Stock markets climbed the wall of worry last week, closing up 2.9% globally (MXWD) as hopes around a coronavirus vaccine and the loosening of restrictions in the U.S. outweighed the rising tensions between the world’s two largest economies, the U.S. and China.
Domestic shares outperformed (SPX +3.3%), while emerging markets lagged due to weakness in Asian markets (MXEF +0.5%). International developed markets gained 3.0% (MXEA). Remarkably, despite the steep losses in the first quarter of 2020, the S&P 500 is now actually up about 6.5% from where it was a year ago [Figure 1]. As of midday Tuesday, it was trading over the psychologically important 3,000 level, last seen in the first week of March. For now, the market seems to be overly receptive to good news and more than willing to discount details that could paint a less-than-rosy picture of the future.
Promising news around a potential vaccine and enthusiasm for reopening drove equities higher in a pro-cyclical fashion early in the week. Small caps and value outperformed, although some of that strength faded as the holiday weekend drew near.
Yield curve steepens as 20-year reopens
Treasury yields shot higher on Monday amid the optimism, but then faded throughout the week, closing up just a few basis points (bps) week over week. The 2-year and 10-year were up 2 bps and the 30-year, 4 bps. The reopening of the 20-year bond for the first time since 1986 also drove the curve steeper. Uncertain of the end demand, the market took rates higher going into the auction but it traded well after issue, showing that there is plenty of appetite for longer-dated U.S. debt. With rates at zero indefinitely, we think this will continue.
While short-term rates in the developed world were already at zero last week, a few emerging market central banks that still had room to cut did so. It now appears that almost every central bank is headed to zero, further compressing yields, especially on safe, high-quality fixed income. This is another reason we don’t see long-end rates shooting higher anytime soon, despite the budget deficits.
More healing needed in credit markets
As the Fed enters its second week of corporate bond buying, credit markets traded well, with investment-grade (IG) and high-yield (HY) debt down 9 and 61 bps, respectively. Despite Fed support, credit markets have yet to fully heal. HY spreads have retraced about 40% of their recent widening, while IG has retraced about 60%.
Large companies, generally speaking, have been able to avoid bankruptcy thus far. But because the economy’s recovery could very likely be a grinding one, we expect more defaults in the future. Companies already in a weakened position and laden with debt prior to the pandemic borrowed even more in early 2020 just to keep the lights on. But this isn’t the kind of debt that pays for itself. In other words, it’s not funding future productivity. With a potentially bigger wave of bankruptcies looming, we aren’t inclined to chase the extra yield available in the HY market until there is more economic clarity.
USD sells off except against Chinese Yuan
The U.S. Dollar (USD) sold off broadly last week, with one noticeable exception — it strengthened against the Chinese yuan [Figure 2]. Bilateral currency valuation was a big sticking point last summer in the U.S.-China Trade War. The signal from this market flies in the face of the optimism the equity and credit markets are broadcasting.
For now, markets appear to be overlooking the fact that the two largest economies, the U.S. and China, are moving farther and farther apart. Tensions are increasing, even as both economies continue to struggle to recover from the impact of the coronavirus. We think this is likely to become a bigger issue in the future and bears close watching.