The first half of an already tumultuous year — and one that has packed in some of the greatest hits from previous episodes of financial turbulence — is closing.
For investors there is really no half-time break, let alone a Super Bowl style show such as this epic performance by Prince from a rain-swept Miami in 2007. Instead, investors are left assessing or fretting about the extent of the coming recovery in economic activity and corporate profits. Complicating matters has been a pronounced recovery in broad terms across equities and credit that appears to stretch well ahead of the underlying macroeconomic story.
US equities are set for their best quarter (up some 18.5 per cent) since the final three months of 1998 when the S&P 500 rallied 21 per cent. Global equities, via the FTSE All-World index, have rallied almost 18 per cent, a performance shy of the 21.7 per cent rise from the second quarter of 2009.
The speed of the response from monetary guardians — known as the “central bank put” — and governments has left a far bigger mark than what was seen during the financial crisis, or after Long-Term Capital Management imploded and was rescued in a Federal Reserve orchestrated bailout in 1998.
Along with the dotcom bust and ensuing credit crunch of 2001, each of these episodes prompted a bigger response from central banks that laid the ground for the next bout of financial turmoil. The current massive open-ended bond buying — that provides cover for hefty government spending — has soothed recession fears. But it does not rule out a lengthy process of healing before economic activity reflects the onset of a new business cycle.
Mark McCormick at TD Securities thinks the second-quarter rebound in risk assets ignores a likely gap of six to 12 months between recovery and the reflation of economic activity:
“Regardless of stimulus, the reflation trade will require a path to normalcy for many parts of the world. Given the staggering nature of reopenings and the challenges that many parts of the developing world have faced dealing with Covid, it’s unlikely that we see anything resembling full mobility in the months ahead.”
In the interim, equity sentiment has support from a truly becalmed area of finance; that of government bonds. The US Treasury Move index surged from a reading of 60 in February and hit 163.7 in early March (some distance from its 2008 peak of 265). Today, there is little movement, with 30-day implied volatility for US Treasuries having loitered just above 50 in recent months. This in turn reflects how the 10-year Treasury note has tracked inside a narrow range between 0.6 per cent and 0.8 per cent since early April.
Clearly the Fed has sequestered the world’s most important fixed-income benchmark. In this respect it is by no means alone and aggressive central banks efforts have narrowed the differences in yields across major bond markets.
But the volatility story looks a little different for equities.
This is highlighted by the elevated nature of implied equity volatility. Not only does the current reading for the Vix index remain above 30, a look at Vix futures for September (shown below) and even out to December are stuck above that threshold.
Analysts at Unigestion reckon elevated Vix “indicates that directional longs in equities have been accompanied by protection buying to cushion larger drawdowns in addition to the ‘central bank put’” and while they have a constructive medium-term view on equities and credit, they add:
“We also believe that the risks of a downside surprise have risen recently on the back of a resurgence of Covid cases and local lockdowns. We have therefore decided to ramp up protection in our strategies to help cushion against any unexpected, meaningful correction.”
That sense of unease reflects the gulf between a central bank assist for asset prices versus a very uncertain economic story at ground level. It also suggests a challenging second half for the year awaits and before mentioning a few other factors. There’s the percolating tension between Beijing and Washington and the risk of new Covid waves, while equity sentiment may well find the upcoming US election results prove rather taxing — at least for future corporate profits.
For now, the start of the second half means that once a slew of economic data is absorbed on Thursday, US financial markets can enjoy a brief respite and the more entertaining kind of fireworks on the Fourth of July.
Quick Hits — What’s on the markets radar?
Emerging market policy actions have also diverged from the usual crisis playbook. Falling inflation has opened the door to many EM central banks cutting policy rates — downplaying currency worries — while the Fed’s provision of dollar liquidity has helped to ease a hard currency funding squeeze.
Gustavo Medeiros at Ashmore Group says “it’s the first major crisis in 30 years in which EM central banks cut policy rates, supporting local liquidity and asset prices” and he also highlights that the JPMorgan EM global bond index remains well above overnight policy rates. Around 4.34 per cent, the bond index provides attractive carry given the much lower level of many EM policy settings, he says:
“Steep curves are also supportive to EM banks, potentially leading to a stronger rebound from the recession.”
And financials are the largest weighting (one-fifth) in the MSCI EM equity index, so any bounce in banks from here will resonate for investors. So far this year, the MSCI EM financials group holds the wooden spoon with a drop of 27 per cent. Healthcare tops the EM scoreboard for the first half, up 26 per cent, but this sector only has a weighting of 4.3 per cent in the MSCI benchmark (down 10.8 per cent for the year and off 13 per cent from its peak in January).
One painful lesson for income reliant investors has been the evaporation of dividends, particularly in the UK. The payout for the FTSE 100 has dropped from an expected £91bn in January to £62bn in June, according to AJ Bell. This leaves the FTSE 100 with its lowest level of dividend payouts since 2014 and after 48 companies have cut, deferred or cancelled a dividend payment.
At the halfway mark of 2020, 49 FTSE blue-chips have maintained or increased their dividend for either fiscal 2019 or fiscal 2020, but as AJ Bell’s Russ Mould notes, “the cuts tend to be much deeper and come from firms whose contribution to the overall pot was so much bigger”.
Still, expectations of a recovery in payouts beckons in 2021 as shown here. With UK gilts yields camped around zero, the FTSE 100’s dividend around 3.6 per cent still provides something that blue-chip fixed income no longer can claim.
I’d love to hear from you. You can email me on [email protected] and follow me on Twitter at @michaellachlan.
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