Opening up economies drives risk sentiment

Investors are watching the tentative reopening steps being taken by countries and US states with a brewing sense of optimism.

Oil prices have recorded their fifth straight day of gains, sending Brent crude above $31 a barrel for the first time since mid-April. Wall Street trimmed some if its earlier strength, and for now equity sentiment is pushing back against the “Sell in May” mantra that typically abounds at this time of year and which has added currency at the moment, given the sharp rebound since late-March.

Plenty rests on a contained second wave of coronavirus infections that enables economic activity to gather momentum. Under that scenario, risk sentiment has scope to run harder and broaden from what has mainly been a narrow defensive and quality-led rebound to date.

From an economic and corporate earnings standpoint, many expect a very tough second quarter around the world. But a relatively smooth few weeks of normalising activity in May potentially sets up June for being a lot better than forecast, spurring market optimism. Don’t be surprised by market sentiment trying to look past a stunning rise in US unemployment (seen in excess of 20m jobs being lost) during April when the report arrives on Friday, given the focus on the process of reopening businesses.

Brad Bechtel at Jefferies sums up the stakes:

“The market has greatly benefited from the central bank and government support around the world and if we can open in time to try to claw our way back to some semblance of normal within a reasonable time period then perhaps the damage won’t be completely horrific, just bad or quite bad.”

There is also scope for a broader recovery in equity sentiment from any sign of a more promising outlook for the economy. To date, the rebound trade in global equities has been characterised by a marked disparity in performance that does not reflect expectations of a relatively swift normalisation post-Covid-19. Defensive and quality companies have been favoured, led by big US tech groups.

As shown here via Capital Economics, there is certainly a divergence between US healthcare and communications services versus those of energy and financials. Global markets have also lagged the US, notably LatAm equities and other emerging market regions.

Percentage change in selected MSCI sectoral/regional price indices since February 19

Analysts at Unigestion highlight the amount of cash that has piled up on the sidelines, with US money market funds attracting an inflow of $1.1tn and bank deposits rising by $1.2tn since equities tumbled in February. This has been replicated in other countries and the asset manager says:

“This mountain of cash could be invested in the short term if the Covid-19 curve continues to decline.”

Added impetus for share prices also looms given the “current low positioning in equities, as tracked by our beta analysis for systematic and discretionary hedge fund strategies”, notes Unigestion. A further decline in implied and realised volatility for equities raises the prospect that some investment strategies adjust their holdings in favour of riskier assets such as equities and credit.

Market sentiment is a fickle beast, and ultimately, it will rest on just how Main Street fares. A long recovery and the permanent loss of economic activity will catch up with financial markets.

TS Lombard’s Andrea Cicione believes that a massive dose of central bank liquidity can only delay the onset of a “real bear market” and “one resulting from the emerging recession”.

Andrea thinks:

“The US economy will remain in recession long after social distancing measures are relaxed. As companies have hinted, the worst for earnings is yet to come, as the lockdowns only marginally affected business last quarter.”

Playing a role in guiding investor sentiment will be the opening of economic activity in China and Asia. Hong Kong today announced it would relax its social distancing measures after reporting no local coronavirus infections for more than two weeks. Commodity prices will certainly find support from stronger signs of economic life in Asia.

And as Unigestion note, their “China GDP Nowcaster shows that, although the recovery in several sectors is on track, current levels for several segments are still markedly lower than those observed before the crisis. We have a similar picture in South Korea.”

Quick Hits — What’s on the markets radar?

Germany’s judges have stirred negative market sentiment towards the euro. Germany’s constitutional court ruled that the European Central Bank’s debt purchases were legal but called for a review into whether they were “proportionate” in pursuit of its monetary policy objective.

The currency market reaction is relatively limited. The euro dropped to a one-week low, as the ECB will probably provide a cost-benefit analysis for its quantitative easing programme (which began in 2014) within three months for the German court. Italian bond yields widened by 0.2 percentage points versus the German Bund to 2.5 per cent.

Beyond the market noise, the medium-term implications of the decision are not so comforting in two important respects argues George Saravelos at Deutsche Bank:

“The ECB’s new pandemic QE does not contain issuer limits and has extremely vague parameters on the timeline over which capital key weights have to be maintained. The pressure on the ECB to be more conservative is higher and the bar for an eventual ruling against the programme is lower.”

George also identifies a legal pathway for Germany to leave the euro and notes:

“The German Constitutional Court has openly disagreed with the European Court of Justice on the interpretation of EU treaties. It has created two parallel legal orders for the Bundesbank and a precedent for the central bank to deviate from ECB decisions.”

Brazil’s central bank meets on Wednesday and expectations are for a 50 basis point cut to a record low 3.25 per cent, following a similar easing in March. Brazil is being hit hard by Covid-19 and a lockdown of its economy. Rate cuts have triggered a dramatic slide in the currency, and while the deflationary hit to the economy allows room for further easing, the implications for Brazilian borrowers in foreign currencies is hardly good news.

Analysts at Bank of America forecast a tough outlook for Latin America’s biggest economy.

“Monetary easing and robust fiscal stimulus (over 10 per cent of GDP) should prevent a deeper economic downfall but will not prevent a recession in our view.”

One point of concern raised by BNY Mellon is a big hit to the earnings of Brazilian companies, many of whom have large foreign currency denominated debt. This is highlighted by wider corporate risk premiums given how the share of corporate foreign currency debt to total corporate debt has increased from about 50 per cent towards 80 per cent during the past five years.

Share of FX-denominated corporate debt out of total vs spread

BNY Mellon adds:

“Non-financial corporate debt denominated in foreign currency now stands at $273bn. This compares to $342bn of corporate debt denominated in the local currency. Persistent FX-hedging demand from local firms is, therefore, a concern.”