Equity markets embed optimistic assumptions on the reopening
JUN. 01, 2020
Equity markets continue to display remarkable resilience in the face of a constant barrage of troubling developments, with investors continuing to focus on the positive signs of reopening despite the added headwind of the nationwide protests, with 95% of the S&P 500 IndexTM trading above their 50-day moving average. The S&P 500 ended May with a gain of more than 4%, following the 13% rally in April. Over the past 12 months, the S&P 500 has returned more than 10% despite the economy largely being closed for the past three months and unemployment spiking. The S&P trades at nearly 19x next year’s estimate, which is likely to be revised lower. This is the most expensive valuation since 2002 and suggests that markets are due for a breather following an unprecedented rally.
With a lack of supportive economic releases, equity investors have chosen to rely on high-frequency data as a sign of a return to normal, including a decline in the purchase of toilet paper, disinfectants and frozen pizza. Investors are far more focused on high-frequency data than normal, given the magnitude of the economic decline and the wide gap between high-frequency and traditional data trends. Positive signs include improvement in flights, truck traffic, car sales and beach visits, along with falling unemployment claims. This Friday’s payroll report could be a reminder of the severity of the current situation. Equity investors have priced in a healthy and fast recovery and could be susceptible to a pullback if the pace of opening disappoints.
The recent rally has taken a “risk-on” tone, led by the industries that were hardest hit during the decline, including travel & leisure, brick & mortar retail, real estate, financials and energy. Also, small caps have seen a strong recovery. As the initial phase of the market recovery is over, we see quality growth continuing to lead. In uncertain times, those companies with diversified and defensible revenues, with strong balance sheets and cash flows have more levers to pull to drive shareholder returns. This includes areas of technology, health care and industrials, but not all of them.
Protests over the death of George Floyd has spread across the country, and in many areas have turned increasingly violent, resulting in loss of property and looting. From a purely economic perspective, the demonstrations raise the prospect for fresh coronavirus outbreaks, while further challenging those local businesses impacted by the economic shutdown. Also, Walmart and Target have closed hundreds of stores and Amazon has scaled back deliveries to major cities. Retail earnings will be in focus this week, likely adding volatility to the sector. The focus on the protests is also likely to complicate negotiations on the next phase of fiscal stimulus.
Rhetoric between the U.S. and China has continued to amplify, with President Trump announcing plans to strip Hong Kong of its special trading status. This could expand to limitations on the financial sector and sanctioning of Chinese officials through visa restrictions and asset freezes. Beijing told major state-run agricultural companies to pause purchases of some American farm goods, including soybeans and pork, until it evaluates the ramp in tensions with the US over Hong Kong.
Bond market resilience is not only reflected in stable interest rates and tightening credit spreads, but also in the receptive market to issuance. Corporate bond sales have topped $1 trillion this year, compared with 2019 (a fairly typical year) where it didn’t occur until November. Initially, this was concentrated in the best credits, but has since shifted down-market. This is largely due to the Fed’s signaling that they will support the corporate bond market, though they have deployed just $95 billion of the pledged $2.5 trillion through 11 emergency facilities.
What to Watch
This is a busy week for data, with economic releases including PMI manufacturing on Monday, durable goods and PMI services on Wednesday, productivity on Thursday and the monthly payroll release on Friday.
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