Last week was another reminder that stocks don’t go straight up all the time.
After 5 weeks of increasing momentum and signs of exuberant investor behavior, equities closed lower in volatile trading. The selling was broad-based but had a bit of a “sell the winners” feel to it, with the U.S. underperforming (SPX -2.3%) and led lower by large-cap tech (CCMP -3.3%). International markets fared better, with emerging markets leading (MXEF -2.0%) and international developed not far behind (MXEA -2.1%) [Figure 1].
Large-cap tech led the way lower
In the prior commentary we flagged the spot-up, vol-up dynamics in U.S. equities — and especially in a few well-known large-cap tech names — as a main driver of the recent price action. Well, it works in reverse too, as shown in a dramatic fashion on Thursday and Friday. The NASDAQ (CCMP) closed down 5.0% on Thursday, its biggest drop since early June.
Indeed, last week felt a lot like the late-May to early-June period, when investor euphoria amid low liquidity was exacerbated by imbalanced option market dynamics. Just as was the case then, we expect this price action to be temporary. But given the pain in the derivatives market (the S&P 500 is at same level from 2 weeks ago while the CBOE Volatility Index (VIX) is ~8 points higher) and given the extreme YTD performance spreads — growth up 32% on value and NASDAQ up 27% YTD — it could run a bit more [Figure 2].
If forced to name a catalyst for last week’s sell-off, we’d point to increasing tensions over Huawei and concerns about the broader U.S.-China relationship. But the risks around this important economic relationship have been around for months with little market impact, so we are skeptical of this as the “cause” of Thursday and Friday’s price action.
Value outperforms, but small caps lag
While value outperformed growth last week, it’s notable that small and mid caps lagged the S&P 500 [Figure 1]. To us this speaks to where the positioning in the market is (long tech and large-cap growth and short large-cap value), and also where investors don’t seem to care much (anything outside of large caps). With the pull of passive market flows into the large-cap space, it will take a big shift in economic conditions for that dynamic to change.
Unemployment rate plunges but devil is in details
Economic data was broadly positive last week, capped off by Friday’s shocking fall in the unemployment rate — an near two-point decline to 8.4%. While census workers and methodology issues distorted this reading somewhat, the improvement in the labor market has been an unexpected source of strength for the economy. That said, the pace of job gains appears to be slowing, consistent with other non-traditional economic activity measures.
Bond yields fall just slightly amid sell-off
In a low liquidity week, bonds reacted to price action in equities and to adjustments in positioning following the prior week’s steepener. The curve flattened with fairly modest week-over-week moves, but day-to-day the moves were more volatile. The U.S. Treasury 30 Year yield fell 13 bps through Wednesday, only to rise 11 bps on Friday to close 3 bps lower on the week.
A modest 3 bp fall in yields on the week with the biggest equity sell-off since June is not what you might expect, but to us it indicates how equity-centric the market action was last week.
Credit & USD don’t share equity market concerns
Credit spreads were broadly flat last week, another sign of the lack of cross-asset concern around the equity action. The heavy issuance in the next few weeks may weigh on spreads (and back-end interest rates) a bit in the near-term, but demand for credit is strong and the massive issuance so far — 2020 is a full-year record after only 8 months — hasn’t been an issue. Indeed, investment-grade (IG) corporate bonds are up almost 7% in total return this year (LUACTRUU).
In another sign that the equity concern is not shared by other asset markets, the U.S. dollar rose only marginally last week. That’s a big departure from the correlations we saw earlier in the year, when equity weakness would drive considerable dollar strength. The action in bond, credit, and currency markets reinforces our view that this is not the start of some new macro trend in markets.
No more clarity on Fed policy changes
Fedspeak last week did little to clarify the framework review Federal Reserve Chairman Powell announced at Jackson Hole. If anything, it’s becoming clear that this was about new goals, not new tools, for the world’s most powerful central bank.
Given the lack of success at hitting their 2% goal over the last 10 years, markets are coming around to our skeptical view of the impact on inflation of this new policy as market-based inflation expectations fell 10 bps last week. It does, however, mean no interest rate hikes for as far as the eye can see — a bullish development for asset prices.
What to watch next
What are we watching in this shortened holiday week?
The market is still closely watching the movement (up or down) in new COVID-19 cases. There is some indication that the decline in new cases may be leveling off in the U.S. And the COVID situation in Europe continues to deteriorate, an potentially ominous sign for the fall season here in the U.S.
European Central Bank (ECB) Meeting
The ECB’s post-summer meeting is on Thursday. And while no policy change is expected to be announced, markets will be listening to whether the ECB is concerned about further appreciation in the euro, which could impact inflation forecasts. Because of the Fed’s move toward pledging lower rates for longer, it falls on everyone else to continue to ease, which is important for overall global interest rate outlook
Last week, Congress passed a permanent resolution on the budget. While this avoided a shutdown, it also means that stimulus talks may be permanently stalled. Many market participants were expecting the Congress to negotiate the Phase IV stimulus and the new budget together. Now that the budget has passed and the election grows nearer, there’s little other reason or catalyst for Congress to come together on another stimulus package.
Initial jobless claims on Thursday are expected to show only a modest decline. The market hasn’t paid too much attention to the fact that weekly initial claims continue to break pre-pandemic records, largely because of the massive stimulus we’ve seen so far and the fact that consumers are spending. But with a Phase IV package now nowhere in sight, what’s happening in the labor market could become much more important. If there’s no stimulus, then people have to be able work in order to make money to spend.
While the first debate isn’t until the end of month, Labor Day has tended to be the unofficial kickoff of election campaigning. The market will be watching to see if and how candidates engage with one another prior to meeting on the debate stage.
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