Market turbulence continued last week in another “sell the winners” week of trading, shortened by the Labor Day holiday. The action was most pronounced in the U.S. equity market, the underperformer again last week (SPX -2.5%), led lower by weakness in tech (CCMP -4.1%) [Figure 1]. Back-to-back weekly declines haven’t occurred in the S&P 500 since early May, although the index is back to where it was one month ago — a reminder of how strong recent performance of U.S. equities has been. International equities had a better week than their domestic peers, with notable strength in international developed market equities (MXEA +1.5%) and strong relative emerging market performance (MXEF -0.7%) [Figure 1].
Value leads growth, but rotation unlikely
Value led growth again last week [Figure 1]. Is the long-anticipated value rotation finally happening? Not likely. Rather than the start of a new trend, to us value’s recent outperformance feels like a rebalancing of positions against a low liquidity backdrop exacerbated by imbalances in the option market. In our view, a new trend needs new fundamentals, for which we remain vigilant but just haven’t seen yet. Until then, we view events like those over the last two weeks as price corrections only — a healthy sign after the speculative mania we saw in tech and megacaps in August.
Small caps lagging
Small caps (RTY -2.5%), stocks with riskier balance sheets and greater economic sensitivity, matched the decline in the S&P 500 last week [Figure 1], just as they did the week prior . This is another collaborating factor in our above view that recent action is a price correction only.
VIX volatility index falls even as market sells off
The CBOE Volatility Index (VIX) fell significantly during last week’s sell off [Figure 2], beginning 9/2/2020 and ending 9/11/2020 — not what you’d typically expect when equities sell off. Because the stock market and the VIX have tended to be negatively correlated, as the S&P 500 declines, you’d expect to see the VIX surge. That’s exactly what happened during the sell-off in June, beginning 6/8/2020 and ending 6/11/2020 [Figure 2].
The fact that the S&P 500 and the VIX are moving in tandem of late is just another sign that the derivatives market is playing an outsized role in the price action of the cash market. In other words, the tail is wagging the dog. Based on our estimates of current derivatives market positioning, it may be another one-to-two weeks before these positions are cleared.
Republicans fail to vote on skinny bill
The failure of Republican Senators to vote on a “skinny” stimulus bill last week all but closed the door on a Phase IV package coming before the election. Consumers have been very resilient thus far, but lack of additional stimulus could start to bite, which means it will be important to pay greater attention to jobs and spending data going forward.
Potentially negative set-up heading into fall
Rising Covid cases in Europe show just how hard it is to go back to normal, and how important vaccines and other measures are to sustaining economic growth from here. With the upcoming election and a lack of further fiscal stimulus from Congress, the set-up heading into the fall is less positive now than it was a month ago.
Seeking spread in fixed income markets
Yields fell again last week despite a very heavy supply calendar for both government and corporate debt. To us, this signals the market’s desire to seek out spread in the fixed income space in this lower-for-longer interest rate environment. Last week, the U.S. 30-Year Treasury fell 6 basis points (bps), putting its yield right in the middle of the 1.20-1.60 range that it has traded in since April. If the market was truly concerned about inflation or deficits, yields would be much higher.
Credit spreads widened a bit last week, with investment-grade and high-yield up 2 bps and 8 bps, respectively, likely due to equity weakness and a glut of new issuance. We expect any weakness in credit to be temporary unless underlying economic conditions change materially from here. The bottom line is, the lower-for-longer phenomenon is a powerful one for spread products.
Fed meets this week
The Federal Reserve meets this week, but the market doesn’t expect any material changes to policy. The Fed is as dovish as possible right now and rates are on hold for a long time. Given the low expectations, further refinement of their new framework would be viewed as additional policy support, likely pushing yields even lower, equities higher, and the dollar weaker.
Brexit fears shake up currency markets
Speaking of the dollar, there was some action in the currency markets last week. Brexit fears came back into focus for the market after the UK government’s admission of its intent to violate international law threatened to force a disorderly departure from the EU. As a result, the pound had its biggest weekly slide since the dash for dollars in March. And the European Central Bank (ECB) tried, and failed, again to talk down the recent appreciation trend in the euro.
U.S.-China risks remain
While the deterioration in the U.S.-China relationship continues to be blamed for the equity price action, there are no signs of this stress in the place where we’d expect it to show up most directly — the exchange rate. Still, risks remain, as headlines on the TikTok sale and the upcoming deadline for the sale of chips to Huawei indicate.
Six things to watch this week
COVID-19 Cases and Vaccine Progress
Covid-19 cases here in the U.S. appear to be flatlining at around 40,000 new cases per day. And, as we wrote about in last week’s Big Number blog, the situation in Europe is becoming increasingly concerning. France is now fully in a second-wave scenario and it’s 7-day average of new cases now exceeds its first-wave peak reached in April. This makes progress toward a vaccine even more important. In the meantime, we expect the market will continue to chop around on Covid-related headlines. Expectations right now are for some kind of curative treatment to be announced in October. The potential timing of a vaccine or curative treatment will impact the relative winners and losers (e.g., growth vs. value, small cap vs. large) going forward.
Fed Meeting On Wednesday
While not a lot of new information is expected to come out of this meeting, the Fed will for the first time give its interest rate forecasts through 2023 and update long-term rate projections. The market will be looking, too, for additional clarity around the implementation details of the Fed’s announced 2% average inflation target. Any further steps toward formalizing this policy update would be a positive catalyst to likely drive rates lower. Finally, the Fed has long stated that its asset purchase program is about market function. Given that markets are now functioning just fine, it will be interesting to see if the Fed pivots toward policy focused on accommodation.
U.S. Retail Sales
Look for the August U.S. retail sales report on Wednesday. The big question is whether the consumer is still spending. After all, consumer spending has been a surprising source of strength in this recovery. In July, retail sales in the U.S. surpassed pre-pandemic spending levels. This month, consensus is for a modest 1% increase over last month, which — while positive — could suggest the pace of gains may be slowing. Continued consumer spending is crucial to supporting the recovery narrative for risk assets. Given the incredible unlikelihood that Congress will come together at this point to pass a Phase IV stimulus package, the health of the U.S. consumer becomes even more important.
China Retail Sales
Look for China retail sales on Tuesday. China’s has been a very different kind of recovery than here in the U.S. The question for China is whether consumer demand will rebound anytime soon? Retail sales in China have lagged. So while industrial production has been strong — in effect, piggybacking on the stimulus of the rest of the world — domestic demand in China hasn’t been. After six months of straight declines, China’s retail sales this month are expected to turn positive. If the country’s retail engine starts to show signs of life, that would be a bullish sign indeed.
Last week’s initial claims were essentially flat from the week prior while continuing claims edged higher [Figure 3]. This week, expectations are that initial claims will dip just slightly lower. That said, it’s really starting to look like initial claims are leveling off well above the highs reached during any previous recession and that labor market gains overall may be stalling out.
UMich Consumer Sentiment Survey
On Friday, the University of Michigan will release preliminary results of its Consumer Sentiment Survey for September. While the overall health of the consumer has been a pillar of the recovery, this index has tended to lag some other measures of consumer health, remaining essentially trendless and staying well below its pre-pandemic peak. While the survey generally supports broader interpretation of the recovery leveling off, we don’t expect this month’s report to show a meaningful deterioration in consumer sentiment. If it does, that could be cause for concern.
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