gyrations in the coming weeks, leading up to the highly charged U.S. Presidential election.

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