Markets & Fundamentals
Wall Street’s favorite adage, ‘climb a wall of worry’, may soon be put to test. Following the powerful equity market rally of the past two months, investors face unanswered questions regarding sustainable pandemic control, growing unemployment, an uncertain economic recovery, uneven corporate profitability, heightened default risk, opaque policy responses and record valuations. Adding to the list of potential concerns are widespread and at times violent US demonstrations—ongoing protests that may have far-reaching and uncertain impacts on the November elections.
In what follows, we preview and place in context the economic data on tap this week, which will shed important light on how deep the economic damage wrought by the Covid-19 pandemic has been. We also review what key polls and other metrics tell us about the US 2020 elections. Finally, we draw broad implications for markets as we head into mid-year.
The week ahead brings various purchasing manager indices (including the US Institute for Supply Management manufacturing index), which will illuminate the degree to which manufacturing activity has slumped since the outbreak of the pandemic, and whether low points have arrived in hard-hit countries such as Italy, Spain or the US. Market rotation recently underway into domestic cyclicals, including small capitalization stocks, may be tested if PMI’s do not confirm that the industrial recession is bottoming. Market participants will similarly eye Thursday’s US jobless claims figures for evidence that the re-opening of the economy is translating into re-hiring.
On the policy front, the ECB is expected this week to announce another half trillion Euro asset purchase program. But the biggest release of the week will be the US May employment report. For historians, the unemployment figures will harken back to Depression-era levels, with the consensus expecting a jump to nearly a 20% jobless rate.
Investors, on the other hand, are more likely to focus on the details behind the numbers, particularly for signs that hard-hit sectors such as restaurants, hotels, travel and retail are seeing a slowing or even a reversal of job losses. In the April employment report, the leisure and hospitality sector recorded -7.7 million jobs lost, followed by healthcare and education (-2.5 million), professional and business services (-2.1 million) and manufacturing (-1.3 million). Put differently, in April alone 50% of all US workers in restaurants, hotels and travel lost their jobs. Hopes for a stabilization in the May employment report could be disappointed, given that the report’s survey week early in the month probably took place before the jobs market could respond to the relaxation of lockdowns and social distancing norms.
Politics and the November elections
US protests (in some cases riots) and their potential impact on the autumn elections may also draw the attention of market participants. At this point, it is too early to predict what significance they may have on the electorate. The percentage of genuinely undecided voters may be small, but perceptions of the demonstrations, their causes and the political responses they engender could have potentially significant impacts on voter turnout across various constituencies, including in key US states.
The starting point from which to gauge shifts in sentiment can be gleaned from public opinion polls and political futures markets. According to a poll of polls, President Trump’s current approval rating is 43.1%, versus a disapproval rating of 53.3%. The results are much the same when likely or registered voters are queried. Those figures represent about a 3-percentage point deterioration in both approval and disapproval ratings for the President since April, and therefore probably reflect concerns about the economy as its slump extended last month. Importantly, neither Trump’s approval nor disapproval ratings are out of the normal ranges seen over the past 18 months.
Polls also suggest that the presumptive Democratic nominee, Joe Biden, enjoys a 6-8 percentage point lead over President Trump in national polls. Based on electoral college numbers, however, that lead shrinks to nearly a ‘toss-up’. In Republican leaning ‘swing states’, such as Arizona, Pennsylvania, Michigan or Florida, the polls suggest races will be competitive, potentially tipping the scales to former Vice President Biden.
Futures markets are more decisive. The longest running political futures market in the US, organized by the University of Iowa (Iowa Electronic Markets), points to a 53.5% vote share for Biden versus 47.4% for Trump, with odds of an electoral college victory for Biden at 67%. The IEM also reckons the Republicans have only a 48.9% probability of holding their Senate majority and just a 24.7% chance of re-taking the US House of Representatives in November.
What does all this mean for markets?
Over the past week, US stock investing styles such as value, high dividend and small capitalization stocks narrowly outperformed growth, momentum or low volatility styles. Real estate, financials, industrials and materials have also done better than the overall market in the past week. Investors, it seems, are beginning to anticipate a rebound in economic activity and in the fortunes of more cyclical and riskier companies. That shift in market sentiment is quite recent, but points to rising hopes that the pandemic has crested, that the end of social distancing will improve economic activity and corporate earnings, and that other risks are not emerging.
In our view, improved market sentiment correctly anticipates some probable pick-up in business activity. Economic, social and political forces have changed pandemic attitudes in Europe, the US and elsewhere. Anecdotal evidence points to some recovery in hard-hit sectors. Covid-19 infection rates are not spiking sufficiently to lead to a near-term reversal of re-opening moves. Historically bad data this coming week may also be seen as backward looking, particularly if the details or higher frequency numbers point to improving demand and employment conditions ahead. Hence, risk assets appear supported in the near term, with rotation to cyclicals providing added impetus.
Medium-term risks, however, remain unresolved. Epidemiologists warn of fresh infection spikes. Consumers and businesses may respond more slowly to the easing of restrictions than investors expect. Governments may prematurely slow or reverse fiscal stimulus and credit support measures. Surprise defaults could occur. US or global politics could easily spring surprises. Civil unrest could grow, as could tensions with China. Taking these considerations in mind, we doubt investors will readily double-down on the market gains they’ve enjoyed since late March. Market advances may continue into mid-year, but not as dramatically as has been in the case in the past two months.