Stocks head for best quarter in years, Powell testimony weighs on yields

Morning Note

The UK’s economy shrank a little more than expected in the first quarter – the 2.2% plunge was the joint worst since 1979. Of course, it will be dwarfed by the Q2 drop, with April already printing 20% lower. Meanwhile China’s PMI data showed a slight improvement and Japan’s industrial production plunged over 8%.

Does any of this tell us much as investors and traders? In normal times, yes of course, as it might make a difference of a few points on the margins, but in the time of coronavirus there is an awful lot of noise around the data which makes it a lot more challenging, as well as of course all the stimulus, which muffles the notes that the data is trying to sound. Boris Johnson will launch an FDR-like New Deal infrastructure package today to distract us from the harsh reality of rising unemployment and ongoing restrictions on our liberties.

Powell’s economic outlook weighs on US yields

US Treasury yields declined as Federal Reserve chair Jay Powell said the outlook for the economy is ‘extraordinarily uncertain’. In prepared remarks for today’s Congressional hearing alongside Treasury Secretary Steve Mnuchin, Mr Powell said output and employment remain ‘far below their pre-pandemic levels’, adding: ‘The path forward for the economy is extraordinarily uncertain and will depend in large part on our success in containing the virus.’

He also noted that ‘a full recovery is unlikely until people are confident that it is safe to reengage in a broad range of activities’. San Francisco Federal Reserve President Mary Daly said it’s too early to tell and is just ‘watching the data’. Aren’t we all.

A strong quarter for stocks, but risks of a sharp pullback abound

Stocks rallied on Monday despite a wobbly start, as US pending home sales jumped the most on record in May, whilst Boeing surged 14%, heaping dozens of points on the Dow as it restarted test flights on the 737 MAX aircraft yesterday.

But as I keep stressing, this is a very rangebound market. The S&P 500 rose 1.5% but is caught between the 38.2% and 50% retracement of the pullback in the second week of June. The Dow added more than 2% but couldn’t even achieve the 38.2% line. Whilst indices are still trading this range, there is a downside bias evident lately and emerging down trend channels as we’ve made a couple of lower highs and lower lows. If this trend strengthens it could gain enough momentum to retest of the June lows.

Indeed, during cash equity trading hours the last 5 sessions has produced a lower low and lower high on the S&P 500. Valuations still look too high and based on a far-too-optimistic view of an earnings rebound in 2021 and does not account for permanent productivity and demand destruction. Of course stimulus is making a big difference here, but risk assets are exposed if we see the pandemic get worse from here. World Health Organisation boss Tedros said the worst is yet to come. Cases across states like Arizona, Texas and Florida continue to surge and look to be completely out of control.  A short, sharp pullback is a very real possibility.

Nevertheless, it’s been a solid month and an exceptionally strong quarter. US equities have enjoyed their best quarter in 20 years, whilst stocks in Europe have fared pretty well too as investors participated in the rebound off the March lows. It’s mirrored elsewhere in risk assets – copper is up a fifth, but is slightly weaker for the year. For instance, the S&P 500 is up 18% QTD, but down 5% YTD. The FTSE 100 is up almost 10% QTD, but down over 17% YTD.

On the open on Tuesday, European stocks were mixed and lacking direction as they traded either side of the flatline. The FTSE 100 was trading around the 50% retracement of the June pullback and took a little hit as Shell downgraded its oil outlook and warned it will need to take up to write down the value of its assets by as much as $22bn. This follows a similar move by BP, which moved lower apparently on the Shell read-across.

Chart: Dow tests 50-day SMA support, downtrend starts to gain momentum.

Elsewhere, gold was supported around $1770 but slightly below the recent 8-year high as the flag pattern starts to near completion following the leg up on Friday. Needless to say, we can look to US real rates and 10yr Treasury Inflation Protected Securities (TIPS) dipping to –0.7%, a new seven-year low. Across the curve real rates are more negative than they have been a decent while.

Crude oil recovered the $39 handle but has failed to ascend all the way to $40 and has peeled back this morning. The near-term rising trend is offering support but the double top still exerts its influence and may well result in a further pullback to $35.

In FX, the dollar continues to find bid and the dollar index is making a nice little move off its lows still in a strong uptrend channel but is just running into horizontal resistance around the 97.65 area – breakout could see 98 handle again in short order. The downtrend dominates for cable as the pair continued south down the channel to test 1.2250. Whilst this held, the failure to recover 1.23150 on the swing higher may call for a further decline to the 1.22 round number support, and thence our old friend 1.2160 may come into play.

Chart: Downward trend dominates for cable

European shares cautious after Wall Street soars

Morning Note

Risk on resumes? Wall Street enjoyed one of its best days this year as hopes grew for a Covid-19 vaccine The Dow rallied 900 points, up almost 4%, while the S&P 500 rose 90 points, or 3.15%, to 2953, closing at its highest since March 6th. The close was just a little shy of the 2954 peak on Apr 29th, the most recent swing high.

European shares were firmer at the open before losing steam quickly. The FTSE 100 added to yesterday’s gains to trade above 6100 again on the open but then followed Frankfurt and Paris. US futures were off their highs. Asian markets were green across the board.

Indices are now at or slightly above the top of the recent trading ranges since the March trough. The question we have now is whether it makes sense for equities to take another leg higher and re-approach record highs against a backdrop of the worst economic slumps in decades. Hence, we would expect some pullback around these levels even if bulls muster again for a fresh drive. Economic reality may eventually hit home, the question is whether we first see a new leg higher and post-Covid high made.

Moderna shares rose 20% to $80 after the company said its early-stage human trial for a coronavirus vaccine produced positive results, with Covid-19 antibodies seen in all 45 participants. It’s early days but markets are prepared to see the glass half full at this stage. Four years is the fastest it’s taken to deliver a vaccine – for mumps in the 1960s. Technology may have moved on, but pinning all your hopes on a vaccine seems overly optimistic, which suggests these moves are driven by algos playing the news.

A vaccine – not treatment – is key of course to resuming life as normal – no social distancing on planes or in bars. It’s the holy grail right now and markets are prepared to take a leap of faith.

News from Europe is further supporting risk appetite with the old Franco-German engine at work. Merkel and Macron have agreed to push for a €500bn EU fund which would be in the form of grants not loans. With Germany on board now it should drive the holdouts in the Netherlands and Austria to agree. It will be funded by the European Commission borrowing money – coronabonds in all but name. This is an important breakthrough for the EU – at least it should be.

UK unemployment claims jumped, and wages fell, but the unemployment rate actually fell to 3.9% because of the furlough scheme keeping employees in their jobs. This is in marked contrast to the US, where there is no furlough scheme. The worry is that furlough simply delays the inevitable when companies do reopen, and at massive cost. For markets this could be seeing a big rise in unemployment and therefore hit to the economy even as cases of Covid-19 are fading.

After breaking out to new 7-year highs above $1764 yesterday gold has backed off and tested support at $1725 as the risk rally tempered the bulls’ passion. US 10 year Treasury yields advanced to 0.74% but have since pulled back to 0.70%.

WTI (Jun) seems to have safely negotiated today’s expiry after another big gain for crude on Monday indicated further confidence that oil markets are rebalancing more quickly than feared. Front month WTI traded at $32, with August now at $32.59. Brent futures traded above $35. Given the extent of the recent gains, there is ample room for a pullback from these levels.

In FX, the dollar was weaker apparently on better risk appetite, lending support to major peers. GBPUSD continued to break free from Sunday’s lows as better risk appetite boost sterling. Cable rallied into resistance at 1.2250, the past support level, and has now added around 1.5% this week. The pound continues face pressure though as a risk proxy – as previously noted sterling has become a RoRo (risk-on, risk-off) currency of late, as well as doubts around progress on talks between the UK and EU. The British government has just announced a new tariff regime for the post-transition world that would see 60% of imports without tariffs.

Today Jay Powell speaks at 3pm as he faces questions from Congress. In a prepared testimony he said: “We are committed to using our full range of tools to support the economy in this challenging time even as we recognize that these actions are only a part of a broader public-sector response.”

Chart: S&P 500 facing big test at the top of the range: confirmation of the breach of the late Apr swing high and push above the 61.8% retracement at 2934 opens path back to 3140 and the early March swing highs.

Equity markets track lower after Wall St falls

Morning Note

Public Health England has approved an antibody test from Roche, which could mean easing lockdown restrictions sooner. A junior health minister described it as a ‘game changer’. We shall see – the record on testing so far has been sketchy but it’s a step in the right direction. Russia has also announced positive trials of a treatment drug favipiravi, which was first developed under the name Avigan in Japan. Despite some good news around these drugs however, it seems markets are waking up to the economic reality at last.

US Treasury yields fell and equity indices rolled over, with the S&P 500 down 1.75% at 2820 and the Dow dropping 500 points as hopes for a swift recovery from the Covid-19 recession faded.

Fed chair Jay Powell painted a pretty gloomy picture, He warned that additional policy measures may be needed to avoid an extended period of low productivity. He is erring towards doing more not less. Nothing explicit on negative rates, just repeating the preference for not using them.

As we near the end of earnings season, the recent gains look like over exuberance. David Tepper, a billionaire hedge fund guy, said it’s the second-most overvalued market ever – only ‘99 was worse. Certainly at 20 times forward earnings, it looks pricey – the priciest in 18 years. Earnings in Q1 for S&P 500 companies are down 14% and are seen weaker all year, with Q2 especially hard hit. Already this is the 4th quarter in 5 of year-over-year earnings declines. Valuations are starting to look exceedingly optimistic at these levels – 2600 on SPX is a lot more realistic than 3000.  We may not retest the lows, but a significant pullback from the post-trough highs around the 61.8% level seems likely.

At the lows SPX tested the 2790 level, the 50% retracement. MACD crossover confirmed.

Asian markets tracked the fall on Wall Street and European bourses traded broadly weaker on Thursday.

WTI and Brent futures spiked after a surprise draw on US oil stocks but have pared gains. EIA figures showed a 745k barrel drawdown vs an expected build of more than 4m barrels. Stocks at the key Cushing, Oklahoma hub fell by 3m barrels, the first such draw since February.

The Commodity Futures Trading Commission warned brokers and clearing houses “to prepare for the possibility that certain contracts may continue to experience extreme market volatility, low liquidity and possibly negative pricing”. The June WTI contract expires on May 19th.

In FX, the pound weakened further as the risk-off trade hit currency markets. Andrew Bailey, the Bank of England governor, said markets’ basic assumption was that there would more QE.

GBPUSD breached the 1.2250 support and headed for the bottom of the range and is now on track to knock on the Apr 6th low around 1.2160.

Negative rates: not now Bernard

Morning Note

Not Now, Bernard is a children’s story about parents who don’t pay attention and don’t notice their son has been gobbled up by a monster, which they duly allow into the house. One could make parallels with central banks and the monstrosity of negative rates.

Last week a strange thing happened: Fed funds futures – the market’s best guess of where US interests will be in the future – implied negative rates were coming. The market priced in negative rates in Apr 2021. It doesn’t mean they will go negative, but the market can exert serious gravitational pull on Federal Reserve policy. Often, the tail wags the dog, and the market forces the Fed to catch up. Of course, given the vast deluge of QE, it’s not always easy to read the bond market these days – central bank intervention has destroyed any notion of price discovery.

Now this is a problem for the Fed. Japan and Europe, where negative rates are now embedded, are hardly poster children for monetary policy success. Nevertheless, the President eyes a freebie, tweeting:

As long as other countries are receiving the benefits of Negative Rates, the USA should also accept the “GIFT”. Big numbers!

The Fed needs to come out very firmly against negative rates, or it could become self-fulfilling. Numerous Fed officials this week are trying their best to sound tough, but they are not brave enough to dare sound ‘hawkish’ in any way. Minneapolis Fed president Neel Kashkari said Fed policymakers have been ‘pretty unanimous’ in opposing negative interest rates, but he added that he did not want to say never with regards to negative interest rates.

It’s up to Fed chair Jay Powell today to set the record straight and make it clear the Fed will never go negative, or the US will go the way of Japan and Europe. Powell has to push very hard against this market mood. Too late says Scott Minerd, Guggenheim CIO, who believes the 10-year yield will eventually hit -0.5% in the coming years. Powell speaks today in a webinar organized by the Peterson Institute for International Economics. If he doesn’t lean hard on the negative rate talk it will cause a fair amount of mess on the short end.

UK 2yr yields turn negative, RBNZ doubles QE

Another strange thing happened this morning – UK interest rates also went negative. The 2yr gilt yield sank to an all-time low at -0.051% as markets assessed how much stimulus the UK economy is going to need (more on this below).

Inflation may or not be coming; deflation is the big worry right now as demand crumbles. The Covid-19 outbreak, or, more accurately, the response by governments, creates a profoundly deflationary shock for the global economy. Just look at oil prices. And yet, as central banks approach the precipice of debt monetization and Modern Monetary Theory, inflation could be coming in a big way.

So, we move neatly to the Reserve Bank of New Zealand (RBNZ), which last month said it was ‘open minded’ on direct monetisation of government debt. Today’s it has doubled the size of its bond buying programme but kept rates at 0.25%. The kiwi traded weaker.

German judge slams ECB

Sticking with central banks, and Peter Huber, the German judge who drafted the constitutional court’s controversial decision was reported making some pretty stunning remarks about the European Central Bank. Speaking to a German publication he warned the ECB is not the ‘Master of the Universe’, and, according to Bloomberg, said: ‘An institution like the ECB, which is only thinly legitimized democratically, is only acceptable if it strictly adheres to the responsibilities assigned to it’. These are pretty stunning and underline the extent to which this decision upends the assumption of ECJ oversight in the EU and over its institutions. Remarkable.

US stocks tumble on talk of lockdown extensions

US stocks had a dismal close, sliding sharply in the final hour of trading as Los Angeles County looked set to extend its stay at home order for another three months and Dr Fauci warned of reopening too early. The S&P 500 fell 2% and closed at the session low at 2870. The close could leave a mark as it broke support and we note the MACD crossover on the daily chart. European markets followed suit and drove 1-2% lower – this might be the time for the rollover I’ve been talking about for the last fortnight.

Pound off overnight lows after Q1 GDP decline softer-than-expected

Sterling is softer but off the overnight lows after less-bad-than-feared economic numbers. GBPUSD traded under 1.23 having tested the Apr 21st swing low support at 1.2250 ahead of the GDP print. The UK economy contracted by 5.8% in March. However, the –1.6% contraction in Q1 was less than the –2.2% expected, while quarter-on-quarter the economy contracted -2% vs –2.6% expected. GBPUSD bounced off its lows following the release, but upside remains constrained and the bearish MACD crossover on the daily chart still rules. We know it’s bad – the extension of the furlough scheme does not indicate things will be back to normal this year.

Oil markets are still looking quite bullish. A number of OPEC ‘sources’ yesterday suggested the cartel would stick to the 9.7m bpd cuts beyond June. API figures showed a build of 7.6m barrels, though there was a draw on stocks at Cushing, Oklahoma of 2.3m barrels. Gasoline inventories fell 1.9m barrels, but distillates continued to build by 4.7m barrels. EIA inventory data is later today is expected to show a build of 4.8m barrels.

Market Insight: Earnings Season

Equities

Earnings season is just around the corner, with reports trickling out until the action starts week beginning July 15th. However, companies have already warned that this earnings season could be worse than even the pessimistic analyst forecasts.

According to information from FactSet, 77% of the 113 companies that have issued earnings per share guidance have warned that their figures are likely to be worse than analyst estimates. The report revealed that the number of S&P 500 companies issuing negative EPS guidance for Q2 is the second highest since 2006. The worst was in the first quarter of 2016, which saw 92 negative such warnings.

Against continuous rallying from Dow Jones and the best June for S&P 500 since 1955, this is a challenging circle to square. While markets are sluggish and trade tensions are having an impact, equities remain attractive.

Earnings also declined by 0.29% in Q1, so it’s likely to become an earnings recession. There have been rumblings of recession for a while now, but markets remain fixated on the Fed and are not pricing in bad news.

Neil Wilson, Chief Markets Analyst for MARKETS.COM said: “The problem for bulls from here is that several rate cuts by the Fed are already priced in, meaning, in the absence of a material rerating of valuations, we would need to see an improvement in earnings to push equities higher still. 

There are therefore two big risks coming up: The Fed doesn’t cut as expected (even one cut this year won’t be ‘enough’), and two, corporate earnings guidance is significantly weaker than the market expects.”

What to expect from Earnings Season

Aside from some early releases, earnings season really gets going on July 15th and wraps up around mid-August. So, for three weeks, traders need to keep a close eye on the market and their assets to ensure they’re making the most of the volatility.

While estimated earnings fell by 2.6% for Q2, this decline is smaller than the five-year average (-3.3%), however the volume of companies issuing negative guidance is higher than the five-year average by some margin (77% to 70%).

Specifically, certain industries have issued more negative guidance than others with Materials and Industrials sectors leading the decline. Freeport-McMoRan, DuPont and Mosaic all recorded a decrease in their mean EPS estimate of more than 10%, while in industrials the decrease was led by Boeing, 3M and American Airlines.

Perhaps surprisingly, the Energy sector recorded the largest increase in expected earnings growth for the quarter, led by Chevron.

With a gloomy outlook for the global economy and the ongoing trade tensions, traders are unlikely to be surprised by a grim earnings season. But all eyes are on the Fed today as market participants hold their breath for a rate cut. While corporate earnings don’t directly impact policymakers, reduced earnings based on a weaker economic outlook and trade worries make a rate cut (or two) look more likely.

Jay Powell is giving his semi-annual testimony later today, and the minutes from the last FOMC meeting are published tomorrow, so traders could get some insight into where the Fed is looking.

Wilson sums it up by saying: “Expectations for earnings are low but may not be low enough. Forward earnings guidance for the remainder of the year may face downward revisions, which would drag on equity markets. However, with little else out there in terms of yield and bonds looking pricey, equities may still appeal as central banks drive investors towards risk. Over to Mr Powell…”

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