Data Source: Bloomberg
COVID-19: Markets Seesaw Between Prospects For Medical Treatments And Second Wave Outbreaks
Source: form PxHere
[3D Note: As part of our ongoing commentary concerning the coronavirus global contagion and its impact on human and global markets, we remind readers that the situation remains fluid as evidenced by volatile market reactions to most new developments, although the pace of these reactions seems to have slowed down from March/April. In addition to our bi-monthly articles and periodic podcasts, 3D has started publishing weekly updates to our advisor partners as we navigate through the coronavirus pandemic. Please contact us if you would like to be added to the distribution list.]
Outlooks for a vaccine to treat the COVID-19 virus have seesawed between hope and dismay as coronavirus headlines continue to dominate day-to-day market volatility. The first week in June saw a burst of risk-on appetite for beaten-up cyclical assets (small caps, real estate, commodities) overpromising vaccine development news from Oxford University and Moderna (NASDAQ:MRNA). Moderna is considered the front-runner for developing a vaccine as it began Phase 3 human trials whose results are expected to be released later this summer (the National Institute of Health is also advancing vaccine trials from AstraZeneca (NYSE:AZN) and Johnson & Johnson (NYSE:JNJ)). According to the Milken Institute, 14 vaccines are currently in human trials out of a total of 178 in various stages of development.
Yet, many are skeptical of Moderna’s bold predictions of rolling out an experimental vaccine by the end of the fall as “no company using [Moderna’s] experimental approach has managed to pull off a successful drug.” Moderna’s vaccine approach is considered more promising since it “can be designed and manufactured more quickly than vaccines based on older technologies…”
Here is a summary breakdown of the vaccine trials:
Source: Wall Street Journal, 7/1/2020
An aggressive timetable for a mass-produced vaccine by year-end is now being questioned. Oxford University warned United Kingdom lawmakers to ” prepare for the worst” as scientists scaled back expectations that a coronavirus vaccine breakthrough would arrive before the cold winter months. Expect further news headlines on vaccine progress (or lack thereof) to drive market volatility throughout the summer.
Growing net positive infection rates across the United States dominated much of the headlines throughout June as many parts of the country have experienced a resurgence in cases and hospitalizations, particularly Arizona, California, Texas, and Florida. Younger age cohorts are driving the bulk of new cases, most likely a result from the reopening of popular venues such as bars (although mass protests over social injustice have also been a contributor). Several states, such as Texas and Florida, have shut down bars and water park venues. The concern isn’t so much around rising mortality rates but rather the subsequent increase in hospitalizations which are starting to tax the U.S. health care system (especially in Texas and Arizona). The COVID-19 Tracking Project is publishing daily tests, positive results, hospitalizations, and mortality.
The next chart plots each state based on % positive tests versus average tests per 100,000 population. The major hotspot states are located on the right; many of the former hotspot states (i.e. the northeast region represented by the green dots) located on the left are in much better shape.
It appears that a bipartisan consensus is forming on the wearing of masks for indoor and outdoor use where social distancing is not feasible as it now appears that no major area across the U.S. is experiencing a decline in net positive cases. In addition, several states are imposing or re-imposing indoor restrictions to limit social gatherings.
Mixed U.S. Employment Picture as Continuing Claims Remain Elevated
The employment picture also remains mixed despite a strong May release that saw an unexpected rise in payrolls (2.5 million) and an unemployment rate lower than what consensus had been projecting (reported 13.8% versus expected 19.8%). The positive reaction to the U.S. May Employment report should not be dismissed, but there are some ‘caveats’ to point out not evident from the headline numbers:
The broader U-6 or underemployment rate (includes those who haven’t searched for a job recently or want full-time employment) is still elevated at 21.1% (down from 22.8% in May) compared to 7% at the end of February; The U-3 employment rate of 13.3% would have been 3% higher were it not for workers who were recorded as employed but absent from work due to other reasons rather than unemployed due to temporary layoffs (according to the U.S. Department of Labor); Businesses who took out Payroll Protection Program (PPP) loans are incentivized to rehire laid-off workers (originally June 30 now extended through year-end) in order to qualify for such loans to be forgiven (up to 125% of payroll expenses). The Employment/Population ratio remains historically depressed at 52.8% (peaked at 61% pre-COVID). Looming on the horizon is the expiration of unemployment benefits expire on July 31 barring some extension from the federal government; however, the U.S. government is expected to pass another stimulus spending program that will extend these benefits in some form.
Since its release, the shine has come off the robust employment release as unemployment claims remain elevated even though they’ve declined from the March peak (Figure 1).
Figure 1 – U.S. Unemployment Claims Remain Elevated
Global Debt Binge to Counteract Pandemic Shutdown (Not for a Lack of Trying)
Governments (Figure 2) and corporations (Figure 3) are borrowing at unprecedented levels in the face of declining gross domestic product (GDP). Although this borrowing will help counteract economic contractions, it will likely weigh on future growth potential.
Figure 2 – Major Countries Need an Economic Recovery to Normalize Unprecedented Levels of Fiscal Deficit Spending
Figure 3 – Corporations Scrambling to Raise Rainy Day Capital but Could Weigh on Future Growth Potential
The U.S. government and investment-worthy corporate borrowers need not worry about near-term funding sources thanks in part to the Federal Reserve’s emergency lending measures (leveraged up special purpose vehicles with initial funding from the U.S. Treasury), which have definitely restored liquidity and functionality to the debt capital markets. The Federal Reserve balance sheet has grown nearly $3 trillion over the post-COVID-19 recovery to reach $7.08 trillion (Figure 4) down from a peak of $7.1 trillion due to the expiration of emergency dollar swap agreements between the Fed and other central banks along with declining demand for repo liquidity from the primary dealer community.
Figure 4 – Federal Reserve Balance Sheet Now at $7.08 Trillion Although Pace of Expansion Has Slowed
The Fed continues to purchase Treasuries and mortgage-backed securities to support fixed income liquidity. And now having added corporate bonds into the mix, the Fed announced plans in mid-June to purchase individual corporate bonds in addition to exchange-traded funds containing corporate bonds. So far, the Fed has purchased $7 billion in corporate bond exchange-traded funds since the ETF purchase program began in mid-May. The Fed then disclosed that it has purchased $428 million individual corporate bonds through the Secondary Corporate Credit Facility with an end goal of purchasing up to $250 billion or ~3.5% of the Fed’s current balance sheet.
The Fed’s calming of the fixed income markets can also be seen in the decline of the U.S. dollar (Figure 5), partly reflecting the rolling off of emergency currency swap arrangements with other central banks and reduced dealer demand for overnight repo financing. The dollar did appreciate towards the end of the month and seems to be inversely tracking coronavirus infection rates.
Figure 5 – U.S. Dollar Appreciates Toward Month-End Over Concerns of Rising Coronavirus Cases
Past the Worst but a Slow Recovery Nonetheless
Many U.S. economic time series resemble Figure 6 which displays the Transportation of Security Agency (TSA) airport foot traffic – a timely indicator of air travel recovery following the coronavirus shutdown. In general, economic activity, as indicated by consumer or manufacturing sentiment, reveals a slow recovery off a steep drop from March/April. The debate now is whether this recovery will level off in light of the renewed coronavirus outbreaks.
Figure 6 – TSA Airport Traffic Showing a Slow Recovery
The market’s recovery and general unease can also be seen in the implied volatility metrics priced into equity and bond options. Following the mid-March meltdown spike, both indicators have settled down although equity volatility remains elevated versus the pre-COVID-19 period. Downside risk protection will likely remain at a premium through the summer and into the November election.
Figure 7 – Implied Equity Volatility (Bid for Downside Protection) Has Settled Down but Remains Elevated Following the Mid-March Market Meltdown
Implied volatility priced into fixed income risk assets has dropped following the Fed’s quantitative easing and emerging lending measures to support the credit markets. For now, the Fed has solved liquidity issues but not necessarily solvency issues, although the latter seems to be pushed off down another year or so except for the weakest borrowers (i.e. retailers, energy). Corporate credit spreads, or the cost of financing over U.S. Treasuries (Figure 8), narrowed throughout much of the second quarter but did widen towards the end of June over concerns of rising coronavirus cases.
Figure 8 – High Yield Credit Spreads Widened Over Rising Coronavirus Infections
Similarly, municipal bond spreads have narrowed from their mid-March panic levels as liquidity returns to the market. AAA-rated municipal bond yields (Figure 9) remain at a premium relative to Treasuries reflecting heightened credit concerns as many state and local issuers are facing a depressed revenue environment and are counting on further federal government support.
Figure 9 – AAA-Rated Municipal Bonds Recover from Mid-March Sell-Off but Still Yield at a Premium Relative to U.S. Treasuries
With the rally in U.S. equities, the S&P 500 trades near a 10-year high at 21.6 times next 12-month’s expected earnings (Figure 10). The multiple expansion to new 10-year highs is a result of both global equity rallies and declining forward earnings expectations due to the global economic shutdown. According to FactSet Earnings Insight (6/26/2020), Wall Street analysts are expecting a sharp recovery in earnings and revenue for S&P companies in 2021 following a sharp decline in 2020. Consensus analyst estimates for S&P earnings are expected to decline 21.6% (revenue down 3.9%) in CY2020 but recover 28.8% (8.5% revenue growth) in CY 2021.
Figure 10 – Global Equities Trade Near 10-Year High Valuations on Projected Next 12-Month Earnings
International developed (MSCI EAFE) and emerging markets (MSCI Emerging) are also trading at 10-year high valuations on forward earnings but remain at a sizeable discount to the U.S. However, U.S. corporate earnings are expected to recover at an earlier rate versus Europe and Japan, although emerging market earnings estimates have recently turned up (Figure 11).
Figure 11 – Forward 12-Month Earnings Estimates Are Turning Up for the S&P 500 and Emerging Markets
Second Half Outlook
3D wants to emphasize the importance of aligning client time horizons and risk profiles with the appropriate asset mix (stocks, bonds, alternatives) and not to be overly swayed by the daily/weekly market-moving headlines. There could be more turbulence ahead until the markets get more clarity on coronavirus medical advancements and the timetable for an economic recovery.
It’s hard not to state the obvious, but we expect COVID-19 developments to drive market volatility for the remainder of the year as investors get a better sense of the structural impact government-imposed restrictions on social gatherings will have on economic activity as well as the potential for antiviral treatments. Over the near term, we are more sanguine on the risk environment as China also appears to be ramping up infrastructure spending as a means to jumpstart the economy. Figure 12 displays two proxies for China-focused risk appetite – rising 5-year government bond yields and a stable CNY/USD exchange rate can be interpreted as procyclical indicators.
Figure 12 – Rising 5-Year China Bond Yield and a Stable CNY/USD Exchange Rate Indicate Point Towards Pro-Cyclicality
Global risk assets have benefited from government fiscal stimuli and coordinated central bank policies to restore liquidity back to the capital markets. Commodities should continue to benefit from a combination of a recovery in demand and structural impairment of supply production. Real estate will likely remain highly sensitive to coronavirus headlines as this sector has experienced a larger impact from quarantine measures. After starting cautious on the year for global equities due to stretched valuations, we remain neutral given forward valuations as future equity advances will likely rest on the progress of the economic recovery and progress on coronavirus infection rates and treatments.
With respect to fixed income, the Federal Reserve will seek to maintain open borrowing windows for both the Federal government (via yield curve control and quantitative easing) and credit-worthy corporate borrowers (via primary and secondary market lending facilities); hence, we expect interest rate and credit spread volatility to remain muted barring a major credit event. We see municipal bonds as offering attractive after-tax yields and expect further financial support from the next federal stimulus spending program.
June 2020 Market Review
Global markets continued their advance in June on the hopes of progress being made on COVID-19/coronavirus medical treatments as well as signs that the worst of the global economic contraction may be behind us. MSCI All-Country World Index (ACWI) returned 3.2% for the month led by Emerging Markets (up 7.4%) followed by international ex-U.S. developed (MSCI EAFE up 3.4%) and the U.S. (S&P 500 up 2.0%).
MSCI Asia-ex-Japan led major developed market regions rising 8.2% followed by MSCI Europe (+4.1%) and the U.S. (S&P 500 +2.0%) (Figure 13). MSCI Japan was a notable laggard returning flat for the month after outperforming in May. International market performance was helped by a weaker U.S. dollar (down from its mid-March funding shortage peak) as global central banks unwound currency swap arrangements that provided emergency U.S. dollar funding during the height of the mid-March panic.
Figure 13 – Asia ex-Japan and Emerging Markets Led Major Regions in June While the U.S. and Japan Lagged
At one point early in the month, U.S. small caps had returned ~8% in excess of large caps and then surrendered much of that outperformance over the course of the month as investors’ hopes for a V-shaped recovery gave way to the prospects of another shutdown brought on by a second coronavirus wave. The S&P 500 (large caps) returned 2.0% while the S&P 600 (small caps) returned 3.0%. Similarly, value stocks surrendered much of their early outperformance over growth stocks with the S&P Pure Value returning 2.1% versus 2.7% for S&P Pure Growth (Figure 14).
Figure 14 – U.S. Small Edges Out Large and Growth Outperforms Value
Technology and consumer discretionary stocks (primarily e-tailers) led in June as investors continue to favor ‘shelter-in-place’ growth themes. Defensive sectors such as utilities and healthcare lagged as did the energy sector, dragged down by a month-end sell-off in oil prices (Figure 15).
Figure 15 – Growth Sectors (Technology, Consumer Discretionary) Led in June While Energy and Defensive Sectors Lagged
Among factors, Momentum and High Quality outperformed Minimum Volatility, Value and High Dividend (Figure 16). Minimum Volatility, High Dividend, and Value underperformed as investors increasingly focused on pure growth momentum themes.
Figure 16 – Momentum and High Quality Led Factor Performance in June
Investment-grade fixed income posted a positive month helped by a combination of lower interest rates and narrower credit spreads. The U.S. Bloomberg/Barclays Aggregate Index returned 0.6% for the month (Figure 17). Following an early month sell-off in reaction to an unexpectedly strong U.S. employment report, U.S. Treasuries have now settled into a narrow range of 0.60-0.70%. U.S. High Yield continues to recover from the 1Q20 sell-off, returning 1.0% for the month, although high yield surrendered early month gains due to the rise in coronavirus infections.
Figure 17 – U.S. High Yield and Emerging Market Debt Continue to Benefit from the Global Risk Asset Recovery
The Federal Reserve continues to strongly hint at implementing yield curve control where the Fed would target Treasury rates, possibly out to seven years, as a means of maintaining monetary stimulus (as well as aiding U.S. Treasury borrowing needs). This has helped flatten the U.S. yield curve (difference between short versus long rates) which still remains positive (Figure 18). With 1.5% long-term inflation implied by breakeven rates between U.S. TIPs versus nominal Treasuries, the bond market is bracing for slow non-inflationary growth, but not deflation.
Figure 18 – 2-10 Year Term Structure Remains Positive but Has Flattened While Inflation Expectations Implied by TIPs versus Nominal Treasuries Remain Subdued
Among equity alternatives, U.S. REITs returned 2.3% for the month after having risen as high as 12% earlier in the month (Figure 19). U.S. commercial real estate experienced renewed selling pressure as investors now expect more lockdown measures to be imposed in response to the rise in coronavirus infections. Precious metals turned in a positive month (+2.5%) after having been down earlier in the month, while commodities outperformed equities, returning 5.1% on the strength of oil prices and industrial metals (Figure 20). The 3-month generic oil price settled at $39.48/barrel, up from a low of $18/barrel in late April.
Figure 19 – Equity Alternatives Had a Positive Month Led by Commodities
Figure 21 – Oil Prices and Industrial Metals Continue Their Rally in Anticipation of Some Recovery in Demand
Second Quarter 2020 Market Performance and Exhibits
Year-to-Date 2020 Market Performance and Exhibits (Ending 6/30/2020)
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