July 7, 2020
The second quarter saw an equity market rally among the strongest in history exist simultaneously with global economic data resembling the worst periods of the Great Depression. Investors are clearly looking through the current collapse in profit growth in expectation for a sharp economic recovery. But these two trends are incompatible over any significant time period.
These two charts will be vital for investors to follow in the coming months, providing clues on how and when this disconnect between markets and economic growth will be resolved.
The first chart, in hindsight, was the only one investors needed to follow in 2020. It compares S&P 500 returns with financial conditions – corporate borrowing costs, essentially – and it highlights the degree to which central banks have saved the day for equity investors.
The Goldman Sachs U.S. Financial Conditions Index was developed by the company’s prominent economist Jan Hatzius. The index combines (in order of importance) government bond yields, corporate bond spreads, the trade-weighted U.S. dollar index, stock prices and the Federal Reserve Policy rate to measure the ease of credit availability for major borrowers.
Financial conditions and U.S. equity prices have tracked extremely closely since October, 2018. A rising purple line indicating easing monetary conditions and lower borrowing costs has been accompanied by climbing stock prices.
In 2020, the dramatic loosening of financial conditions from March 23 was primarily Fed-driven. The slashing of interest rates pushed government bond yields, which make up 45 per cent of the Goldman Sachs index, lower.
Fed chair Jerome Powell’s announcement that the central bank would purchase corporate bonds narrowed the spread – the difference between corporate and government bond yields – significantly. Corporate spreads make up 40 per cent of the financial conditions benchmark, so this also had a major effect.
Lower borrowing costs have direct positive effects on corporate profitability and they are also important in driving stock valuations (such as price-to-earnings ratios) higher. When bond yields are extremely low, the potential earnings growth of equities looks more attractive in comparison. As a result, an influx of assets into equities justifies higher valuations.
It's not just profit potential that makes U.S. equities attractive relative to bonds. The indicated yield on the S&P 500 is well above bonds.
Savita Subramanian, U.S. quantitative strategist at B of A Securities, emphasized the importance of low bond yields for stock markets in a June 29 research report. She pointed out that the S&P 500, even after a spate of dividend cuts, offers approximately three times the yield of the 10-year Treasury – close to a 70-year record. Or, as the report’s lengthy title put it: The S&P is Statistically Expensive on Almost Every Measure Except Relative to Bonds (and Maybe That’s All That Matters).
The bulk of rate cuts and central bank assistance to stock prices is behind us. It’s an open question, then, whether equities can continue higher as monetary stimulus fades.
The second chart features U.S. data, but the focus on cyclical stocks makes it very significant for Canadian investors. The purple line represents the MSCI USA Cyclical Sectors Minus USA Defensive Sectors Return Spread Index, which tracks the relative performance of economically sensitive stocks, including the resource industries and industrials that still make up a large portion of the S&P/TSX Composite, and defensive equity sectors such as consumer staples, health care and real estate.
The cyclicals minus defensives index is plotted against the U.S. 10-year Treasury yield. The relationship between the two lines is inconsistent, matching closely between late 2015 and mid-2018 but going their separate ways from September, 2018, to early 2020.
There are, however, two periods on the chart where the cyclicals versus defensives index appears to have provided early warning of falling bond yields and loosening financial conditions. The MSCI index led yields lower from November, 2015, to July, 2016, and again for eight months after September, 2018.
The most recent data show a strong rebound for cyclical equity sectors – owing in large part to a sharp recovery in energy stocks – and that’s been good news for the TSX.
Scotiabank strategist Jean-Michel Gauthier noted in a research report last Thursday that equity sectors showing the strongest price momentum have shifted tremendously from defensives toward cyclicals and resources in North American markets. For Canada specifically, “gold continues to dominate rankings, but other cyclicals and resources are catching up. Discretionary, tech and energy stand out for their June ranking gains. Meanwhile, defensives see universal weakness, with communications, utilities and real estate suffering from the steepest falls.”
So far, bond yields have not followed suit with the cyclicals versus defensives index. If yields do head upward, this would put pressure on dividend-paying stocks in defensive market sectors – the risk-free yields on government bonds would become more attractive relative to equity payouts.
Most importantly, continued outperformance by cyclical sectors would signal the recovery in global economic growth that is already reflected by the rally in stock prices.
The MSCI cyclicals minus defensives index will likely also provide guidance on the relative returns of domestic versus U.S. equities. The S&P/TSX Composite, with its large weighting in economically sensitive companies – should outperform the S&P 500 as cyclical equities outpace defensive market sectors.
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