Data Source: Bloomberg
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Market action during the third quarter was largely uneventful despite a moderate pickup in volatility and a “pause” in the global reflation trade. The first two months saw rallies in the global reflation trade, broadly represented by growth technology stocks, emerging markets, commodities/non-U.S. currencies, and corporate credit, only to see investors back away from this trade in September due to technical reasons (e.g. over-exposed long positioning in large-cap technology stocks via call option purchases and speculative non-commercial long positioning in EUR/USD) and diminishing prospects over a second U.S. pandemic relief spending program as well as rising prospects over Hard Brexit. The end of the quarter saw elevated (i.e. buy-the-dip) risk sentiment after having peaked in mid-August, prior to the early September sell-off (we wrote about this in peak in investor sentiment in mid-August titled “Market is Euphoric”).
The furious global technology growth rally that characterized the early quarter advance spilled over into the first week of September before the “trade” unwound itself following reports of a large options “whale” (later to be revealed Softbank – Japan’s publicly-traded venture capital fund) having bid up single stock call options on key technology stocks, forcing options market-makers to buy the underlying stocks in order to hedge their positions. We mentioned this activity in our August 2020 Market Commentary, prior to media reports confirming the options trading activity.
The final two weeks of September saw a reversal of the growth technology stock sell-off amidst reports of renewed call option buying by retail investors regardless of prospects for another U.S. spending program (U.S. Treasury yields and the dollar whipsawed between diminishing prospects versus renewed prospects). Markets are being tested in the first week of October as U.S. President Donald Trump tested positive for the coronavirus.
As of the writing of this commentary, prospects for a second pandemic relief plan diminished despite reports of active negotiations between the White House (Treasury Secretary Steve Mnuchin) and Congress (House Speaker Nancy Pelosi). The Republican-led U.S. Senate is still resisting a negotiated plan, but the spending gap between the White House plan and House plan has narrowed with remaining differences over the level of unemployment benefits and state/local aid. The House passed a $2.2 trillion version of the plan, but the prospects for Senate passage are dim as Republican leaders claim the House version is full of “poison pills.” An estimated $2 trillion aid package could serve as a shot in the arm to a U.S. economy still trying to recover from the coronavirus pandemic, regardless of how much this spending would add to the long-term debt burden.
And despite escalating tensions between the U.K. and European Union (this time over Internal Market Bill passed by U.K. Parliament that potentially violates the Northern Ireland border agreement) as the deadline for a post-Brexit trade deal approaches, both sides have not ended talks and will likely posture to the “11th hour” rather than opting for a hard Brexit (resorting to World Trade Organization framework). Differences remain over access to U.K. fishing waters and nature of state aid for “local champions”. Although the U.K. pound has dropped versus the euro and U.S. dollar, investors are largely anticipating a no-Hard Brexit scenario despite what is being projected by the media.
Reports of Berkshire Hathaway’s (NYSE:BRK.A) (NYSE:BRK.B) (Warren Buffett) purchase of five Japanese trading companies also helped reverse sour investor sentiment on Japanese stocks, still suffering from the pandemic and whose earnings outlook remains worse versus the rest of the world (Figure 1). Japanese stocks initially sold off over the unexpected resignation of Prime Minister Shinzo Abe due to chronic health problems, although investors cheered a trade deal signed with the U.K., the first deal to be signed post-Brexit.
Figure 1 – Earnings Outlook for Japan Remains Anemic Versus Rest of the World
Source: Bloomberg for the period ending 9/30/2020. Time series indicate % increase or decrease of current forward EPS expectations versus expectations from the prior year.
Asian markets have been tracking China’s economic recovery from the pandemic as witnessed by China’s increased fixed asset spending, export activity, and industrial demand. Pro-cyclical China risk proxies such as government yields and the USD/CNY exchange rate (Figure 2) have served as telltale signs of this recovery which began shortly after the worst of the pandemic shutdown. In addition, COVID-19 has barely put a dent in China’s credit appetite as year-over-year credit growth (including social financing – see Figure 3) continues its surge from the depths of the 2018 U.S. trade conflict.
Figure 2 – China Pro-Cyclical Recovery Continues as Indicated by Rising Bond Yields and Strengthening Currency
Figure 3 – COVID-19 Could Not Arrest China’s Total Credit Growth
China’s recovery is likely driving the overall rebound in global trade whose pace of recovery has exceeded that of the post-2008 Financial Crisis (Figure 4).
Figure 4 – Rebound in Global Trade Exceeds Post-2008 Financial Crisis
Global central banks led by the U.S. Federal Reserve remain committed to quantitative easing for the foreseeable future which has driven real (inflation-adjusted) interest rates to negative levels. As expected, the Federal Reserve confirmed its revised inflation strategy at the September meeting, but some questions remain over the execution of the policy shift targeting average inflation of 2%.
For instance, the Fed did not communicate forward guidance on the magnitude and length of balance sheet expansion, now above $7 trillion (Figure 5), as the Fed continues its purchases of U.S. Treasuries and mortgage-backed securities. Is the current run rate of expansion enough to satisfy market risk appetite, or will the Fed need to take more aggressive measures? The Fed has communicated a “lower-for-longer” policy on interest rates and will not likely preemptively tighten policy should inflation surpass 2% (it would need to sustainably remain above those levels); however, the Fed has also passed the pandemic-support “baton” to Congress to pass meaningful fiscal spending as a means of bridging the output gap until the economy can recover from the pandemic.
Figure 5 – Fed Balance Sheet Back Above $7 Trillion, But Is Current Run Rate Enough to Sustain Market Risk Appetite?
We wrote about Fed policy, accommodative as it is, entering into a holding pattern as we’ve likely reached a floor on negative real (inflation-adjusted) interest rates barring an aggressive pivot such as setting Fed funds rate below zero (negative interest rate policy) or a sudden outbreak in inflation. This has created a near-term headwind for commodities, especially precious metals with gold prices having dropped from peak +$2,000/ounce levels reached in mid-August (Figure 6), although copper prices have held up largely due to dwindling stockpiles.
Figure 6 – Gold Fades Away from $2,000/oz While Copper Prices Remain Resilient
Traditional Cyclicals (i.e. Energy, Industrials, and Consumer Retail) Remain Stuck
Traditional cyclicals such as energy, industrials, and consumer retail (this downturn’s version of “subprime borrower”) are increasingly being left behind as the world struggles to fully recover from the pandemic-induced shutdowns and social-distancing restrictions. Airlines and hotels continue to struggle (Figure 5) largely due to anemic business travel even though 2021 leisure bookings are expected to recover (largely determined by the pace of re-openings from travel bottleneck government authorities), perhaps catalyzing a return in demand for expert travel advisors. Corporate borrowing costs (option-adjusted spreads) for energy and consumer discretionary (i.e. retail) companies remain elevated versus other sectors (Figure 6), reflecting higher bankruptcy filings and operating stress facing levered borrowers.
Figure 5 – U.S. Consumers Eating Out More But Avoiding Air Travel and Hotel Stays
Figure 6 – Energy/Materials and Consumer Discretionary Borrowers Are Becoming the New “Subprime” for This Cycle’s Downturn
Despite the laggard across traditional industrials, U.S. manufacturing sentiment has recovered from the pandemic downturn as companies are reporting rising trends in new orders and employment (Figure 7). However, the recovery in manufacturing sentiment and trade activity has yet to translate into a broader-based global recovery so long as world governments remain preoccupied with containing COVID outbreaks.
Figure 7 – U.S. Manufacturing Sentiment on the Mend (New Orders, Employment)
As worries emerged over a re-acceleration of COVID outbreaks across the U.S. and Europe (despite not being met with subsequent spike in hospitalization and mortality rates) and lower expectations of a COVID-19 vaccine would not likely become commercially available anytime soon (i.e. AstraZeneca (NASDAQ:AZN) suspending phase 3 trials due to “health irregularities”), the “stay-at-home” trade continues to remain in vogue as investors believe the world is being conditioned to live with social distancing. There is an emerging consensus that we may have seen peak global energy demand while U.S. gasoline demand is running well below five-year averages (Figure 8), not a conducive pricing environment for OPEC-Plus nations and North American shale producers.
Figure 8 – Have We Witnessed Peak Energy Demand?
Throughout the second half of September, reflation beneficiaries such as commodities, corporate credit, and cyclical stocks gave way to a rebound in the U.S. dollar (Figure 9), lower Treasury yields, and lower inflation expectations priced into Treasury Inflation-Protected Securities (TIPS). Both the U.S. Term Structure (2- vs. 10-Year Treasury Yields) and Inflation Expectations implied by breakeven rates between TIPS vs. nominal Treasuries remain at post-COVID elevated levels but have fallen back from the optimistic levels reached in mid-August (Figure 10). Prospects for additional fiscal pandemic spending and vaccine developments will likely influence investors’ expectations for the pace of economic recovery and inflation pressures heading into 2021.
Figure 9 – Rebound in the U.S. Dollar a Telltale Sign of Diminished Risk Appetite
Figure 10 – The U.S. Treasury Term Structure and Inflation Expectations Priced into U.S. TIPS vs. Nominal Treasury Yields Remain Elevated But Off From Optimistic Highs
What is interesting is that mega-money manager BlackRock is forecasting much higher inflation five years from now (Figure 11) than what is implied by TIPS/nominal breakeven rates. If BlackRock’s forecast for > 2.5% inflation bears out, this will have significant negative repercussions for fixed income and interest-sensitive assets as “bonds” get repriced for higher inflation. Perhaps the world will eventually recover from the coronavirus pandemic, but whether that recovery manifests itself into higher inflation remains to be seen.
Figure 11 – BlackRock Forecasting Higher Inflation Five Years from Now
September 2020 Market Review
Global markets pulled back from a torrid pace set throughout July and August. The U.S. market, led by large-cap growth technology stocks, led global markets but then pulled back following reports of a technical unwinding of call option positioning and dealer hedging. Japan equities rallied following reports of Warren Buffett’s Berkshire Hathaway purchase of Japanese trading companies (value play) despite the unexpected resignation of Prime Minister Shinzo Abe due to chronic health problems. Europe lagged due to rising risks of a hard BREXIT as prospects for a post-Brexit trade deal were threatened with U.K. Parliament’s passage of a bill targeting the Northern Ireland/Irish border. The MSCI All-Country World Index (NASDAQ:ACWI) was down 3.2% for the month with Japan (-1.0%), Emerging Markets (-1.6%), and Asia Pacific ex Japan (-2.3%) leading major regions followed by Europe (-3.3%) and the U.S. (S&P 500 -3.8%) (Figure 12).
Figure 12 – Asia and Emerging Markets Led Major Regions in September While the U.S. and Europe Lagged
At one point early in the month, U.S. Value had been outperforming U.S. Growth by nearly 4% before giving up this outperformance as banks and energy stocks sold off during the second half of the month. U.S. Pure Value returned -3.7% versus -2.6% for Pure Growth as large-cap technology stocks recovered some of the early month sell-off. The S&P 500 (large caps) returned negative 3.8% outperforming the S&P 600 (small caps) which returned -4.7% (Figure 13).
Figure 13 – U.S. Large Edges Out Small and Growth Outperforms Value
This month saw Defensive sectors such as utilities, staples, and healthcare outperform as did traditional cyclicals such as materials and industrials while growth technology lagged as did the energy sector, dragged down by a sell-off in oil prices (Figure 14).
Figure 14 – Materials and Utilities Posted Positive Returns While Energy Significantly Underperformed the Broader Market
Among factors, Minimum Volatility, Value and High Dividend outperformed Momentum and High Quality (Figure 15). Minimum Volatility, High Dividend, and Value benefited from some rotation away from Momentum, which is predominantly growth technology.
Figure 15 – Momentum and High Quality Led Factor Performance in June
Investment-grade fixed income posted a slightly negative return hurt by wider credit spreads and modest interest rate volatility. The U.S. Bloomberg/Barclays Aggregate Index returned -0.1% for the month (Figure 16). The 10-Year U.S. Treasury yield has settled into a narrow range of 0.60-0.70%. U.S. High Yield was affected by the negative equity performance, returning -1.0% for the month, as high yield spreads widened above 5% after hitting an intra-quarter low of around 4.5% (Figure 17). Non-U.S. dollar and emerging market debt were hurt by the strengthening U.S. dollar.
Figure 16 – U.S. High Yield and Emerging Market Debt Sold Off with Equities
Figure 17 – Lower Investment Grade (BBB-Rated) and High Yield Spreads Widen After Narrowing to Post-COVID Lows Earlier in the Quarter
Among equity alternatives, U.S. REITs returned -2.3% for the month after having risen d2% earlier in the month, while commodities and precious metals sold off (Figure 18). Precious metals came under pressure as negative real interest rates appear to have a reached a floor (see comments above), while commodities were hurt by a pullback in oil prices over concerns of waning demand and OPEC overproduction (Figure 19).
Figure 18 – Equity Alternatives Had a Negative Month as Commodities and Precious Metals Pulled Back from Earlier Quarterly Gains
Figure 19 – Oil Prices and Industrial Metals Continue Their Rally in Anticipation of Some Recovery in Demand
Third-Quarter 2020 Market Performance and Exhibits
Other Notable Charts
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