The last week’s market highlights:
Quote of the week:
“When there is no wind, row.” ̶ Latin proverb
Oil succumbs to the laws of supply and demand
Investors often refer to “volatility” when asset prices are in the midst of a steep, sharp decline. Actually, volatility more accurately describes dramatic swings in both directions. And make no mistake, the COVID-19 pandemic has brought plenty of volatility—in the truest sense of the word. Here are some recent high and low lights:
- The bear turns into a bull. After hitting an all-time high on February 19, the S&P 500 fell 34% by March 23, easily exceeding the 20% threshold that technically defines a bear market. And it’s taken a mere month for the index to soar 26.8% back into bull market territory.7 (A bull market is generally viewed as a gain of 20+% from the most recent trough.)
- The VIX vacillates. In January, the VIX, or Wall Street’s “fear gauge,” mostly hovered between 12.0 and 14.0, well under its 20-year average of 19.6. But it soared to an all-time high of 82.7 in mid-March before easing down into the 30s in April as market sentiment improved. The VIX closed at 35.9 on April 24.8
- Corporate bonds yield to the pressure. Between January and March, the extra yield, or spread, provided by investment-grade corporate bonds over U.S. Treasuries jumped from just 93 basis points (0.93%) to 373 basis points (3.73%)—the widest spread since the 2008-09 financial crisis.9 The widening occurred as surging demand for safe-haven assets pushed Treasury yields down, while investors’ desire to offload assets deemed riskier, such as corporate bonds, drove yields on those bonds higher. (Price and yield move in opposite directions.) Spreads have narrowed again, due in large part to the Federal Reserve’s liquidity assistance programs aimed at the corporate bond market.
- Munis moves are magnified. Even the historically staid municipal bond market hasn’t been immune to the volatility. Prior to the pandemic, daily swings of 10-15 basis points in key tax-free benchmarks would have raised eyebrows. Now, traders have become accustomed to shifts of up to 50 basis points in a single trading session.
It was only a matter of time until commodity markets experienced their own extreme turbulence. Oil prices tumbled, albeit without much volatility, for the first 3½ months of 2020 as the global COVID-19 pandemic sapped demand. A supply glut courtesy of Saudi Arabia’s March decision to ramp up production contributed to lower prices as well.
Then, on Monday, April 20, oil markets snapped. As measured by the West Texas Intermediate (WTI) benchmark, the price of a barrel of oil to be delivered in May plunged from $18.31 on Friday, April 17, to -$37—that’s right, minus $37—on Monday, April 20. This marked the first time oil had ever traded below zero.10
The collapse left many investors wondering how oil prices can be negative.
It’s because the commodity is traded using oil futures contracts, which require traders to buy or sell oil at a specified price in the future. In this case, contracts requiring buyers to take delivery of oil in May were expiring on April 21, meaning the agreed-to terms were set to go into effect the next day. With oil supply outstripping demand to such a degree that there were few places in the U.S. to store crude, sellers were actually paying buyers to take it off their hands rather than bear heavy storage costs.
WTI regained its footing to finish last week at $16.94/barrel.11 The rally was spurred by a potential supply shock—this time courtesy of Middle East tensions—as President Trump ordered the U.S. Navy to “shoot down and destroy any and all Iranian gunboats if they harass our ships at sea.”
In our view, last Monday’s subzero nosedive doesn’t signal a long-term drop in oil prices. But with storage capacity expected to remain low, they could be vulnerable to brief yet sharp declines as upcoming futures contracts approach expiration.
In fact, we believe oil will rebound if and when OPEC and its non-OPEC partners agree to cut production further on the heels of their April 9 pact to trim supply. Kuwait, OPEC’s fourth-largest producer, has already decided to do so. Demand for crude oil should also improve as the global economy reopens in the second half of the year—though the road back could be a slippery one.
Europe’s economy should bounce back, but will its stock markets outperform?
More than a dozen European countries have announced plans to reopen their economies or have gradually begun to do so. The list includes smaller economies like the Czech Republic and Austria, as well as the region’s largest, Germany. These steps to slowly restart economic activity follow data showing that the pace of COVID-19 fatalities is declining across the continent.
Meanwhile, with the fatality rate just starting to taper in the U.S., only a mere handful of states have considered easing their stay-at-home mandates and opening non-essential stores before April 27.
In light of Europe’s further progress, the recent tendency of equity markets to rally based on optimism over the coronavirus battle would suggest that European stocks have been outperforming their U.S. counterparts. Not so. In fact, the Euro STOXX 600 Index trails the S&P 500 Index by more than 700 basis points since both benchmarks hit all-time highs on February 19, since they bottomed in mid-to-late March and for the year to date.12
Why the overseas lag? A brief look under the hood of these indexes provides some clues.
- The STOXX 600 is more heavily weighted toward value shares—those with lower price/earnings or price/book ratios, for example. Value stocks have underperformed growth stocks for the past 10 calendar years, and that trend has continued into 2020.13 In contrast, investors have been hungry for companies generating strong earnings, a hallmark of growth shares, benefiting the S&P 500 and its growth tilt.
- Information technology is the largest sector of the S&P 500, making up 23% of its market capitalization.14 And with Apple, Google, Microsoft and Amazon among its largest components, tech has been on a relative tear. In contrast, Europe’s far smaller technology sector (-11.6% in 2020) has disappointed.15
- In addition to such divergent sector performance, Europe is home to two of the world’s worst-performing equity markets this year—Italy and Spain. Although each makes up less than 5% of the STOXX 600, both have struggled mightily in large part due to their difficulties containing the coronavirus.16
- Lastly, the U.S. has implemented significantly more aggressive stimulus than Europe—at least in terms of funding totals. This has boosted investor sentiment and riskier assets (like stocks) with it.
All of that said, better days could lie ahead for the STOXX 600 and its cyclical sectors. While European governments may not have opened their checkbooks to the same extent as the U.S., they have implemented some creative stimulus measures to help revive economic activity. One key example: wage subsidies.
Under this arrangement, eligible employees receive a check equal to all or most of their wages—up to 80% in the U.K., for example—while not working or working only part-time. The benefits of keeping payrolls intact are twofold: employees gain immediate financial relief, and business owners are spared from having to hire and retrain staff once they reopen their doors.
This method is more direct than the CARES Act’s Paycheck Protection Program (PPP). A cornerstone of the $350 billion CARES Act, the PPP offered forgivable loans to small business owners if they used the proceeds to meet payrolls, mortgage interest, rent and utilities. Congress passed a bill replenishing the PPP on April 24 after the program had run out of money in less than two weeks. The second tranche of $310 billion might not last even that long, according to reports.