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Stone's Weekly Market Guide - Week of August 31, 2020

Chart of the Week: Federal Reserve (Fed) Chair Powell unveiled a significant shift in monetary policy strategy last week and markets reacted quickly to the changes. The most important change was an average inflation target of 2%. This will result in the policy rate remaining lower for longer and allowing the economy to run hotter before the next rate hike. Measures of inflation expectations hit a post-pandemic high with the 10-year Treasury Inflation-Protected Security (TIPS) breakeven reaching 1.78% and the 5-year, 5-year forward breakeven reaching 1.85% (see chart). It is important to note that these are still not high inflation expectations and moderate inflation is helpful in avoiding ultra-low and negative interest rates which can have negative consequences for our economy and financial system. Recent infection and economic data trends have also reinforced optimism about the current economic recovery. The U.S. 10-year Treasury yield rose to 0.72%, while the 2-year yield fell to 0.13%. Since the Fed only explicitly controls short-term policy rates, the 2-year now reflects less probability of a hike in rates over the next 2 years. This caused the yield curve, as measured by the 10-year yield minus the 2-year yield, to steepen to 0.59% which can be viewed as reflecting a healthier economic outlook. Banks performed very well last week in the wake of Powell’s speech, as our piece recently noted, they have become very correlated with interest rates and the economic outlook. Banks earn some part of their profits by borrowing short-term (think checking deposits) and lending long-term (think mortgage loans) so a steeper yield curve is helpful. It is more complicated than that, but this provides a reasonable mental model. For investors expecting the economic recovery to continue, banks due to their low valuation, high dividend yields and positive sensitivity to higher yields continue to be interesting in our view.


Chart 1: The Fed, Reflation & Banks YTD
Chart 2: The Fed, Reflation & Banks - Announcement Week

Chart 3: Banks - Valuation & Dividend Yield

Week in Preview


· Geopolitical: With lockdown measures being re-introduced in parts of the 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 will be watched for flare-ups. U.S. markets are closed on Monday, September 7 in observance of Labor Day, so our next weekly will be published on Tuesday, September 8.


· U.S.: Initial jobless claims reversed lower last week and will be watched again this week for a high frequency read on the labor market, but the primary focus will be on the August jobs report. Consensus expects an increase of 1.4 million in nonfarm payrolls and the unemployment rate to fall to 9.8%. ISM manufacturing and services readings for August are on tap and should indicate some continued momentum in the economic recovery. Negotiations over the next fiscal stimulus package remain stalled, but both the House and Senate could return to vote if a deal is reached. Fedspeak ramps up with a heavy emphasis on the new monetary policy framework in the wake of Chair Powell’s unveiling of the new strategy last week. Readings for our U.S. Reopening Monitor improved last week and initial readings on new COVID-19 cases have now fallen on a week-over-week (W/W) basis for six weeks in a row with the uptick in infections that began in June having peaked. Improvement is showing up in the underlying high frequency economic data for retail sales, transit and consumer sentiment. Our forecast of improved economic momentum has continued to play out as expected. 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 has only 7 S&P 500 companies reporting. As we forecasted, 2Q earnings showed large earnings declines but handily beat expectations and some companies have reinstated earnings guidance which is a positive in removing some unknowns. 3Q earnings estimates have improved and are expected to be less bad with consensus estimates of -22.5% and -4.1% year-over-year (Y/Y) decline in earnings and sales, respectively. The calendar year 2020 and 2021 earnings estimates improved last week.




· Europe: Confirmed COVID cases have risen on a W/W basis for eight straight weeks in the Eurozone and could weigh on the outlook. Eurozone consumer inflation (CPI) for August is expected to accelerate to 0.0% month-over-month (M/M) from -0.4% in July. The U.K. pace of infections may have peaked with two weeks of W/W improvements. The U.K. markets are closed on Monday, August 31 for a bank holiday. U.K. mortgage approvals for July are expected to rise to 55,000 from 40,000 in June.





· Asia: August official manufacturing and non-manufacturing PMI readings for China were mixed at 51.0 and 55.2 from 51.1 and 54.2 in July. China Caixin manufacturing and services PMI readings for August should continue to indicate expansion as well. Japan has had three straight weeks of W/W declines in infections after a nine week streak of increases. Japan PM Abe resigned last week for health reasons, but the new government should continue to back many of the same policies to support the economy. Japan’s monthly job data for July should weaken with the unemployment rate expected to rise to 3.0% and the job-to-applicant ratio fall to 1.08.



Central Banks: The central banks of Colombia, Bulgaria, Australia, Chile and Ukraine are scheduled to meet with Colombia expected to cut their policy by 25 basis points (0.25%).


Week in Review


· Stocks rose by 3.3% for the S&P 500 with ten out of eleven sectors higher for the week. Although initial jobless claims rose, U.S. economic and infections data were supportive of continued economic and earnings recovery. Communication services (4.8%), technology (4.5%) and financials (4.4%) outperformed the S&P 500, while utilities (-0.7%), healthcare (1.0%) and energy (1.1%) were the biggest laggards. WTI (1.5%) and Brent (1.6%) oil were higher with MLPs (-1.2%) and the energy sector (1.1%) underperforming. Small cap stocks underperformed the S&P 500 with the Russell 2000 higher by 1.7% and small cap value stocks outperforming at 2.5%. The 10-year and 30-year U.S. Treasury yield were higher at 0.72% and 1.50% respectively.


· High yield credit spreads narrowed reflecting increased risk appetite. AAA municipal bond yields as a percentage of Treasuries fell, 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 underperformed the S&P 500 returns in U.S. dollar terms (0.1%) and on a hedged-currency basis (0.1%). MSCI Japan underperformed the S&P 500 returns in U.S. dollar terms (1.6%) and on a hedged-currency basis (0.5%). Emerging market stocks underperformed the S&P 500 with the non-hedged return of 2.7% for MSCI EM.


· The 10-2 yield curve widened to +59 basis points. Another curve measure of three-month yield six quarters forward minus the current three-month yield fell to +6 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.

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