A tale of two markets, once again
Financial markets were caught by surprise this week as a surge in bond prices, which caused a sharp drop in Treasury yields, has infected stock markets and dampened risk appetite as we move into the end of the week. The markets have shifted from being concerned about the Fed raising interest rates and tightening global monetary policy, to concerns about global growth after signs that growth has peaked in the US and is slowing in China.
The bond market has been at the forefront of this week’s moves, the 10-year US Treasury yield is trading at 1.3%, compared with 1.48% a week ago, the 30 -year is trading at 1.91% compared to 2.07% last week, and even the 2-year Treasury yield, which is closely linked to interest rate expectations has fallen 6 basis points this week to 0.19%. These sharp moves in the bond markets are telling us two things: firstly, that growth is not as strong as we thought it was last month, secondly, that interest rates are not going anywhere fast. Those who thought that they were in for a quiet summer of trading had better think again.
Volatility is back with a bang
We have mentioned many times over the years that financial markets seem to focus on one topic at a time. In recent months that topic was the global reflation trade and untethered economic growth on the back of increased Covid vaccination rates and the alchemy of fiscal and monetary stimulus that was sending growth rates surging to multi-decade highs.
However, this week’s price movement suggests that the market has recalibrated its ideas about the future: growth has peaked and could weaken in the second half of the year, and fiscal stimulus has run its course and will no longer provide a boost to global growth. These are pretty big drivers that have triggered panic in financial markets and sparked rotation out of economically sensitive stocks and into the safety of Treasury yields, which are once again proving to be the safe haven of choice for the world.
Divergence in performance as Apple and Amazon earn their safe haven stripes
If we paint the recent market picture in broad brush strokes, then the pattern is clear: safe havens are up, risky assets like stocks and indices are down. However, it’s not as simple as this picture looks. If you drill down into individual asset classes and individual stocks then you see a very mixed, and some may say confusing, picture.
For example, on Thursday, Amazon and Apple made record highs. This could be explained by the fact that these “super” stocks act like a mixture of growth and value stocks, their balance sheets are so large and their valuations so gargantuan that they are pretty much untouchable when the market has a crisis of confidence like we have seen this week. Bitcoin, which was once touted as a hedge in periods of equity market volatility, has fallen sharply this week, it was down nearly 3% on Thursday, and remains close to its lowest level since January.
In contrast, the retail trading army’s other favourite trading picks are having a more nuanced week, with AMC Entertainment, the stricken cinema stock beloved of Reddit users, rising 6% on Thursday. Banks were generally lower, as were real estate stocks. Interestingly, oil was higher on Thursday, yet copper futures declined, most likely on the back of Opec + continuing to prop up the oil price. So, do not think that this is an easy market to trade.
What goes up, and what goes down, does it go up again?
When volatility rises this brings with it great opportunities, however, you need to plan your trades carefully. Chart 1 below, highlights the contrasting fortunes of individual US blue chips, with Amazon surging to fresh record highs, JP Morgan and other banks sinking, and Berkshire Hathaway, which is a play on value stocks due to Warren Buffet’s investing style, also coming under pressure in the current environment.
We mentioned that investors crave certainty, and when economic data clashes with the market’s view of where the US economy is, we can see fall-out like we have this week. For example, US payrolls were not seen as particularly strong even though more than 850,000 jobs were added last month. Likewise, a 60.1 reading in the US ISM services sector survey also added fuel to the volatility fire in the bond market, since the market had expected a reading of 63.5 for June. It is worth remembering that these are still big numbers and thus we could see the reflation trade recover from this stumble, particularly if we get a good Q2 earnings season in the US and across the world.
Has China ditched capitalism?
There was another shock that markets had to digest this week, news that Didi, the Chinese ride sharing app, could see its Chinese business wiped out after the Chinese regulator ordered online stores not to sell its app due to “concerns” about data privacy, sent the shares roiling. Within days of its listing its share price has fallen by 65%, and its shares fell another 6% on Thursday.
After seemingly accepting capitalism it now seems that China wants to punish firms in the tech sector that it deems are too powerful or are a risk to China. It is too early to say if this is a rejection of Western capitalism by China, but there are different rules to play by in Beijing, and China has made it clear that it will stamp out any Bezos wannabe or any tech giant that follows the model set by Silicone Valley. This shift could weigh on stocks linked to China in the coming weeks, including Zoom, its share price fell more than 2% on Thursday. However, US tech giants including Amazon or Facebook, which barely do any business in China, could be immune to this move.
US Bank earnings, a high bar after Q1
Whether or not sentiment can be reversed could be determined by the Q2 earnings season that will kick off in earnest next week. Below we take a closer look at what to expect from the major US banks for Q2.
- Record earnings are expected for 2021 as a whole, but it looks like growth may have peaked in the US and globally, thus it may be hard for banks to beat stellar Q1 earnings. For example, Goldman Sachs beat earnings estimates in Q1 by more than 80%, we do not think that this will happen this time.
- Analysts tend to be quite conservative when it comes to earnings estimates, however, Q2 EPS estimates for the US banking sector has been revised up by 9% over the course of Q2, according to FactSet. This raises the bar for banks to post earnings that are better than expected, thus it could make it hard for banks’ stock prices to get a boost from this earnings data.
- Banks are also set to release more reserves that they kept in case of large loan losses on the back of the pandemic. Since the pandemic has had a limited impact on credit demand and on loan losses, we expect more of this cash to be released, which could also boost Q2 earnings data.
- Net interest income, which comes from loans, could be mostly unchanged, as major US banks have noted in recent weeks that credit demand remains strong, boosted by fiscal and monetary support to help householders and to keep interest rates low. Added to this, the housing market remains incredibly strong in the US and elsewhere, which could also boost net interest income.
- Lower investment banking and trading revenues are expected across the major banks, but this could be especially notable at Goldman Sachs and Morgan Stanley, which rely heavily on their IBs. This is a sign that market volatility has dropped since Q1, and also that financial markets and the reflation trade has started to normalise.
The US banking sector has been under pressure for the last month, a recent pick up in the share prices of JP Morgan, BOA and Wells Fargo has not lasted, and stocks have sold off sharply this week as the reflation trade has sold off.
The technical picture is not supportive of near-term gains for the banking sector, and stocks do not yet look oversold on a longer-term basis. Thus, unless banks’ earnings can smash Q2 EPS estimates, like they did in Q1, we think that banks could remain under pressure during this earnings season.