Strict social distancing for crowded trades

Crowded market trades are enduring a hefty dose of social distancing. The beneficiaries of the “reopening trade” that includes the likes of banks, travel, airlines, energy, industrials and small-caps are being shunned after their solid run in recent weeks. Tech stocks have also been hit hard, but losses for the Nasdaq Composite have lagged those of other big US equity benchmarks.

No one should be surprised by the price action that has spurred a 5.9 per cent slide in the S&P 500 after a 4 per cent drop in European benchmarks. Blaming Mercury, aka the Federal Reserve, for sending dour tidings about the economy is absurd.

Beyond signs of Covid-19 infections picking up as lockdowns ease, the main catalyst for the current equity slide according to traders is the prognosis from Jay Powell during the Fed chair’s press conference on Wednesday that a “jobless” economic recovery looms.

Casting doubt on the merits of a V-shaped recovery is hardly an earth-shattering view. The broader market response in the past 24 hours simply highlights how equities and credit have lately jumped well ahead of economic realities. Particularly in the case of some retail day traders applying their sports betting strategies to stocks that included companies with bigger debts than the value of their assets and broken business models.

Puncturing some of the brimming optimism that had underpinned markets is not a bad development given the fragile macro backdrop. An extended period of high unemployment is not good news for service sector economies and consumer spending. Until February, a resilient consumer was a source of solace for equity investors. Gauging the true extent of any post-Covid-19 recovery rests heavily on whether consumers lean towards precautionary savings or not.

This also shapes the Fed’s sombre outlook and indicates that Treasury yields are not moving significantly higher any time soon. Indeed, with equity benchmarks tumbling and enduring their worst one-day slide since March, the 10-year note yield is below 0.7 per cent after tasting the air above 0.9 per cent at the start of the week.

Long-term bond yields are a very important indicator for many markets, and that includes equities and credit. A bumpy recovery accompanied by low bond yields for an extended time has implications for some of the recent big shifts seen across global equities.

Let’s start with the recent buyers of companies that benefit from a stronger economy, known as cyclicals (financials, industrials and energy among others) and an area of the market that also contains plenty of cheap “value” stocks. What really animates a rotation away from growth stocks such as tech towards cyclicals and the ranks of value companies is the expectation of stronger economic activity, a prospect that is typically signalled by rising long-term bond yields.

Of late, expectations of a robust bounce, backed by aggressive fiscal and monetary policy has encouraged buyers of cyclical and value stocks. That trend was showing signs of fatigue earlier this week and has come under intense pressure in the wake of the Fed meeting.

Seema Shah at Principal Global Investors says the lack of inflation pressure and “discussions of potential yield curve control suggest that Fed will look to keep the yield curve low and flat”. This kind of policy backdrop argues Seema “is a strong headwind for value stocks and so, while they may get a boost as economic data improves over the next few months, it is unlikely to be lasting”.

Now another perspective is provided by analysts at BCA Research and they think Fed policy will keep real or inflation adjusted Treasury yields firmly depressed and below zero as their chart here shows:

And as economies steadily reopen, this kind of monetary backdrop leaves equities looking good a year from now and they write:

“This very easy monetary slant is becoming clearly positive for growth and inflation. While these forces are not enough to prevent a short-term pullback in equities, they increase the chances that any correction will not morph into a bear market and that global stocks will be significantly higher one year from now.”

Such an outcome requires definite signs of a robust earnings recovery and a relatively muted corporate default cycle in the coming quarters.

Ewout van Schaick at NN Investment Partners cautions:

“The trailing price earnings for the US market is currently well above the average of the past 20 years. Europe and emerging markets are just below this long-term average. Even if we take into account earnings growth for this and next year, the valuation picture remains unsupportive.”

That only looks worse should deflationary winds freshen. An economy flirting with deflation explains why the Fed is focused on extending loans to smaller companies via its Main Street lending programme.

Albert Edwards at Société Générale via this chart highlights slowing nominal growth — the blue line — which stands to “drag down analyst forecasts of long-term EPS growth, which are already weighed down by the ongoing profits collapse”.

The current retreat in equities likely finds a floor soon given the gushing liquidity flowing into markets via central banks. But all the liquidity in the world only works up to a point when the fundamental outlook remains a guessing game. The renewed volatility for equities and credits seen on Thursday simply highlights the degree of uncertainty at the moment.

Paul O’Connor at Janus Henderson believes:

“The surge in cyclical stocks in recent weeks suggests that more constructive scenarios on the economic outlook are also being factored into global stocks. While, to some extent, this reflects an emerging optimistic shift in consensus views on the coronavirus, opinions here remain fragile and could quickly shift a lot in either direction.”

Quick Hits — What’s on the markets radar?

Well some bond investors certainly don’t think nominal yields are destined to rise for some time. The latest 30-year US Treasury sale found buyers at a yield of 1.45 per cent, and after the long bond kicked off the week testing 1.7 per cent. This comes after Germany’s 30-year sale on Wednesday attracted record demand.

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