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:
“Life is a cycle, always in motion. If good times have moved on, so will times of trouble.” – Indian proverb
Taking stock of the U.S. equity rally
“Do you believe in miracles?” announcer Al Michaels rejoiced as the U.S. ice hockey team concluded its win over the heavily favored Soviet Union in the 1980 Winter Olympics.
A miracle may be what equity investors are thinking about the past two months. After plunging 34% from February 19 to March 23, the S&P 500 Index has surged 36% despite a drumbeat of devastating economic data releases and rampant uncertainty over the coronavirus outbreak.6 Last week’s 3% advance put the icing on May’s 4.7% overall gain for the index, pulling it to within 10% of February’s all-time high.7
The initial bounce from March’s bottom was fueled by institutional investors’ quarterly portfolio rebalancing. They booked profits on U.S. Treasury holdings as yields on U.S. debt plummeted during the three-month period (yield and price move in opposite directions) and used the proceeds to buy stocks at depressed levels. Since early April, the S&P 500’s upswing has gained further momentum as market leadership began to shift away from growth-oriented companies with the potential to deliver strong earnings despite COVID-19 and toward cyclical sectors like financials and industrials, which tend to benefit from increased optimism about the U.S. economy.
Why the optimism, though? U.S. manufacturing and service-sector activity plunged in April to levels last seen during the 2008-09 global financial crisis.8 Meanwhile, initial unemployment claims exceeded 2 million for the tenth reporting week in a row, bringing the total to more than 40 million since mid-March.9 On top of that, consumer spending fell by a record 13.6% in April.10 And corporate earnings are projected to plunge 24% in 2020.11
Markets have been adopting a “glass three-quarters-full” approach in the face of these grim reports, betting on a sharp rebound in earnings over the next one to two years. They’re also focusing less on traditional monthly economic data releases, most of which are backward-looking, in favor of higher-frequency metrics, including traffic congestion, airline bookings and restaurant reservations, which provide a more “real-time” picture of the economy’s health. Crucially, these measures and others like them have been slowly improving without a corresponding spike in new COVID-19 fatalities amid the economy’s gradual reopening.
Not everyone has been participating in the S&P 500’s rally, however. Many “mom and pop” (i.e., retail) investors are either staying on the sidelines or heading for the exits. Indeed, according to data from the Investment Company Institute, these types of investors withdrew $70 billion from equity mutual funds and exchange-traded funds (ETFs) between late February and late March, before briefly dipping a toe back into the pool through mid-April. Sensing the water was too cold for comfort, they redeemed another $75 billion of equity holdings over the next five weeks.12
Is it too late for them to jump back in? Not in our view. While stocks aren’t cheap based on commonly used valuation measures like their price-to-earnings (P/E) ratio, they look attractively priced when compared to many traditional fixed-income asset classes, such as U.S. Treasuries and investment-grade corporate bonds.
Investor demand for these securities has driven their prices up and their yields down. Investment grade corporates, for example, yielded 2.4% as of May 29, down from 4.6% on March 20 at the peak of the COVID market turmoil, while the yield on the bellwether 10-year Treasury note has generally been trading in a tight range of 0.60%-0.90% after collapsing to its record low of 0.54% on March 9.13 In contrast, stocks were offering a relatively generous payout, with the S&P 500 Index yielding 1.95% as of Friday’s close.14
A chill in U.S./China relations
In 2018 and 2019, investors were laser-focused on the U.S./China trade war, a standoff that produced little but investment-killing uncertainty and declining trade flows. It appeared that 2020 had gotten off to a promising start, though. In January, the two sides signed a “Phase 1” trade deal in which the U.S. reduced tariffs on Chinese goods in exchange for China’s pledge to purchase more American farm, energy and manufactured goods and to provide added protection for U.S. intellectual property.
Then COVID-19 hit, putting trade talks to the back burner as the global economy skidded to a halt. The outbreak also fanned tensions between Beijing and Washington, with the U.S. calling out China’s alleged lack of transparency in handling the pandemic.
Last week, the row escalated further. On May 26, China passed a national security law that would bypass Hong Kong’s legislature, prompting U.S. Secretary of State Mike Pompeo to announce that the U.S. could no longer certify Hong Kong’s political autonomy from China. U.S. law requires Hong Kong to retain a high degree of political and legal autonomy in order to qualify for special trading status with the U.S.—favorable treatment that includes exemption from tariffs levied on mainland China.
Beijing’s action threatens Hong Kong’s status as a global financial hub and could change the business environment for U.S. companies operating there. In response, two U.S. senators began to draft a bill imposing sanctions on Chinese banks that directly or indirectly enable the anti-democracy crackdown.
In yet another potential sore spot for U.S./China relations, last week China devalued its currency, the yuan, to 7.1 per dollar. This is among the yuan’s weakest exchange levels versus the greenback since the early stages of the 2008-09 global financial crisis.15
Devaluing the yuan makes Chinese exports more competitive in overseas markets, a key consideration as the government struggles to reignite its economy. Doing so is also likely to draw the ire of President Trump, who has previously labeled China a “currency manipulator” under similar circumstances.
While we expect plenty of sabre rattling by both countries, we’re also looking for cooler heads to prevail. And on Friday afternoon, Trump accused China of violating its "promises to us" but didn’t mention ending the Phase 1 agreement or sanctioning China. U.S. equities rallied on this news. He did, however, state that the U.S. will look to revoke Hong Kong’s trade privileges with the U.S., which could severely damage Hong Kong’s economy.