Stone's Weekly Market Guide - Week of August 17, 2020
Chart of the Week: Banks within the S&P 500 have recently begun to outperform the S&P 500 with the relative performance bottoming on August 6th. Interestingly, the outperformance coincided with the better than expected July jobs report and the low in 10-year U.S. Treasury yields. Not surprisingly, the bank index is typically positively correlated with Treasury yields but the correlation has been rising since the S&P 500 bottom in March (see chart). The July payrolls report, which reflected an almost 1.6 million increase in jobs, was a significant positive surprise with the U.S. economy losing some momentum due to the increase in COVID infections and some economists expecting further job losses. Outperformance of the banks has also helped spark outperformance from the value versus growth indexes, which also bottomed on August 6th. With the financial sector comprising 18.6% of the Russell 1000 Value index versus 10.0% of the S&P 500, the value outperformance is logical. Value strategies in general have been outperforming since at least early August although banks are certainly not the only reason for value outperformance. In our view the improved economic outlook, as signaled by the payrolls report, has helped drive the turn in value and smaller-cap stocks. With the benefit of some lucky timing and extreme relative valuations, we highlighted the opportunity in value and smaller stocks in our report on August 3. If in fact the economy continues to mend, bank stocks continue to look interesting at less than 0.9 times estimated price to book(P/B) versus a low of 0.6 times during the global financial crisis in early 2009 and an average of 1.1 times since 2005. The estimated dividend yield is also enticing at almost 3.6% if dividends remain unaffected by the need to conserve capital for loan losses.
Week in Preview
· Geopolitical: With lockdown measures being re-introduced in parts of the U.S. and globe to combat a resurgence in COVID-19 infections, the impact on economic activity will be closely monitored. Tensions between the U.S. and China continue with the two countries expected to discuss progress of the trade deal as well as TikTok and WeChat this week. Ministers from OPEC+ will meet to discuss production compliance. The $1.2 trillion sovereign wealth fund for Norway releases its first-half report. A primarily virtual Democratic National Convention will be held.
· U.S.: Attention will continue to be on negotiations over the next fiscal stimulus package. Talks seem to remain stalled with President Trump having signed an executive order to provide some temporary relief. Both the House and Senate are on recess until early September but could return to vote if a deal is reached. July housing data should continue to be a strength for the economy with building permits, housing starts and existing home sales expected to improve. The Federal Reserve releases the minutes from their July 29 meeting which will be scrutinized for clues as to future policy. Readings for our U.S. Reopening Monitor took a step back last week, but initial readings on new COVID-19 cases have now fallen on a week-over-week (W/W) basis for four weeks in a row with the uptick in infections that began in June likely peaking. Improvement is showing up in the underlying high frequency economic data for public transit usage and retail sales. We will be looking for improved economic momentum over the coming weeks with the August Markit PMI data for manufacturing and services expected to improve this week. Please see our weekly U.S. Reopening Monitor and our Guide to the U.S. Reopening Monitor for more details.
· S&P 500 Earnings: 2Q earnings season is nearing its end with only 17 S&P 500 companies reporting, dominated by retailers this week. As we forecasted, 2Q earnings showed large earnings declines but handily beat very depressed expectations and some companies have reinstated earnings guidance which is a positive in removing some unknowns. 3Q earnings are expected to be less bad with consensus estimates of a -23% year-over-year (Y/Y) decline. The calendar year 2020 and 2021 earnings estimates improved last week.
· Europe: August PMI data across the Eurozone including Germany and the U.K. are expected to further improve reflecting economic expansion. The PMIs should reinforce our view that the 2Q economic decline in the Eurozone will mark the economic nadir and provide some clues as to the strength of the 3Q. U.K retail sales for July should moderate from June’s strong bounce, but still remain positive. The European Union (E.U.) and the U.K. are scheduled to resume their trade negotiations after a summer break.
· Asia: The economic calendar for China is empty of any notable releases. Japan released 2Q GDP with a COVID-lockdown induced plunge of -27.8% quarter-over-quarter (Q/Q) annualized. July Japan trade data is expected to improve with exports estimated at -20.7% Y/Y from -26.2% in June. August Japan Jibun Bank PMI data should improve with the June readings below the expansion versus contraction level of 50, the rare major developed economy remaining below that level.
Central Banks: The central banks of Indonesia, Sri Lanka, Namibia, Zambia, Norway, Philippines, Turkey, Mozambique and Botswana are scheduled to meet with Sri Lanka expected to lower its policy rates.
Week in Review
· Stocks rose by 0.6% for the S&P 500 with eight out of eleven sectors higher for the week. U.S. economic data continued to be supportive with better initial jobless claims and retail sales growth. Industrials (3.1%), energy (2.3%) and consumer discretionary (1.6%) outperformed the S&P 500, while utilities (-2.1%), real estate (-1.8%) and communication services (-0.3%) were the biggest laggards. WTI (1.9%) and Brent (0.9%) oil were higher with MLPs (2.4%) and the energy sector (2.3%) outperforming. Small cap stocks performed roughly in line with the S&P 500 with the Russell 2000 higher by 0.6% and small cap value stocks gaining 1.6%. The 10-year and 30-year U.S. Treasury yield were higher at 0.71% and 1.45% respectively.
· High yield credit spreads widened reflecting decreased risk appetite. AAA municipal bond yields as a percentage of Treasuries decreased sharply, causing municipal bonds to outperform. The negative revenue impacts of the economic lockdown on local governments and talk of state bankruptcy have driven municipal bond valuations to low levels relative to Treasuries. Allowing states to declare bankruptcy should remain an unlikely outcome with the heart of the issue really about the size and distribution of Federal government aid. Additional support for the states is likely to come in the next stimulus bill.
· The U.S. dollar was weaker against developed and emerging market currencies. Developed international stocks as measured by MSCI EAFE outperformed the S&P 500 returns in U.S. dollar terms (2.4%) and on a hedged-currency basis (2.4%). Emerging market stocks underperformed the S&P 500 with the non-hedged return of 0.4% for MSCI EM.
· The 10-2 yield curve widened to +56 basis points. Another curve measure of three-month yield six quarters forward minus the current three-month yield rose to +8 basis points. The yield curve has historically provided an accurate forecast of future recessions when the difference in these measures turns negative, also known as inversion. Yield curves are one of the major indicators that we monitor to judge recession risk, but these inversions typically happen more than a year in advance of an economic recession but external shocks like the current coronavirus-induced recession might not be accompanied by one. Stocks have historically had significant advances post-inversion.
The PDF version of Stone's Weekly Market Guide is linked here.
The Guide to the U.S. Reopening Monitor is linked here.
The weekly update to the U.S. Reopening Monitor is linked here.