Separating the Wheat and Chaff

The recent price action, and in particular, the sideways trend in many segments of the capital markets, reflects the challenge investors are having in separating the wheat from the chaff. The strong co-movement of risk assets has weakened. There is a lack of near-term visibility and contradictory signals, while the trends in place since March have stretched valuations and complicate risk-reward calculations.

The US followed the much better than expected jobs report with news that retail sales surged by 17.7% in May, more than twice what economists were expecting, and April's decline was pared.  The real signal is more nuanced. 

First, the government has acted quickly to replace much of the wage income that has been lost.  Consider that an estimated 2/3 of people collecting unemployment insurance are receiving money than their work paid.  The surge in savings was involuntary for the most part, and when the opportunity availed itself, Americans went shopping.

This will likely be reflected in May's personal income and consumption figures out at the end of next week.  Personal income jumped 10.5% in April.  This is an exaggeration, and around half may be given back in May.  Consumption, on the other hand, crashed by 13.6% in April and could have recouped almost half in May.  Separately, May durable goods orders should also recover smartly from the 17.7% crash in April, owing primarily to the transportation sector. Excluding it, durable goods orders may have risen by around 1% after dropping 7.7% in April, illustrating the cautiousness about investment. 

The pandemic and the universal response of reduced social interaction was shaped by perceptions of safety and government edicts.  The shock has synchronized business cycles.  Leaving aside a handful of countries, including most notably China, the steep contraction is being experienced this quarter, and, already, there are signs that the worst has passed.   The preliminary June PMIs--the data highlight of the week--for Europe, the US, Australia, and Japan can be expected to confirm that the pace of contraction is slowing, setting the stage for a recovery in H2. 

Second, it seems clear from alternative data, like Open Table reservations and traffic patterns, while there has been increased activity, most people are far from resuming their normal activities, even in states and cities that have re-opened.  Moreover, some areas are seeing increased cases and hospitalizations.   Beijing seems to be struggling to contain a flare-up, Germany, and the Australian state of Victoria are also reporting an increase of infections.  California, Florida, and Arizona reported one-day records, and infections in Texas are rising. The surge in several US states, which has prompted Apple to close several stores again.

The stay-in-place orders were never suggested to be a cure for the virus but rather a means to stretch out the occurrences to avoid over-burdening the medical capacity.  Many people are understandably concerned about the increase in incidents.  Nearly a fifth of US states are reporting either a new record number of cases or new seven-day averages.  For many, talk of a second-wave is a way to get around talking about the relaxation of containment procedures before meeting the criteria that the federal government provided.

Third, the economic data is really more mixed than the focus on the jobs report, and retail sales would suggest.  The contraction here in Q2 will be historic, whether it is 30% or 45%.   Industrial output last month rose by less than half of the 3% that economists expected, and April's 11.2% decline was revised to show a 12.5% decline.  A similar development was evident in the narrower measure of manufacturing output.  The 3.8% increase disappointed forecasts, and the April series was revised to show a 15.5% decline rather than 13.7%.  May housing starts were well shy of expectations.  The 4.3% gain was less than a fifth of what economists had projected (23.5% median forecast in the Bloomberg survey) after plummeting a revised 26.4% in April (initially estimated at -30.2%).

Fourth, there are going to be temporary and longer-lasting effects of the virus and economic shutdown.  The unwind of the temporary factors, like some furloughed workers, the re-opening of stores, will see economic activity increase.  This is what the "soft" June data, like the Empire and Philadelphia Fed manufacturing survey showed.  Weekly jobless claims proved to be stickier than expected, and, as it stands now, many of the Fed's emergency facilities end in September, while the $600 a week extra unemployment insurance ends July 31. 

Congress and the White House most likely will find an agreement on more fiscal support during this important election year. Still, it is unlikely to be as direct as the household checks and extended unemployment benefits.   Nevertheless, investors and businesses may turn cautious, given the coming cliff in economic support.   And like after the Great Financial Crisis, the risk is that support is withdrawn before the economy is on a strong path toward full-employment.  As companies reassess their business outlook and the Payroll Protection Program incentives fade,  permanent layoffs seem likely.  Several large banks and non-financial firms are already moving in that direction.  Some businesses are going to realize that they do not need as much office space, and commercial real estate may be challenged.

Central banks did move in concert last week though it was hardly coordinated.  The Federal Reserve's Main Street facility was launched after being announced in late March.  The Fed's corporate bond purchase program began to include individual issues rather than just ETFs, which has been the case until now.  The Bank of Japan expanded interest-free loans to corporations to JPY110 trillion from JPY75 trillion.  The ECB made net new three-year loans of nearly 550 bln euro (at minus 100 bp), or a 10% increase of its balance sheet (~5.63 trillion euros as of June 12).  The Bank of England boosted its bond-buying program by GBP100 bln.  The People's Bank of China cut its reverse repo rate by 20 bp, and officials signaled further easing of monetary policy would be delivered.  Other central banks, including Brazil (-75 bp to 2.25%), Russia (-100 bp to 4.50%), and Indonesia (-25 bp to 4.25%), also eased policy. 

More central banks meet in the week ahead. The Reserve Bank of New Zealand meets following the larger than expected contraction in Q1 (-1.6% vs. 1.0%)  but will likely be content with the policy setting (0.25% cash rate) after doubling the long-term asset purchase plan to NZ$60 bln last month from NZ$33 bln announced in March. 

Among emerging market countries, central banks in Mexico and Turkey are likely to deliver additional rate cuts.  Under intense political pressure, Turkey's central bank halved the key one-week repo rate last year to 12%.  It cut it to 8.25% and is expected to reduce it by another 25 bp on June 25.  The small move anticipated reflects the sense that stubborn price pressure limits the scope for additional cuts. Turkey's CPI fell from 11.84% in December 2019 to 11.39% in May.  The lira was already under pressure before the crisis hit, and despite reserve-draining intervention, the currency did not bottom until early May.  It recouped some losses in May but is softening again in June and is off about 13.2% this year. 

The dramatic risk-off move in March offset the high real and nominal rates that had lifted the Mexican peso in 2019 and early 2020.  The peso bottomed in early April and appreciated by more than 18% through last week, leaving it still down almost 17% year-to-date.  With the virus hitting Mexico hard and the deflationary impact spreading, the central bank will likely cut the target rate by 50 bp to 5.0%.  Banxico's easing cycle began last August.  It has cut rates at every meeting since but October 2019 and January 2020.  The target rate has fallen by 125 bp since February.  Inflation is running below 3%.  It has plenty of room to reduce rates, though the peso's pullback may continue.

Geopolitics is on radar screens, but outside of a flicker, the impact seems negligible.  South Korea appeared more sensitive than India or China.  Taiwan's markets seemed unperturbed by reports of China's incursions into its airspace.  On the other hand, the resignation of Brazil's Treasury Secretary weighed on the real, which fell even more following COPOM's rate cut.  The US removal of troops from Germany, withdrawal from the Open Skies Treaty, and the World Health Organization, in relatively rapid succession, also seem to have no tangible impact.  Canada lost its bid for a UN Security Council seat to Ireland and Norway, and while chins wagged and column inches were delivered, investors were unmoved.  

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