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Stone's Weekly Market Guide - Week of May 18, 2020

Chart of the Week: Following up on last week’s analysis and another week of underperformance from high dividend yield strategies, our chart of the week takes a deeper look at two of the historically more defensive high yielding sectors. During the current crisis, the S&P 500’s dividend yield spread over the 10-year U.S. Treasury reached the highest level in over 50 years. This is a function of both the decline in stocks sending the dividend yield higher and the historic lows in Treasury yields. Utilities and real estate had worse declines from the February peak than the S&P 500 and have lagged during the rebound. Interestingly, utilities outperformed from 2007 to 2009 during the Global Financial Crisis (GFC) while real estate was significantly worse. Utilities currently have a higher dividend spread over Treasuries than during the GFC. While there are exceptions, utility dividends generally look secure with weakness in commercial demand somewhat offset by increased residential. Real estate came under even more severe stress during the GFC, but the coronavirus outbreak brings its own challenges to the sector with retail, healthcare and hotel REITs registering as three of the worst performing groups in the S&P 500 year-to-date. The real estate sector was added to the S&P 500 in 2016, so the FTSE NAREIT index was used as a proxy for this analysis. Prior to August of 2016, real estate was part of the financials sector. As one would expect given the S&P 500 overall, most sectors currently have a dividend yield spread over the 10-year Treasury in excess of that during the GFC with the other major outlier being financials.


Dividend Yield Minus 10Yr Treasury Yield since October 2007

Week in Preview


· Geopolitical: Reported economic data for April will continue to be dismal with much of the world on lockdown to fight the spread of the coronavirus during the period, but May data will begin reflecting the restarting of economies and the rebound in activity. There is much uncertainty about the speed and strength of the economic recovery, so markets could be volatile during any adjustment to the outlook. Economic data, credit conditions and medical information will continue to be monitored closely for clues as to the path of the recovery. May Markit PMI readings for the U.S., Eurozone, U.K. and Japan this week will give the first glimpse at some of the “less bad” but still poor levels of economic activity as the series should have bottomed in April. Deterioration in the relationship between the U.S. and China will be watched and has added another risk to the economic outlook.


· U.S.: Initial jobless claims remain very elevated but have declined for six straight weeks as states begin to reopen and will continue to be monitored for a real-time labor market measurement. Heavy week for April housing data which will be dreary but should reflect the worst of the lockdown. Federal Reserve Chair Powell and Treasury Secretary Mnuchin testify before Congress regarding the CARES Act on Tuesday. Plenty of Fedspeak with eight speeches by Federal Reserve officials on tap with Chair Powell on Thursday plus the FOMC minutes.


· S&P 500 1Q Earnings Season: With 90% of companies reporting so far, 65% of companies have exceeded earnings estimates. The 1Q blended earning growth rate is at -13.8% year-over-year (Y/Y) which deteriorated slightly from the previous week primarily due to the consumer discretionary sector. With 1Q earnings generally heavily trimmed by COVID-19, more attention is paid to forward guidance with 2020 earnings declining further and now expected at -20.3% Y/Y. 2Q earnings will be even worse than 1Q with consensus estimates deteriorating last week at -41.9% Y/Y. Even judging future estimates is complicated with many companies removing earnings guidance due to the unknown depth and length of the shutdown related economic weakness. Earnings season is slowing with 26 S&P 500 companies expected to report with a heavy emphasis on retailers this week.


· Europe: German ZEW expectations survey for May could improve slightly, while the current conditions component should remain grim. The U.K. April retail sales report will be bleak, following in the footsteps of U.S. retail sales last week.


· Asia: China’s calendar is light but the National People’s Congress is scheduled to meet. Japan reported 1Q GDP declined at a -3.4% quarter-over-quarter (Q/Q) annualized rate which is the second straight quarter of declines and there is an even worse quarter on the way for 2Q. Japan April trade data will reflect very weak activity.


Central Banks: The central banks of Indonesia, Thailand, Iceland, Sri Lanka, Zambia, Turkey and South Africa meet with Indonesia, Thailand, Turkey and South Africa expected to cut their policy rates.


Week in Review


· Stocks fell by -2.3% for the S&P 500 with only one sector higher as gloomy April retail sales pointed to a greater than -30% Q/Q annualized contraction in 2Q GDP and tensions with China rose. Healthcare (0.9%), consumer discretionary (-1.0%) and communication services (-1.2%) outperformed the S&P 500, while energy (-7.6%), real estate (-7.3%) and industrials (-5.9%) were the biggest laggards. WTI (19.0%) and Brent (4.9%) continued their rebound with MLPs (-1.2%) outperforming but the energy sector (-7.6%) significantly underperforming. Small cap stocks underperformed the S&P 500 with the Russell 2000 down -5.5% with small cap value stocks the primary driver of the poor showing. The 10-year and 30-year U.S. Treasury yield fell slightly to 0.64% and 1.33% respectively.


· High yield credit spreads widened reflecting decreased risk appetite. AAA municipal bond yields as a percentage of Treasuries decreased, and municipal bonds outperformed. 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 to the states.


· The U.S. dollar was stronger against both developed and emerging market currencies. Developed international stocks as measured by MSCI EAFE underperformed the S&P 500 returns in U.S. dollar terms (-3.3%) but outperformed on a hedged-currency basis (-2.2%). Emerging market stocks outperformed the S&P 500 with the non-hedged return of -1.2% for MSCI EM.


· The 10-2 yield curve narrowed to +49 basis points. Another curve measure of three-month yield six quarters forward minus the current three-month yield narrowed and closed the week 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 and external shocks like the current coronavirus outbreak might not be accompanied by one. Stocks have historically had significant advances post-inversion.


The dividend yield spread for all the S&P 500 sectors since 2007 are shown in the two charts below:



The PDF version of Stone's Weekly Market Guide is linked here.

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