Equity markets embed optimistic assumptions on the reopening
JUN. 08, 2020
Equity markets “risk on” as payrolls surprise to the upside
Equity market continue their historic rebound from what was an unprecedented decline. The S&P 500 IndexTM has delivered three consecutive weeks with a 3% gain for the first time since 1982. While facing a global pandemic, the shutdown of the economy and now widespread protests, the S&P is down just 1% year-to-date. While most observers were concerned that equity markets were out of line with the economic reality, the much stronger-than-expected payroll report gives credibility to a V-shaped recovery that equity markets reflect. Equity markets remain expensive, but a quicker and more powerful economic recovery would limit the downside. While the payroll report was encouraging, it is necessary for us to see confirmation from other data points given the volatile nature of reports.
Somewhat lost in the impressive market recovery has been the changing complexion of leadership. Participation in the recent rally has expanded, with 65% of the S&P 500 trading at a 3-month high Friday, among the best readings in history. Historically, strong readings on this metric are a good harbinger of forward returns. Areas of the market that were left behind, notably high beta, small caps and value stocks, have become leaders. Global markets have begun to outperform domestic as the dollar trades at the lowest level in three months. Risk-on outperformance generally occurs at the beginning of market cycles, similar to 1982, 2002 and 2009. The outperformance of early sector areas is encouraging for the near term, leadership will likely shift back to the quality growth names once the initial recovery is exhausted
Nonfarm payrolls shocked economists, showing growth of 2.5m in May (largest in history) compared with an expected loss of 8.3m, suggesting the rebound in the economy is faster than expected. This represents a remarkable rebound from the 20.7m lost last month, with the unemployment rate falling to 13.3% from 14.7% in April and an estimated 19.5%. Average hourly earnings jumped 6.7%. Leading sectors included leisure & hospitality (+1.2m), construction (+464k), education & health (+424k) and retail (+368k), while government was weak (-585k), suggesting that many of those furloughed were brought back, in line with the goals of the PPP. The lone negative take is that while temporary layoffs fell by 2.7m, permanent job losses jumped 2.3m.
The Fed is considering unlimited purchases of Treasuries to cap yields at low levels across the yield curve. This would be the first time the Fed capped yields on Treasury securities since 1951 coming out of World War II. The Fed has committed to keeping interest rates low, and this tool would allow much greater influence. This discussion comes as the spread between the 10-year and 2-year Treasury yield is at the widest level since early 2018. While rates have remained near historic lows on demand factors, this would limit the risk from a spike from the pending surge in issuance or an increase in inflation expectations. The 5-year breakeven inflation rate at 0.95% is at the highest level since early March. There is unlikely to be a tangible plan by this week’s FOMC meeting.
The better-than-expected jobs report complicates discussions on the fifth coronavirus relief package, with Republicans against another round of direct payments or the extension of the $600/week enhanced unemployment benefits. President Trump plans to focus on payroll tax relief and deregulation, with the potential for an infrastructure package.
What to Watch
Given the volatility in the economy, data points that are more forward looking, such as the NFIB Small Business and Consumer Sentiment, will be closely watched. Inflation data (CPI and PPI) are historically closely watched but given the degree of moving parts and the backward-looking nature, this week’s releases will likely have muted reactions.