Winter is coming for the SP500

Yvan Berthoux - October 8, 2020

In the past few weeks, in the run-up to the elections, the US equity market has been showing signs of ‘fatigue’. Most of the equity gains we have seen in the past 6 months have been associated with the massive liquidity injections by the Fed in conjunction with US fiscal support aimed at preventing the economy from falling into a deflationary depression. As government aid expires and the Fed has called a halt on balance sheet expansion, can equities overcome the political and financial headwinds?
First of all, it is interesting to see that after nearly doubling during the three months following the pandemic, Fed assets have steadied at around US$7 tr since June (figure 1, left frame). It seems that central bank has quietly stepped out of the market as the recovery in equities has been very fast and US policymakers may have decided to leave some room in the Fed balance sheet in case the market experiences another setback. In addition, government benefits have dramatically fallen after the CARES act expired in early August, down from US$600 to US$300 per week with up to 1 million citizens ineligible to receive the aid under the Lost Wages Assistance (LWA) program. Hopes for a new round of stimulus before the US elections have completely collapsed, with negative implications for US economic indicators in the coming quarters, especially retail sales.  

Figure 1

Data source: Eikon Reuters, Oxford economics

In addition, it is extraordinary how rapidly the equity market has recovered in the past 6 months despite the dramatic plunge in profits. Figure 2 (left frame) shows that after-tax corporate profits plunged by over 20% in the first half of 2020. Even though the two times series have shown strong divergence in the past, equity valuations imply that profitability will be restored to its pre-Covid levels. It is difficult to see how the momentum in equities can continue if profits do not follow.
Leading indicators of global trade have struggled to recover in recent months. For instance, due to its high reliance on exports (over 40% of the country’s GDP), we prefer South Korean exports as a leading indicator for global equity valuations or earnings. Figure 2 (right frame) shows that South Korean exports have strongly led global equities by 3 months over the past 20 years and are currently not pricing in any signs of pick up in the near to medium term.

Figure 2

Data source: FRED, Eikon Reuters

Another striking divergence is between the equity and credit markets. Figure 3 shows the SP500 total return against the relative performance of US high yield over high-grade credit. As far back as the beginning of 2018, the credit market has warned of a new debt delinquency cycle with clear implications for equity returns. A significant number of companies has been downgraded by rating agencies since the pandemic and the uncertainty over another round of lockdowns makes the market appear even more vulnerable.

To conclude, equities look clearly fragile in the near term with the risk of material reversal during the winter period.

Figure 3
Source: BoAML


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