July Monthly Update

Here are the top 7 market developments we have been watching in July.

1. Over the last two months, emerging markets returned almost 13%, outperforming the S&P 500 by over 500 bps.

  • Are we witnessing a transition after more than a decade of emerging market equity under-performance? The chart below highlights the magnitude of the under-performance for the ten years ending July 31, 2020.

The graph shows the total return for the iShares Emerging Markets ETF in red and SPDR S&P500 ETF in blue from July 2010 - July 2020.

The graph shows the total return for the iShares Emerging Markets ETF in red and SPDR S&P500 ETF in blue from July 2010 - July 2020.

  • What do know from history about when and why to expect a reversal of performance trends. As Touchstone Investments observed, the relative performance of emerging markets vs. US equities closely tracks relative earnings.

Source: Touchstone Investments

Source: Touchstone Investments

  • We are already witnessing an uptick in sell-side analyst earnings estimates for emerging market equities, though admittedly part of the uptick can be explained by a weakening USD. So why could we finally be at an inflection point, after many head fakes? Why could emerging markets earning growth outperform US earnings growth going forward?

  • Over the last several years, the composition of emerging markets has improved; poorly managed countries, cyclical industries, and poorly capitalized financial companies have declined in emerging market equity indices. And as we discussed previously (here), a weakening USD alleviates financial pressure on emerging markets, who tend to be short USD.

  • While the media is mostly focused on equities, developments in other financial markets merit scrutiny as well.

2. Interest rates continue to decline. It is becoming increasingly difficult for businesses and individuals to generate interest income.

  • Two-year Treasury note yields dropped to a record low of 0.12% at July month end. Ten-year Treasury note yields declined 11 basis points in the month to 0.55%, within a whisker of March’s low of 0.54%.

  • The story is the same everywhere. According to ICE Data Services and reported by the Financial Times, as of June 30, approximately 86 percent of the $60 trillion global bond market traded with yields of 2% or less, with more than 60 percent of the market yielding less than 1%. Almost $16 billion of debt market securities currently offer a negative yield!

Low Yielding Debt.jpg

3. Credit risk is beginning to manifest itself. Credit creation is akin to the arteries in the body’s circulatory system. When the flow weakens too much, the economy will suffer.

  • According to Bloomberg data and analysis and reported by Peter Cecchini, approximately 47% of corporate debt carrying BBB tier ratings, or about $2.6 trillion of BBB tier debt, has either a negative outlook or is on credit watch negative as of June 30. In other words, with further deterioration in business operations, these debt securities are at risk of being downgraded to high yield (“junk” bond) status.

  • Globally, Bloomberg reports 578 companies were downgraded to high yield status from March to June. Given the high yield market is a relatively small and less liquid market, the downgrades are already constricting the flow of credit as buyers of high yield bonds are saturated.

  • Similarly, credit and collateral issues facing collateralized loan obligations have led to a pull-back in issuance by CLO sponsors and bank loan syndicators, a topic we touched on in our First Half 2020 Review.

  • Finally, banks themselves have begun to tighten lending standards, reducing access to credit.

Source: Peter Cecchini, The Federal ReserveThe chart shows bank lending standards, a higher number (more positive) translates to tighter lending standards

Source: Peter Cecchini, The Federal Reserve

The chart shows bank lending standards, a higher number (more positive) translates to tighter lending standards

  • We will continue to watch credit markets closely. They are often the canary in the coal mine. 

4. On the topic of mines, we are monitoring gold prices, which are signaling an erosion of confidence in the financial system.

  • In a Goldilocks (no pun intended) economic environment of strong productivity, strong economic growth, and low debt levels, gold offers little value as a financial asset. In July, the price of gold spiked 11%, bringing its increase to almost 30% year-to-date. Interestingly, gold has exhibited a strong correlation to real rates since the advent of quantitative easing (QE) in 2008. We will have more to say on gold as an indicator in the future.

Source: World Gold Council, St. Louis Federal Reserve BankThe chart compares monthly average gold prices to the ten-year real rate calculated monthly using FRED data

Source: World Gold Council, St. Louis Federal Reserve Bank

The chart compares monthly average gold prices to the ten-year real rate calculated monthly using FRED data

5. The poor performance of bank stocks is explainable, but if the economy is going to rebound and the stock market is to sustain its rebound, history says bank stocks should start participating.

  • As noted by Sven Heinrich of the Northman Trader, bank stocks participated in the stock market rally to new highs in 1998-2000, 2006-2007 and 2014-2015. Bank stocks are failing at the moment, massively under-performing the other side of the market captured by the Nasdaq Index.

The graph shows the total return for the Nasdaq ETF in red and SPDR S&P Bank ETF in blue year-to-date through July 2020.

The graph shows the total return for the Nasdaq ETF in red and SPDR S&P Bank ETF in blue year-to-date through July 2020.

6. Is inflation boiling under the surface? Yes, but…

  • As we discussed, here, here, and here, the massive monetary stimulus, massive fiscal fiscal stimulus, and supply chain issues due to Covid-19 and trade tensions with China, have created fertile conditions for inflation. However, the global economy is currently dealing with deflationary pressures from a demand shock (shutdowns) and a burgeoning corporate credit crisis. Monetary policy has become impotent. The question is whether the massive fiscal expansion will continue.

  • Both political parties in the U.S. have demonstrated an inclination to continue socializing private (corporate debt and commercial bank loan) losses and providing transfer payments to businesses and households. If the fiscal authorities go one step further and force commercial banks to lend, then we will know inflation is around the corner.

  • In addition, when well respected investment writers and deflationists, like Russell Napier, start to worry about inflation, it is time to take note.

7. Job Losses

  • To date, while the number and speed of job losses has been unprecedented, most of the job losses in the US economy have been concentrated in areas (restaurants, leisure) that tend to be lower paying, with hourly wages. If the US economy does not exhibit a strong and sustainable rebound by early fall, we anticipate increasing job losses for higher paying, salaried workers. While the number of job losses will nowhere near what we have witnessed in recent months, the loss of high quality jobs will be a big headwind to consumer spending.