Monday Digest

Posted 28 September 2020

September chill continues to bite for equity investors After another wobble last week, the S&P500 is down around 8% in US Dollar terms for the month. An element of Autumnal profit-taking following impressive gains over the summer months was to be expected. But headwinds have undoubtedly parched market optimism: an uptick in virus cases and resumed restrictions in the UK and Europe, as well as an increasingly uncertain political landscape in the US, has left some investors believing markets had gotten too far ahead of themselves.

Yet despite the downward adjustments in stock markets, bond markets have remained eerily calm. Government bond yields have been stable – not falling amid stories of the impending economic slowdown, but likewise not rising in disapproval when governments around the world issue vast amounts of new debt. This inert response has good and bad implications. Immovable bond yields allow governments to borrow at practically non-existent rates indefinitely, helping them reflate their lagging economies through fiscal action. But from an investment perspective, flatlining yields break the inverse relationship between bonds and equities. That hinders the risk offset that bonds provide investors, making multi-asset portfolios riskier, at least in the short-term.

Markets have already shown they are happy with further fiscal expansion – last week’s sell-off suggests stock markets are far more worried about the short-term cost of an avoidable recession. Politicians, on the other hand, are clearly worried about the long-term cost of their fiscal support and have started cutting incomes in response. At the same time, the continued second wave of virus cases is scaring both governments and the public away from normal economic activity. That means that some business sectors will be facing much lower levels of demand. And, with governments now only providing limited support, firms will have to find some way of cutting costs. As usual, wages will be the first costs cut. At least some increase in unemployment is inevitable. We continue to closely monitor whether politicians are playing their part in preventing lasting scarring on those sectors of the economy most affected by the continued restrictions. Central banks and capital markets have done their bit in providing the funding, but as the saying goes, you can only lead a horse to water.

Depending on politicians’ fiscal resolve – and how they spend their money – the default risk of previously-viable businesses will either continue to be contained or begin to rise. The same applies to unemployment. At the moment, credit markets are telling us that default risk is rising, and parts of the equity markets are telling us that the short-term consumer demand outlook is falling. Nothing too dramatic yet, but a clear deterioration from the summer. We are beginning to reach the point where we must hope the impact of the second wave causes the least negative economic impact, before the responsibility for ‘saving lives’ can be handled by vaccination rather than restriction of freedoms. This pivotal moment may not be that far away, and is one that many are not yet fully factoring in.

The reflation trade gets a reality check
For investors, things looked bright between June and August. The global economy was finding its feet again, lockdown restrictions continued to lift, and central bankers were committed to indefinite monetary accommodation. As such, the ‘great reflation trade’ looked on. But September has been a reality check for those expectations.

Given their close correlation with global economic activity, commodities were a central tenet of the reflation trade, and had been gradually recovering following the feverish sell-off throughout March. But since the summer, precious metals have been particularly hard hit, with platinum and silver (down 21% since the end of last month) faring even worse than gold. Not all metals have joined in the sell-off, however. Copper, often used a proxy for infrastructure spending, has held its value, and the same is true for steel and iron, with both barely changed from the end of August. That is almost certainly to do with China’s unleashing of fiscal stimulus – particularly into large infrastructure projects. According to Citibank research Chinese steel demand is the biggest swing factor for iron ore prices. Due to renewed building demand, Citi now expects iron ore prices to be on the up for the rest of the year and into 2021.

Given that oil prices are usually read as another indicator of global economic demand, the fact that the oil price has barely moved in months is notable. But without a significant rally beforehand, there was not much to correct for in oil markets. However, as we enter the winter months, there should be some seasonal effects on oil supply and demand. After prices sank earlier in the year OPEC+ (including Russia) producers agreed to substantial supply cuts. While these production cuts have been scaled back in recent months, oil producers are likely to remain sensitive to price action – dialling back production if needed. As such, prices should remain stable.

Overall, the commodity sell-off has been something of a shake-out from the previous reflation optimism. But the fact that commodities linked to economic activity remain stable is a positive – even if this is mostly down to Chinese demand. Markets seem to be waiting for more signs of optimism before resuming the reflation trade. If (and when) the cavalry arrives – either in the form of additional US fiscal support or a quicker than expected vaccine development – things could pick up again. Optimism has tempered somewhat, which might not be a bad thing. Markets are now just waiting for realistic hope.
Why the FinCEN leak is unlikely to spell long-term trouble for today’s banking sector The leak last week of files from the US Financial Crimes Enforcement Network (FinCEN) covering the period from 2000 to 2017 contained a shopping list of illegal activity, from fraud and money laundering to Russian oligarchs and terrorist bank accounts. Most damaging was the documents that showed the world’s biggest banks allowed at least $2 trillion of suspicious transactions to go ahead, in what investigative journalist Fergus Shiel called an “insight into what banks know about the vast flows of dirty money across the globe”. Damning indeed. In last week’s market sell-off, banks all over the globe had a particularly torrid time. Some of this could have been down to the FinCEN scandal, and the possibility of some renewed regulatory attention on the sector, but most of the nosedive was caused by markets’ economic pessimism. With interest rates pegged at zero for the foreseeable future, the short-term outlook for bank profits is limited – particularly if we do not see more fiscal action in the US.

Banks are, by their very nature, pro-cyclical. When the economy is booming and profits are strong, lending is easier to do. But in a recessionary environment – especially one where government rules might prevent businesses trading at any time – lenders will be more wary. When debtors are happily paying interest, banks are fine. When those debtors break the conditions on the loans, stop paying interest or fail to pay the money back, banks are under strain. The good news is that the Western world’s banks are generally well capitalised. With perhaps the exception of some of Europe’s weaker small banks, the system is as stable – or at least in better shape – than at any time in the past 30 years. So, the current economic crisis is not a financial or banking crisis. Whereas previous downturns were brought on by reckless lending, banks had done a great deal to minimise their risk exposures before the pandemic. And, even if COVID risks did prove overwhelming – which looks unlikely – governments would almost certainly not allow a banking collapse to pile onto the current crisis.

Given its low starting point and sensitivity to the global economy, the banking sector stands to offer significant upside when fortunes do eventually turn around. More fiscal action, the development of a vaccine or a quicker-than-expected rebound in sentiment are all possibilities that could prompt a quicker economic recovery. Even with all the headwinds and negative news stories, we suspect that any further sell-offs will be limited. From here, banks still stand much to gain.

Important Information
This material has been written by Tatton Investment Management and is for information purposes only and must not be considered as financial advice. We always recommend that investors seek financial advice before making any financial decisions. The value of investments can go down as well as up, and investors may get back less than originally invested. All calls to and from our landlines and mobiles are recorded to meet regulatory requirements.

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