Week in Review
Domestic equities rallied for the second consecutive week, again driven higher by smaller cap performance. With the rally in smaller cap companies over the last two weeks, mid- and small cap benchmarks have regained their outperformance over large cap since the March 23 lows.
We remain skeptical of the sharp rally in smaller cap companies, as the fundamental backdrop has not improved in our view. Both mid- and small cap missed first-quarter consensus earnings per share (EPS) estimates significantly (-18% and -105%, respectively), whereas large cap maintained its 10-year streak of beating consensus estimates in the first quarter. Furthermore, with mid- and small cap next-12-month EPS estimates continuing to decline, forward price-to-earnings multiples have moved to all-time highs of 22 times (x) and 48x, respectively.
The 10-year (Y) US Treasury yield was little changed last week, and has trended sideways over the last two months in a range of 20 basis points (bps), from 0.57% to 0.77%. However, the yield curve continues to steepen, with the 10Y-30Y and 2Y-30Y curve spreads at their highest since 2017 as short-term interest rates remain near zero given expectations for easy Federal Reserve (Fed) policy for the foreseeable future.
In sympathy with the strong rally across risk assets last week, credit spreads continued to tighten in investment grade and high yield by 12 bps and 43 bps, respectively, helping both outperform Treasuries by over 4% in May. The rally was broad-based with every sector and rating cohort experiencing spread tightening over the last 10 sessions. Additionally, CCC-rated credit spreads compressed a whopping 117 bps last week, and finished down 253 bps for the month.
March’s 3.9% year-over-year (Y/Y) increase in the S&P CoreLogic Case-Shiller US National Home Price Index suggests the housing market remains surprisingly stable, with broad gains across most cities. This increase compares favorably to February’s increase of 3.5% Y/Y. While these data are an incremental positive for banks and mortgage lenders, the impact of the pandemic may be more noticeable in future months.
Chart of the Week
The US economy saw another 2.1 million (M) in initial jobless claims last week, bringing the lockdown total to 40.7M. However, continuing claims, which account for individuals who remain jobless and file for further support, actually fell. While we expect it may take some time for the labor market to recover from recent losses, this indicates the backdrop for jobs may be starting to improve as businesses reopen.
Household spending fell by a record 13.6% month over month in April, while the personal saving rate hit a record high 33% of disposable income. View Chart 1 on the full report Since consumer spending accounts for nearly two-thirds of GDP, factors that affect the ability and willingness to consume will be critical gauges in assessing the economic path forward.
While business sentiment remains challenged, regional manufacturing indexes moved higher and beat expectations in May. View Chart 2 on the full report This suggests the worst may be behind us as the economy begins to reopen and adjust to a “new normal.”
The Ifo Pan Germany Business Climate Index rebounded in May to 79.5 from April’s all-time low. View Chart 3 on the full report While the current conditions component of the survey showed a further decline, the expectations component increased significantly.
Last week, the European Commission proposed a €750B recovery plan (Next Generation EU). The package would provide €500B in grants and €250B in loans to countries and sectors hit hardest by the pandemic. Combined with the proposed 2021-27 budget of €1.1T, total spending would amount to €1.9T. If approved, the proposal would represent a positive step in the willingness of EU nations to cooperate in the face of the ongoing downturn.
US-China relations came under further pressure last week. In response to China’s freshly imposed national security legislation on Hong Kong, the US administration declared that Hong Kong was no longer autonomous, putting its special trading status in jeopardy. While we believe it may be too early to draw broad conclusions about any near-term implications, the recent rhetoric underscores the ongoing strain between the two nations.
The MSCI World ex USA index outperformed the S&P 500® last week. The index benefited from an overweight in cyclical sectors, including Financials, Industrials, and Consumer Discretionary companies, which were boosted by the rotation into higher risk assets. The MSCI Emerging Markets benchmark slightly lagged the S&P 500. Particularly strong performance from the largest sector, Financials, was partially offset by modest declines in large names within the Information Technology and Communication Services sectors.
The US Department of Commerce added 33 Chinese firms to an economic blacklist for activities that are against US national security and foreign policy, or alleged to create human rights violations against minority communities. Companies added to the blacklist are considered national security threats and prohibited from doing business with American companies without US government approval. Social issues, especially human and employee rights, have become increasingly important globally during the coronavirus pandemic.
The Week Ahead
This week we expect initial jobless claims, ISM® Manufacturing and Non-Manufacturing PMI, the May unemployment rate, consumer credit, and the Eurozone unemployment rate.