December 2020 Monthly Report: Equities Rally on Vaccine Optimism

Good Afternoon,

I awoke to no power this morning because a tree had fallen on some power lines. Which is odd because I live in South Florida and would have bet that one of the many hurricanes this season would have knocked the power out.  Lucky me, none really touched us.

This brings to the markets. I was pleasantly surprised to see them roar back from the coronavirus. Yes, I bought in at the lows, but even I was shocked to see it come back so fast and strong.

December 2020 still could be crash the markets. Everyone is looking for the “storms” but a tree could knock the markets. This doesn’t mean I am not Bullish, but let’s just say I am nervous bullish.

Vaccine developments drove a furious rally on Wall Street and global stock markets in November, as news that multiple efficacious vaccines could be administered by early next year was cheered. The faster than expected timetable on vaccines put a return to “normal” in sight for 2021, ending the uncertainty over the time it would take to develop a vaccine.

However, the here and now remains challenging for the U.S. and European economies, as virus cases continue to march higher and restrictions tighten, threatening the progress of the recovery. In contrast to the unabashed optimism in equities, the bond market took a more measured view, as yields rose but remained at historically lean levels. Virus developments and economic data through December will test the optimism of the stock market versus the agnostic view of the bond market.

Upbeat vaccine news captured the market’s attention in November. Pfizer and Moderna both applied for approval from the EU, with officials expected to decide by the end of December. The vaccine produced by Pfizer and BioNTech has shown a 95% efficacy rate in trials. Moderna said its vaccine is more than 94% effective.

A vaccine developed by the University of Oxford and AstraZeneca is in the final stage of testing. Moderna is seeking emergency use authorization from the FDA, with Pfizer doing the same. Vaccines could be available later in December on a limited basis, with a broad rollout slated for next year.

In other matters, the Brexit saga continued, as market participants waited in vain for a concrete development from the EU and UK on future relationship negotiations. Fishing and level playing field rules remain the major blocks. What is clear, deal or no deal is that the EU and UK’s relationship will be an ever-evolving and complicated one when the UK exits its transition membership of the common market and customs union at the end of this year.

The UK wants to diverge from EU rules, while EU states are concerned that the UK will undercut their markets. The relationship will be subject to dispute arbitration with the possibility of retributive measures. Hence, markets are anticipating only a narrow free trade deal, which would be centered on manufacturing. The stakes are high, which is why we expect a deal.

FOMC: No New Clues on Policy

The FOMC didn’t make any waves at its November 4-5 policy meeting. None were expected given the intersection with the general election that accounted for the one-day meeting push-back. The uber-accommodative posture was extended, with improvement in the economy and a lack of inflation pressure. The Fed likely intended to keep this meeting a non-event for the markets, and in that the FOMC succeeded. The 0.0%-0.25% rate band was maintained, and there was nary a change in the statement versus September.

Chair Powell’s press conference didn’t add to the general body of knowledge either, and there was nothing to suggest a shift anytime soon. The focus will remain on the economy, where the path will depend on the course of the virus. The Fed also repeated it will use the “full range of tools to support the economy in this challenging time.” The vote was a unanimous 10-0, versus an 8-2 vote in September when the new policy framework was included.

The minutes to the November FOMC meeting, released on November 25, revealed the discussion on asset purchases indicated by Chair Powell, but judged that “immediate adjustments to the pace and composition… were not necessary, they recognized that circumstances could shift to warrant such adjustments.” However, “many” thought the Committee might want to “enhance” its guidance “fairly soon.” The purchases were seen supporting the smooth functioning of the markets and they also helped provide insurance against emerging risks. And a “few” thought purchases could help guard against “undesirable upward pressure on longer term rates.”

The Committee also talked about the need for well communicated forward guidance. There was no indication of a change as soon as the December 15-16 FOMC, even though many officials have been open to the idea. The economy still looks too good, with rates still low, for the Fed to act. The minutes reiterated that the pandemic was causing “tremendous” hardship. However, while the rebound has been stronger than expected, it’s moderated recently. “Several” participants were concerned over the lack of additional fiscal support. On inflation, there had been some pick up in consumer prices, but broader price trends were still quite soft.

Looking ahead, we expect Chair Powell to continue arguing for more fiscal stimulus, especially with the expiration of more programs at the end of this year. The surge in virus cases has increased restrictions and threatened the pace of the recovery, providing more support for further stimulus. We do not expect Powell or other Fed speakers to give any indication on QE plans in front of the December 15-16 FOMC.

The European Central Bank (ECB) remains on course to ease policy further in December, with officials highlighting that despite positive vaccine developments, the recovery will need ongoing monetary and in particular fiscal support through 2021. Comments confirm that the ECB remains on course to extend stimulus at the December 10th meeting with asset purchases and longer-term loans the central bank’s main weapons.

The ECB is expected to strengthen PEPP, but could also boost regular asset purchase programs and improve TLTROs, although the final package will likely also depend on what happens on the virus front. Even in the best-case scenario, PEPP is still expected to be extended through next year, and Lagarde has made it clear that the ECB is firmly focused on helping governments to extend fiscal support by maintaining favorable financing conditions.

The Bank of Japan (BoJ) left rates and asset purchases unchanged at the October 29 meeting, matching widespread expectations. However, BoJ head Kuroda stressed downside risks while the economic outlook was cut back with the bank expecting a more volatile recovery path amid high virus uncertainty.

Kuroda also stressed the uncertainty for the economic outlook and said the bank will closely watch developments in emerging economies, which may have fewer policy tools at hand. Advanced economies meanwhile have ample room for a policy response, he assured. The BoJ will firmly continue monetary easing and special programs will be extended if necessary. The BoJ next meets on December 18, with no change anticipated to the current policy setting.

The Bank of England (BoE) topped up its asset purchase program by a further GBP 150 bln at the November 5 meeting. The increase was GBP 50 bln more than markets had been expecting. Lingering hopes that the BoE would join the negative rate club were not realized however. The BoE’s statement and minutes highlighted that asset purchases will remain the weapon of choice going forward.

Economic Trends

In the U.S., the Q3 GDP data revealed a powerful rebound of 33.1% after the -31.4% Q2 drop, led by household consumption and residential investment, alongside a big bounce in equipment spending and a rapid reversal of the out-sized Q2 inventory liquidation rate. The Q3 bounce was restrained by a powerful surge in imports that sharply exceeded the bounce in exports, as much of the U.S. inventory build was fed by imported goods, alongside weakness in nonresidential investment in structures.

We also saw a Q3 drop-back in government purchases after a CARES Act boost in Q2, though most of the CARES Act expenditures were transfer payments that didn’t enter this GDP component. The Q3 GDP bounce reversed 66% of the GDP plunge in Q1-Q2, and left GDP -3.5% below the level in Q3 of 2019. Our Q4 GDP estimate is at 6.4% for now. More broadly, the balance of U.S. economic data released through November provided timely insights into the impact of cross-currents at play in the economy. Rising production to feed restocking inventories contrasted with fresh coronavirus restrictions, a dynamic that will play out in the remaining Q4 economic reports.

German Q3 GDP growth, released November 24, was revised up to 8.5% (q/q, sa) in the final reading, from the 8.2% reported initially. It was an impressive bounce back from Q2’s -9.8% plunge, but the performance was not sufficient to compensate for the contraction that was triggered by lockdowns earlier in the year. Activity remained -4% below that seen in Q3 of last year when adjusted for working days. The report showed a solid rebound from lockdowns, but that was always expected and the report is already looking outdated against the background of renewed restrictions that may not be as severe in Germany as elsewhere in Europe, but will still weigh on Q4 GDP. European economies are likely to face further misery over the winter and well into next year under even the most optimistic vaccination scenarios.

China’s recovery appears to be broadening, as a key manufacturing sentiment measure improved to its best level in three years during November while a non-manufacturing sentiment measure saw its best reading in eight years during November. GDP is expected to accelerate to a 6.0% y/y pace in Q4 following the 4.9% growth clip in Q3 and 3.2% gain in Q2. China’s economy contracted -6.8% y/y in Q1 with the impact of the pandemic and lockdowns.

In Japan, GDP rebounded 21.4% in Q3 (q/q, saar) following the -28.8% plunge in Q2. The bounce was a bit stronger than anticipated, but the strength of the report was undercut by a heavy contribution from government spending. Consumer demand picked up and exports also climbed, as trade flows resumed after the weakness in Q2. As was the case in the U.S. and Europe, the level of GDP in Q3 was below the pre-pandemic level. Government spending remains a crucial driver of the economy. We expect GDP to slow to a 3.0% rate in Q4. The government and BoJ were struggling to transition the economy to self-sustaining growth even before the pandemic ravaged the global economy.

Market Developments

Stocks posted double-digit gains in November (with the exception of China), buoyed by positive news on vaccine development that significantly boosted the prospects for a return to normal in 2021. Meanwhile, the U.S. election removed a source of considerable uncertainty — President elect Biden will take office with a House that is just barely under Democratic control, while the Senate looks to be retained by the GOP. Of course, run-off elections in Georgia scheduled for January will ultimately decide Senate control, but the GOP is widely expected to retain the two seats up for election. A divided government tends to be favored by the market, as such a composition makes drastic policy changes highly unlikely. Meanwhile, early December saw a return of stimulus hopes, with talk of a $908 bln bipartisan stimulus bill out of Congress making the rounds.

Wall Street went to “eleven” in November, with the Dow, S&P 500, and NASDAQ all surging 11% relative to late October levels. Compared to March lows, the Dow was 60% higher, the S&P 500 up 64%, and the NASDAQ a remarkable 80% firmer. European bourses also jumped in November versus October, with the Euro Stoxx 50 up a stunning 19% while Germany’s DAX was 16% in the green on the month. The UK’s FTSE rose 15%. Japan’s Nikkei 225 improved 14% while China’s CSI saw a more modest but still strong 7% gain. Moreover, the rally saw a broadening of gains on Wall Street as shares of firms that would benefit from a return to normal saw fresh buying interest.

Longer-dated Treasury yields did rise through November but by a relatively modest amount given the rally on Wall Street. The 10-year Treasury yield climbed to 0.911% to begin December from 0.875% at the end of October. The rate was in the 1.60% region during early February. The German 10-year Bund improved to -0.527% from -0.628% while the UK’s Gilt rose to 0.345% from 0.259%. The 10-year Japanese Government bond (JGB) edged up to 0.014% from 0.037%.

While yields did climb through the month, fixed income appeared to a take a more measured view of the vaccine — indeed, it will take some time to manufacture, distribute and vaccinate the large numbers of people needed for a return to normal. In the meantime, the U.S. and Europe face a challenging winter as cases spike and lockdown measures return. Meanwhile, central banks continue to supply the system with considerable liquidity, keeping a lid on rates by design.

WTI crude oil rallied to an eight-plus month high of $46.26 in the final week of November on optimism that the vaccine will restore demand next year and that OPEC+ will agree to extend production caps. Oil demand in Asia recovered from its worst Covid impacted levels, though demand remains relatively soft in the U.S. and Europe.

The jump in risk-on sentiment that benefited stocks and crude oil resonated through commodities in general, lifting the Reuters/CRB commodity index 8% to 159 by the beginning of December. Recovery hopes had the edge over worries about demand destruction. Gold prices fell 4% to $1,815, as gold continued to retreat from the record high $2,063.55 in early August as the safety premium further eroded.

Covid Crisis Poses a Challenge for Eurozone Banks

Europe is in the middle of the second wave of Covid-19 infections. The prospect of another hit to the economy in Q4 still leaves ECB and fiscal authorities in crisis mode, but positive news on the vaccine front leaves investors looking ahead to the recovery. Once the focus shifts, it will also become increasingly apparent that the rise in sovereign debt and private debt through the crisis will leave not just banks vulnerable to a likely rise in non-performing loans. It also leaves the risk of another debt crisis on the table if and when the ECB tries to rein in the stimulus.

The first wave of the pandemic saw central banks and governments going into crisis mode, with preferential and subsidized loans implemented to help keep companies afloat through the crisis. Measures like the subsidized wage scheme helped employers retain skilled staff through lockdowns, which in turn allowed a quick restart of activity once economies re-opened. This has been particularly effective for the manufacturing sector, especially as major export partners continue to expand, and demand picked up pretty quickly again. It also helped to keep consumption underpinned, and it put a lid on unemployment.

Looking past the crisis, however, it is clear that governments and companies will have to pay back the debt accumulated during the crisis. The ECB’s Financial Stability Report highlighted that not only does the strength in asset prices and renewed risk-taking leave some markets increasingly susceptible to corrections, but it also highlighted “rising fragilities among firms, households and sovereigns amid higher debt burdens”.

Some banks already struggled with the “hangover” of non-performing loans (NPL) accumulated during the financial crisis. Not only has the reduction of NPL levels come to an end, but banks are also likely to face a rise in non-performing loans as not all companies that have been kept alive with the help of crisis loans will survive the pandemic. Also, not all households will be able to cope with the accumulated debt burden amid the rise in jobless numbers. The banking system as a whole had already started to increase provisions at the start of the pandemic, but developments are uneven across countries and at the same time the nightmare of the Eurozone sovereign debt crisis is raising its head again.

According to the ECB, “banks’ exposures to domestic sovereign debt securities have risen almost 19% in nominal amount — the largest increase since 2012”. This reflects to a large extent the sharp rise in sovereign debt issuance that was necessary to finance crisis measures, which was not only snapped up by the central bank, but also by banks. Again, cross-country differences, which were already large before the crisis, have become even more pronounced.

For Italian banks the share of total assets invested in domestic sovereign debt securities have now reached 11.9%, for Spanish banks, it still amounts to 7.2%, while for German and French banks it is only around 2%. The ECB estimates that if banks increase their holdings in-line with the projected rise in fiscal debt over the next couple of years, these exposures could rise a further 0.8-4.7 percentage points. It is unlikely that developments will reduce cross country differences.

So far this hasn’t been a problem, thanks to the ECB’s asset purchase program, which is keeping demand for sovereign debt underpinned and spreads narrow, despite the sharp differences in debt burdens. The EU’s proposed recovery fund, which transfers some of the financing responsibility for the necessary recovery programs to the EU level and thus allows debt sharing to a limited extent, also helped markets to look past vulnerabilities at the country level — these vulnerabilities are likely to increase going forward.

As long as that remains the case and spreads remain low, there is unlikely to be a problem. However, developments highlight risks going forward once the focus of markets and investors moves away from immediate crisis measures and central banks attempt to rein-in stimulus measures. Joint financing of the proposed recovery fund may have been an important step, but it does not constitute a move towards general debt sharing or the finalization of a banking union.

For now, the ECB’s PEPP program, which also removes the need to distribute purchases according to the ECB’s capital key, is helping to gloss over the issue. Yet the books have to be balanced at the end of the program, which currently is set for June of next year. However, even if vaccine developments offer a glimmer of hope for a recovery next year and ECB officials seem to try to dampen speculation of additional stimulus, the above highlights that in Italy in particular, the risk of a negative feedback loop between sovereign and bank debt is still high and rising. So rebalancing the books won’t be easy, and if nothing else the ECB will push out the end date of the program. Indeed, unless there is a move to joint financing and debt sharing in the Eurozone, which currently seems unlikely, the temptation to push out the end of PEPP indefinitely will be high.