Horror Show

Horror Show

In horror movies, an incongruous, dissonant sound frequently alerts the audience that danger lurks. A rustling in the bushes or a tapping on the wall. Or the return of a musical score—an audio reminder of when things might go horribly wrong.

Yet directors must keep movie-watchers guessing. Sometimes, therefore, ominous tones betray comic relief. The audience is teased. Relief follows tension. But the grisly scenes have only been postponed, their terror magnified by the manipulation of human emotion.

Investing is not, statistically speaking, a horror show. Over time, diversified portfolios reward savers. But at discrete intervals, it can be useful to keep an ear out for dissonance –  important information can be discerned.

Oddities popped up last week. Equity markets dipped, despite much better-than-expected European economic survey data, an historic agreement on European debt mutualization and common fiscal stimulus, and mostly positive US Q2 earnings surprises. Puzzlingly, high beta, cyclical, small capitalization and value stocks outperformed despite the broader market decline. The dollar evidenced none of its traditional safe-haven attributes, dropping nearly 2% against the euro. Gold continued its powerful rally, topping $1,900 per ounce. Silver also rallied strongly. Meanwhile, large capitalization information technology stocks, momentum and growth strategies—the bulwarks of the bull market—underperformed.

To be sure, some of last week’s moves made sense. Risk premiums on Eurozone sovereign debt (e.g., Italian BTPs) collapsed on news of the fiscal deal. As noted, the euro extended its gains. A weak dollar keyed gold’s surge. Yet, dissonance also reverberated. Better-than-expected economic and policy news failed to lift equity markets. Rotation commenced in a falling market. High beta outperformed as the index declined.

Market peculiarities warrant close attention today because the fundamental backdrop remains precarious. Pandemic control is a genuine concern, above all in the US where public adherence to best practice is spotty. Renewed flare ups in areas that seemed under control, like Spain and even Germany, along with wildfire-like growth in Brazil, Mexico, India, Russia, parts of the African continent and numerous other countries are a reminder that Covid-19 remains a genuine threat to human health and economic welfare everywhere. From the narrower perspective of corporate profitability, better-than-expected results are, in many cases, not good results. To wit, the consensus of analyst’s expectations is for US Q2 profits to fall some 40% from year-ago levels.

The appearance of market dissonance against a still-fragile fundamental backdrop means that this week’s key policy and earnings developments assume even greater importance. Investors should focus carefully on three developments this coming week.

The first and most economically significant will be Congressional wrangling over the extension of fiscal relief measures. Republicans have dropped President Trump’s insistence on a payroll tax cut, appear willing to repeat direct transfers to qualifying Americans (i.e., checks of up to $1,200), and to pay for more pandemic preparedness and healthcare provision. But they are balking at extending the expanded unemployment benefits of the CARES Act. Their latest package, worth about $1 trillion, also falls well shy of the Democrats’ $3.5 trillion proposal. Investors are keenly interested in whether Washington can avoid a ‘cliff’ outcome, where drawn-out negotiations leave financially vulnerable Americans unable to meet short-term obligations, in particular for rents, mortgages and auto-financings.

The Fed’s policy announcement and Chairman Powell’s press conference on Wednesday will also be a highlight. In words and deeds, the Fed has already committed to doing its utmost. Investors will therefore scrutinize this week’s Fed statements for signs the central bank will use forward guidance to push down long-term interest rates. If so, the euro and gold will benefit. Investors are less interested in the confirmation process of Judy Shelton, provided that public opinion polls do not shift in favor of Trump’s re-election. For all the concerns about Shelton, there is little one Fed governor can do on her own.

Finally, Thursday will be ‘triple-A’ day: Alphabet, Amazon and Apple announce Q2 earnings. Expectations are running particularly high for Amazon, given the pandemic boost to online shopping in Q2. Concerns about business advertising revenues or deteriorating US-China relations could cast a pall over the outlooks for Alphabet and Apple, respectively. If mega-capitalization technology stocks can’t beat lofty market expectations, markets will face perhaps their most critical test. Will investors be willing to rotate to more economically sensitive small capitalization, cyclical and value stocks in the face of a still un-contained pandemic and before knowing how much US fiscal stimulus is forthcoming, or will markets have to give back some of their torrid gains since April?

Tap-tap, rustle-rustle, the stringed instruments take up the foreboding tune. McConnell, Pelosi, Powell and a cast of A-listers take their marks. The audience senses something’s afoot. Comedic relief or gruesome display? Who knows, but it might be a good time to hit the pause button and load up on popcorn.

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