The last week’s market highlights:
Each week, we present our featured topics in the context of the major themes listed below from Nuveen’s Q2 Update:
- U.S. economy: Looking for a relatively rapid recovery in the second half of 2020.
- Global economy: Europe may begin to outperform the U.S. in Q3.
- Policy watch: Fed to guide the economy even after the country reopens.
- Fixed income: Stay defensive, stay diversified.
- Equities: Focus on quality companies at reasonable valuations.
- Asset allocation: Consider benefits of active management amid idiosyncratic opportunities.
Quote of the week:
“Dad taught me everything I know. Unfortunately, he didn’t teach me everything he knows.”
‒ Al Unser
‒ Al Unser
The U.S. economy gathers steam after a dismal April
Think back to the start of the second quarter. Much of the U.S. was shut down, with COVID-19 lockdowns expected to last at least until May. Forecasts of a 25% or worse annualized drop in second-quarter GDP brought to mind not just the 2008-09 global financial crisis but also the Great Depression.
By some measures, the economic outlook since then seems to have deteriorated. The Atlanta Fed’s GDPNow tracker, for example, currently points to a shocking 45.5% plunge in GDP, versus a 12.1% decline on April 30.5 (This gauge is not an official forecast of the Atlanta Fed. Rather, it is best viewed as a running estimate of real GDP growth based on available data for the current quarter.)
That’s the bad news.
The good news? Evidence continues to build that the economy may have turned a corner last month.
- Retail sales powered 17.7% higher in May, an all-time best that eclipsed forecasts for an 8.5% increase and left April’s unprecedented drop (-14.7%) in the dust.6 With some states beginning to allow outdoor dining after establishments had been limited to curbside pickup and delivery, restaurants and bar tabs saw healthy gains, as did sales of clothing and accessories, electronics and appliances, and home furniture.7
- The Conference Board’s index of leading economic indicators bounced back into positive territory in May after sharp declines in March and April.8
- Housing starts and building permits both enjoyed healthy rebounds, fueling June’s record-high jump in homebuilder confidence.9
Against that encouraging backdrop, last week the Citi U.S. Economic Surprise Index rose for the fourth straight week, reaching an all-time peak.10 (This index gauges the extent to which economic data releases diverge from consensus forecasts; rising index levels indicate more upside surprises.) Recent consumer data, such as retail sales, has been especially good—a promising sign for third-quarter GDP, as consumer spending makes up about two-thirds of the U.S. economy. Based on the currently available data, we expect third-quarter GDP growth of 15%, up dramatically from -25% in the second.
Eurozone data has also improved, albeit not as dramatically as it has stateside. Manufacturing and service-sector activity picked itself off the mat in May after April’s dramatic fall.11 Provided there’s no significant resurgence of COVID-19 infections in Europe, the further lifting of lockdowns should boost the region’s economy and sentiment heading into the summer. In fact, green shoots of optimism have already begun to emerge. The closely watched Zew Indicator of Economic Sentiment for Germany increased for a third consecutive month in June.12
Similarly, China’s economic bounce has not been dramatic, but data continues to strengthen. In May, the unemployment rate dipped to 5.9%, service-sector activity turned positive for the first time since last December, and retail sales rose for the fourth straight month.13
The elephant in the room? Not the Fed.
Although the Federal Reserve was “off duty” last week, having wrapped up its latest policy meeting the week before, Chair Jerome Powell and his colleagues made headlines nonetheless. On Monday, June 15, the Fed announced that it will begin buying individual investment-grade corporate bonds, fulfilling a pledge it made on March 23. Back then, the Fed added high-quality corporate debt to its menu of quantitative easing (QE) assets for the first time ever, in a bid to quell market panic over the coronavirus.
Until now, however, the Fed’s corporate bond-buying has been conducted only through exchange-traded funds (ETFs), to the tune of $7 billion.14 That’s a far cry from its multi-trillion-dollar purchases of U.S. Treasury and mortgage-backed securities over the past few months. But even these relatively modest ETF investments have packed a punch, fueling a rally in credit markets and spurring record levels of bond issuance.
Armed with the confidence that the Fed would step in to prevent a wave of defaults if economic conditions worsened, investors have scooped up corporate bonds, with strong demand pushing their prices up and their yields down. In fact, the yield difference—or spread—between investment-grade corporate debt and U.S. Treasuries has declined to 54 basis points (0.54%) of its pre-pandemic lows.15 Lower spreads mean reduced borrowing costs, which have helped support the U.S. economic recovery.
And with the Fed prepared to buy up to $750 billion of corporate credit (including both ETFs and individual bonds), borrowing costs are likely to stay low, in our view—even if economic data begins to weaken materially or markets fear a spike in COVID-19 cases.
So how does a central bank like the Fed build a bond portfolio of such size? Carefully. During his two days of semiannual Congressional testimony last week, Powell fleshed out the details:
- The Fed will create a portfolio based on a broad, diversified market index of U.S. corporate bonds.
- Although purchased securities must be rated investment grade, there’s an exception for “fallen angels”—bonds downgraded to below investment-grade status after March 22 (the day before the Fed announced its foray into corporate debt).
- Bonds must mature in five years or less, a time frame that signals the Fed recognizes the need for easy monetary policy over a prolonged period. Looking at the long end of the maturity spectrum, the Fed may still hold some of this debt on its balance sheet in 2025, well after (we hope) it has begun to raise interest rates amid an improving economy.
Powell specified that market conditions will dictate the pace of purchases. He assured Congress that he didn’t want the Fed to “run through the bond market like an elephant snuffing out price signals.” On a more subtle note, he made it clear that the Fed stood ready to use all the tools at its disposal to bolster the economy while urging lawmakers to enact fiscal stimulus to complement March’s CARES Act.