Stone's Weekly Market Guide - Week of July 27, 2020
Chart of the Week: Currently U.S. stocks account for about 55% of the total global stock market capitalization. For U.S. investors, diversification into international stocks has lowered returns relative to owning just U.S. stocks in 2020 and over at least the last 15 years. U.S. investors are blessed by being in a country with a large and diverse home stock market. In addition, about 40% of the sales from the companies in the S&P 500 come from international sales. So why directly own any international stocks at all? International stocks do provide long-term diversification benefits within portfolios. There can also be a benefit in owning some international stocks since the U.S. is not home to the most attractive company in every industry. The U.S. dollar has been noticeably weaker recently which does benefit non-currency hedged returns from international investments. Europe could be boosted by the newly approved recovery fund with European stocks outperforming since the fund was proposed in mid-May. Valuations also point to a possible opportunity in international stocks (see chart). Looking at 12-month forward estimates for several measures, the U.S. is the most expensive across all measures: price-to-earnings ratio (P/E), price-to-cash flow ratio (P/CF) and dividend yield. For Europe and the emerging markets (EM), some of this discount is attributable to sector differences with the adjusted valuations shown in the “U.S. Sector-Adj” data. For example, Europe and EM have lower sector weights in technology and higher weights in financials relative the U.S. and technology should have a higher valuation than financials in general. Interestingly, international stocks have higher expected dividend yields across the board even adjusting for sector differences so income starved investors might want to look abroad as well. Japan stands out as worthy of further investigation with the cheapest valuation across the board and an attractive dividend yield. Japan’s domestic economy has been very weak, but Japan’s companies are very exposed to global growth so a global recovery could be reflected there. In short, maintaining some exposure to international stocks likely makes sense.
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 to indicate a “Cold War” stance and will be watched for further escalation.
· U.S.: Primary attention will be on negotiations over the next fiscal stimulus package with the Senate Republicans releasing their plan. The expiration of the additional $600 per week unemployment benefit at the end of July and the expectation of Congressional recess in August adds to the urgency. The Federal Reserve meets but should leave policy unchanged as they wait for economic data and the fiscal stimulus response to evolve. The 2Q GDP release will make for historically grim reading with a contraction of -35% quarter-over-quarter (Q/Q) annualized pace expected. Of positive note, the July PMI readings last week indicated that the U.S. has likely already exited recession so this recession should end up being the sharpest and shortest economic decline of all time. Initial jobless claims rose last week and will again be watched to judge the impact of the recent surge in infections on employment. Readings for our U.S. Reopening Monitor were little changed last week with the uptick in infections slowing the momentum of the economic recovery on the margin over the last three weeks. Initial readings on new COVID-19 cases fell and deaths rose on a week-over-week (W/W) basis. The negative impacts of rising infections are continuing to show up in the underlying high frequency economic data for dining, airplane travel and public transit usage. Please see our weekly U.S. Reopening Monitor and our Guide to the U.S. Reopening Monitor for more details.
· S&P 500 2Q Earnings Season: 2Q earnings season really kicks into gear with 192 S&P 500 companies reporting. According to FactSet, 81% and 71% have beaten consensus earnings and revenue estimates respectively with 26% of companies reporting. The 2Q blended (actual and estimates) earnings decline improved to -42.4% year-over-year (Y/Y) from -44.0% primarily due to positive surprises from the healthcare and technology sectors. As we forecasted, some companies have reinstated earnings guidance which is a positive in removing some unknowns. In addition, 2Q actual earnings seem likely to beat estimates with the bar so low. Annual earnings estimates moved slightly higher with 2020 at -20.7% Y/Y and 2021 estimates at +30.0% Y/Y.
· Europe: European Union (E.U.) leaders reached an important agreement on a EUR 750 billion recovery fund last week with 390 billion in grants and 360 billion in low-interest loans. July sentiment readings for Eurozone economic confidence and the German IFO are expected to improve. 2Q GDP should reflect a record contraction at -12.0% Q/Q. The E.U. and U.K. hold their last trade deal negotiations before the summer break.
· Asia: China has July official PMI readings which are expected to hold steady and continue to reflect expansion. Japan reports June retail sales which should rebound +8.0% month-over-month (M/M) but remain -6.0% lower Y/Y. Japanese June employment data should weaken with the jobless rate rising to 3.0% and job-to-applicant falling to 1.15.
Central Banks: In addition to the Fed, the central banks of Ghana, Angola, Kenya, Bulgaria and Colombia are scheduled to meet with Colombia expected to lower its policy rate.
Week in Review
· Stocks fell by -0.3% for the S&P 500 with six out of eleven sectors still higher for the week. U.S. economic data was mixed with better June housing data and July PMI readings offset by deterioration in weekly initial jobless claims. Energy (2.1%), consumer discretionary (1.3%) and financials (1.3%) outperformed the S&P 500, while technology (-1.5%), communication services (-1.1%) and healthcare (-0.7%) were the biggest laggards. WTI (1.8%) and Brent (0.5%) oil were higher with MLPs (1.4%) and the energy sector (2.1%) outperforming. Small cap stocks underperformed the S&P 500 with the Russell 2000 lower by -0.4% but small cap value stocks gained 0.7%. The 10-year and 30-year U.S. Treasury yield were lower at 0.59% and 1.23% respectively.
· High yield credit spreads narrowed reflecting increased risk appetite. AAA municipal bond yields as a percentage of Treasuries increased, causing municipal bonds to underperform. 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 (0.4%) but underperformed on a hedged-currency basis (-1.2%). Emerging market stocks outperformed the S&P 500 with the non-hedged return of 0.5% for MSCI EM.
· The 10-2 yield curve narrowed slightly to +44 basis points. Another curve measure of three-month yield six quarters forward minus the current three-month yield was steady at +5 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.