In this week’s market update: stocks hold on as some evidence emerges of economic recovery and second quarter earnings beat expectations; high yield bonds complete their best month since 2011; and gold heads further into uncharted territory.
After last week’s equity market wobbles, shares are holding firm after some positive economic reports and signs that the second quarter was at least not quite as bad as many analysts had feared in terms of company results.
The dollar, which endured a tough July as coronavirus seemed to be spiralling out of control in the US, has regained some poise this week after declining by 4% against its main rival currencies last month. A slight slowing of the rate of new infections helped sentiment but the real kicker has been a bottoming out in expectations for corporate profits.
Nearly 80% of US companies did better than forecast in the three months to June, according to Morgan Stanley. The outcome was still dire, with profits 35% lower than in the same three-month period in 2019. But it was meaningfully better than the 44% decline that had been expected a month ago.
Stock markets respond to changes in expectations and things being less bad than feared can have the same effect or even better than when high expectations are exceeded.
It has been a similar story in Europe, where two thirds of companies have done better than forecast, although the April to June quarter was still the worst on record.
Wall Street started the week 0.7% higher, with the tech-heavy Nasdaq rising twice as much to a new record partly on the back of a strong performance from Microsoft which now has the White House’s approval to bid for the US operations of Tik Tok. The better than forecast performance of a handful of big technology stock last week offset other worries and stabilised what threatened to be another meaningful market setback.
In Europe shares were even stronger, with Germany leading the pack thanks to its export focus as good news for Chinese manufacturing and positive surveys for factory output in southern Europe indicated that economies that had gone into the pandemic early were starting to emerge and recover. The FTSE 100 also rose strongly, up 2.5% on Monday.
In China, the Caixin purchasing managers’ index for manufacturing rose above the crucial 50 dividing line between contraction and expansion to hit 52.8, the highest level for more than nine years. Other surveys showed improvements in Japan and South Korea, although neither of these has yet returned to growth.
China’s economy contracted in the first quarter of the year for the first time in 40 years but bounced back in the second quarter to grow by 3.2%, although this was driven largely by state-owned industrial companies and the retail side of the economy remains fragile.
Friday will see trade data for China which will shine a spotlight on the impact that slowing growth in the rest of the world is having on the world’s manufacturing heartland. In the first two thirds of July China’s top ports registered an accelerating throughput and this week’s figures will show whether that improvement has continued.
The economic picture in the US is less clear cut, notably after GDP was shown last week to be falling at an annualised rate of more than 32% or 9.5% quarter on quarter and the number of Americans filing for first time unemployment benefit rose for the second week running.
This week will provide some crucial evidence in the form of the non-farm payroll employment data on Friday. The US economy had looked as if it was recovering from the second quarter shock on the basis of backward-looking data that largely pre-dated the surge in infections in places like Texas and Florida. This week’s job market data will provide some key evidence about whether recovery in America has been knocked off course by a second wave of Covid-19.
The risk of a resurgence of infections hangs over many countries as experimental returns to normality come to be judged by the harsh reality of the infection data. In Australia, Melbourne has been plunged back into a draconian lockdown, including nightly curfews and stringent stay-at-home orders.
The impact is being felt on Australia’s famously resilient economy, with a fall in consumer prices for the first time in 22 years between April and June. The Australian central bank has already cut interest rates to just 0.25% in March and turned to yield control to keep three-year bond yields at the same level.
In Europe, the holiday season is threatened by a partial reversal of travel relaxations. Holidaymakers in Spain have been hit by new quarantine requirements on return to the UK and everyone with trips to France or Germany planned is holding their breath about whether their holidays can go ahead.
In a low growth and low interest rate environment, investors in need of income naturally look further afield for yield. High-yield, or so-called junk, bonds are one place where they can find it, albeit at greater risk to their capital, but last month the combination of higher income and rising prices delivered the best month for nine years to investors in this corner of the market.
The average yields on high-yield bonds in the US fell last month from 6.85% to 5.46%. As falling yields reflect higher prices, the total return for investors in July was nearly 5%. Investors have moved into higher-risk bonds because the returns available on shares, as well as less-risky government and investment-grade corporate bonds, have fallen to such low levels.
Investors will, of course, only take on the added risk of more lowly-rated company bonds if they believe that the risk of default is diminishing. That reassurance has been provided in spades in recent months by unprecedented measures by the Federal Reserve to support bond markets by buying up debts that they would never have looked at before the pandemic struck.
Other signs that markets may be reverting to some kind of normality have come in the form of a partial reversal of the epidemic of dividend cuts in the spring as UK companies were either forced or chose to slash their pay-outs to shareholders.
Bae Systems last week became the latest FTSE 100 company to say it would start re-paying a dividend, worth about £300m. It joins Smurfit Kappa and Land Securities in returning to the dividend list and others in the lower tiers have followed suit.
It is only a partial recovery, however, in a bruising year for income-focused investors. More than £33bn was wiped off the amount paid out by companies in the first half of the year. This was particularly painful in the UK, where dividends have traditionally been a significant part of the overall total return enjoyed by shareholders. Those days look to be gone for good, with giant dividend payers like Shell, which cut its pay-out in April, unlikely to return to pre-pandemic levels of income for many years, if ever.
Just this morning, BP, another of the UK’s largest dividend payers announced that it would be halving its quarterly dividend to 5.25p a share. BP is facing the twin challenges of operating within an environment of an apparently permanently lower oil price at the same time as it is working out how to become a lower carbon business in the age of climate change.
The absence of income, whether from shares, bonds or deposit accounts, has made non-income generating assets like gold increasingly popular in recent months. Gold continues to hit new record levels at just under $2,000 an ounce as investors seek out its perceived safe-haven status.
Other reasons for gold rising to today’s record levels include the fall in the dollar, already mentioned. The dollar is the currency in which gold is priced, so a falling dollar makes it cheaper to buyers using other currencies and so more attractive.
The reason the dollar is falling is also important because it suggests low expectations for US growth and therefore implies lower interest rates and bond yields. At the same time, inflation expectations are rising thanks to ruinously expensive central bank and government support schemes. This means that real yields, adjusted for inflation, are negative, and this in turn means that investors have even less to lose by holding gold.
So where does gold go from here? For it to continue rising, a combination of rising inflation expectations and lower growth forecasts is probably required - what we used to call in the 1970s stagflation. That was the market’s bet in 2011 when the economy was struggling to recover from the financial crisis and the Fed was intervening in force with quantitative easing.
However, inflation failed to show up then and the price of gold duly halved in value in subsequent years. Gold is never a one-way ticket.