Divergence

Risk-on sentiment continues to be the theme in markets, with stocks flashing “green” across the board for most of yesterday.

The pace of infection across parts of the Asia-Pacific is slowing, Chinese data looks positive, and the WHO is even seeing signs of “green shoots”. Whilst Russia claims to now have an approved vaccine which is going into production, broader testing and due diligence has been short-circuited in order to launch “Sputnik V”. Risk appetite is also diving into bond markets, where another record is due to be broken by a new 10-year bond issued by Ball Corp (a US aluminium repackaging firm). The return for taking 10 year credit risk to this “speculative grade” issuer (or “junk bond” in old, less investor-friendly terminology) is reported to come in at a not so handsome 2.875% – the lowest USD issuance level in history for a sub-IG bond with a term of 5 years or more…

It is challenging to fully justify the gains currently being witnessed, particularly when taking into account the growing levels of debt (already at all-time highs) and the continued damage to revenue that is clear for all to see. Yes, there are many more dollars in the system, the sceptic might argue that this simply means there are more to potentially lose. The inflation-busting $US hedge of gold is also off the highs, but a troy ounce will still cost 30% more today than it did when we rang in 2020. To put this into context, we are close to braking all-time highs in several stock indices. With the S&P near 3750, the market is pricing in 30 times earnings going into 2021. Valuations are extended and very much out of kilter versus long-term values. Yes, as per a report recently published by the Bank of America, we have seen $20Tn in stimulus globally (to date…), this debt needs to be paid off, arguably fundamentals are further from valuations than ever.

Following the agreement of the EU to provide grants and loans to those countries most afflicted both medically and economically by the continued disruption, whilst also extending credit to banks at a rate of -1.00, all is well in EUR. Bond yields have broadly continued to rally with a compression in returns when comparing the periphery and lesser-rated Southern States to the fiscally prudent AAA/AA Governments to the North. An interesting trend observed by the team here – gleaned from our exposure to cash holders across a broad range of sectors, is that the artificial support of 0.00 is all but gone, with depositors being forced to accept rates (on average) of -0.50%, with significantly worse (or swifter erosion of capital) for financial-like cash rich entities. Most big European banks have now reported, and dividend policy as well as bonus payments in this sector are continuing to be controlled by politics. The good news is that all are making provisions, increasing the odds of being part of the solution, unlike the last time around. It feels to us that this story still has a long way to run though, so we would be shy of making any predictions as to the outcome at a point where we still believe that we are early in this crisis. A full employment and economic recovery with earnings returning to pre-pandemic levels is priced in. Disappointments on any of these or indeed another unexpected shock is likely to trigger the next selloff. Structural unemployment (the kind that sticks around) is a real danger here, globally, as certain sectors fail to recover swiftly enough and new jobs and industries do not advance fast enough to pick up the slack.

The Bank of England was more upbeat on UK PLC to the end of 2020, revising GDP to be down 7.5% versus the 9.5% pencilled in at their May meeting. Unemployment will be the key metric to watch in particular once furlough is done, but if one is to believe the accuracy of the numbers this morning, whilst the ONS states 730,000 jobs have been lost since March, unemployment has held in at just 3.9%. Since the Bank’s announcement last Thursday, there has been one notable shift – that of Gilt (UK Government) yields. One-year bonds are trading at 0.06% having been in negative territory for weeks, and the curve has generally shifted higher as the bank also reported observing UK banks being in good shape, and (mostly) prepared for any headwinds. Let us hope this also translates into a smooth transition [through Brexit] later in the year, although from the outside this seems ambitious given where resources on both sides of the channel have been focussed. UK Treasury Bills continue to float above zero, just a little bit more than they did, but unlikely to arouse even the most excitable. At least the risk-free rate can remain a free option as opposed to eroding capital.

Also underway and to be completed by the end of the year per Chancellor Sunaks request is a full review into the shadow banking system, as once again this has proven itself to be a weak point in markets, with intervention being required on a large scale in several jurisdictions. Not the stable financial system one wants and now more than most times, absolutely needs. Good thing there are other options on the table now to reduce risk and increase return.

This morning the UK is officially reported as going into recession, with Q2 GDP printing at -21.7%, versus the same period last year, or down 20.4% quarter-on-quarter. Unfortunately, this also places the UK as the worst performer in Europe and behind the United States. This does require contextualising. In the previous crisis, GDP at its worst reached -6.2% (Q2 ’08 to Q2 09). This quarter represents a shrinking of the economy over three times as deep as the entire GFC (see link below from the ONS confirming this). Added to this the drop in Q1 2020 the UK has witnessed and we are back to Q1 2014 in terms of overall size. In just two quarters. All this prior to furlough ending which has supported over 9 million employees.

The sunshine belt of the United States which has been somewhat overwhelmed with cases appears to be getting matters back under control. This along with talk from President Trump of a keenness to review and reduce capital gains tax has Wall Street partying like it’s 2019. Whilst an Executive Order went through to provide emergency paychecks to those most in need, the market awaits further clarification and agreement on the next formal (and no doubt gigantic) stimulus package. For now, keep that finger close to the equity buy button, knowing that access to the exit will be equally important! Worth mentioning is the stellar performance of those banks most exposed to financial markets (and the right way around) as well as bond underwriting where profit has been up in several cases by more than double. Speaking from experience, this tends to be short-term in nature and the potential for drag is only increasing with very low interest rates impacting the ability of banks to generate revenue as fees compress, as well as growing potential fallout from a slower recovery than previously expected.

Articles of interest:

Gross Domestic Product: Quarter on Quarter growth: CVM SA %

Bank of England warns of Risk From Rise of Non-Bank Players

Banks braced as pandemic poses biggest test since financial crisis | Free to read

Breakingviews – Does $20 trillion buy much inflation?

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