Surfing the endless summer for risk sentiment

Global equities and risk assets appear set for surfing an endless summer. Importantly, another type of wave remains absent as economies slowly reopen for business and consumers.

Economists at Goldman Sachs note they have “seen little evidence of a widespread pick-up in [Covid-19] infection rates as western economies have begun reopening”.

Unless, infection rates pick up substantially in the coming weeks, investor appetite for equities and commodities will probably broaden, gaining comfort from incoming data affirming that April marked the nadir for many economies. For now, gauging the trajectory of the economic recovery plays second fiddle to a broader sense of relief that the worst is behind us. In turn, fear of missing out is back among investors who are notably shrugging aside tensions between the US and China and the protests in many US cities.

In terms of the macro story, survey data released on Wednesday showed that business activity in Europe revealed signs of a recovery as lockdowns loosened, while the latest monthly snapshot of US private sector hiring declined a lot less than expected in May (down by 2.76m versus a forecast drop of 9m).

In spite of prevailing bullish market sentiment that has pushed global equities to their best level in three months, a long journey towards recovery looms.

Line chart of MSCI All Country World index   showing Global stocks have rallied to within 10% of this year's highs

Earlier on Wednesday I spoke with Shamik Dhar, the chief economist at BNY Mellon Investment Management. Shamik says while he has become a little more optimistic about a stronger recovery in the wake of lockdowns, he thinks “equities are not pricing in the true amount of downside risk”. A recovery in terms of gross domestic product returning to pre-Covid-19 levels under Shamik’s best-case scenario only arrives by the middle of next year.

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That suggests an elongated process or economic repair and one that leaves risk appetite looking a little exposed from any number of likely setbacks that include another wave of infections later in the year, to consumers saving more and furloughed workers being made redundant by cost-cutting and struggling companies. Any delay in governments extending fiscal stimulus later in the year looms as a key threat for risk appetite, given the Teflon nature of the rebound since March.

A deeper look at current data that has prompted some cheer for market sentiment also highlights reasons for caution.

The US service sector on the surface revealed a small bounce in headline activity to 45.4, but this measure remains stuck in contraction territory below a reading of 50. And as many point out, supply chain disruptions entail an elevated supplier deliveries index. That says Oxford Economics masks “an otherwise more contractionary reading for the headline figure”.

But accentuating the positive remains the market story at the moment. Here, BCA Research highlights the pacesetters among economies that are reopening, Germany and Australia. One measure of live data, the number of reservations in restaurants, is shown below. BCA says:

“This suggests that even if the behaviour of households will not return to normal, there is significant scope for improvement from current levels.”

Absent a jump in infections, Goldman thinks “the upside risks to economic activity over the short run could be substantial, because only the riskiest activities would need to be avoided now and in any future lockdown”.

But the bank also highlights how one area of the US equity market still signals reservations about the ultimate path of recovery. S&P 500 equity volatility for much of the year remains elevated when looking at Vix futures — above a reading of 30 — and Goldman says:

“A Vix at those levels for that length of time would be unprecedented and suggests that the market is not overly complacent about the uncertainty further out.”

Even the best surfers acknowledge the risk of a wipeout.

Quick Hits — What’s on the markets radar?

Oil prices are stalling after an extended run with Brent unable to stay above $40 a barrel. Knocking market sentiment is a focus on the lack of production cut compliance among Opec members — Iraq and Nigeria — ahead of a planned virtual meeting on Thursday. Also not helping are higher US inventories of refined petroleum products that raises a question over demand picking up.

Ole Hansen at Saxo Bank says:

“Opec+ cannot afford not to reach an agreement with the current market price nowhere near the level many of the producers need to balance their budgets.”

While an extension of existing production cuts is likely, Ole adds:

“The lack of compliance will leave the deal short in delivering its full price supportive potential. Not least considering news that US shale oil producers are slowly beginning to restart production after seeing the price of WTI return to profitable levels.”

Not only has the S&P 500 broken to a new high since March, so has an important measure, the Treasury yield curve between the five and 30-year maturities. A five-year note yield of 0.37 per cent sits about 1.20 basis points below the 30-year bond’s level of 1.56 per cent and that takes the market back to levels seen in February of 2017.

One can look at the combination of a rally in equities and a steeper Treasury yield curve as affirming a brewing reflation trade. But in early 2017, tax cuts were the driver of higher inflation expectations, whereas at the moment bond market expectations in that respect remain stuck in the basement.

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Ian Lyngen at BMO Capital Markets says one such market measure — a five-year rate starting in 2025 and known as the 5yr/5yr forward inflation break-even — sits “nowhere near levels one would associate with normal inflationary worries leading to a steeper curve”.

Hurting appetite for 30-year bonds is a welter of new debt issuance, with the resumption of 20-year sales in May causing plenty of indigestion. A steeper yield curve also reflects expectations that the Federal Reserve will keep short-dated Treasury rates parked near zero for an extended period.

Such an approach makes life a little easier for banks that are reliant on net interest margin and in turn that helps boost an important sector of the equity market. But higher long-dated yields also tighten financial conditions and at some point, that will compel a response from the Fed, via increased buying of 20 and 30-year Treasuries.

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