My thoughts on the present re-opening rally hiccup

Later today, I am talking to Ash Bennington, my friend and colleague at Real Vision, on our Daily Briefing about what’s going on in the market and the economy right now. And I’d like to use this note at Credit Writedowns to help me collect my thoughts and frame the situation.

The long and short of it is that I doubt we’re seeing a fundamental move. We’re having a corrective pullback, yes. But, it’s not based on any fundamental shift I can discern in the economic outlook. And so, to the degree market internals still show upside momentum, there’s no reason the market can’t rally from here until a fundamental shift does happen.

The ‘fundamentals’

What I am looking for is clarity. And by that, I mean data that, with some certainty, removes some outlier medium-term scenarios from the range of potential outcomes. To the degree the possibilities removed are downside risk events, then it would support the recent rally. But to the degree, upside scenarios become non-viable, the clarity would support another leg down in risk assets.

For example, today the New York Fed released the Empire State Manufacturing Index showing a surge of 48 points to a reading of just negative 0.2 from negative 48.5 in May. That’s a massive move to the upside that was unexpected, as Reuters says economists it polled were looking for a reading of negative 29.8.

What does this mean? It means we are now in the midst of a snapback rally. It means that the US economy is coming out of a near complete shutdown into something much better. The data do not yet show a V-shaped recovery, where the economy rallies completely back to pre-crisis levels in a short span. It will take many more months of data for that. And equivalent PMI readings will need to be into the high 50s and 60s repeatedly for that to occur, not just north of 50%. But, this one survey at least confirms what we all suspected, that the initial bounce of economic bottom will be V-like in shape.

Unfortunately, that’s all the data we are getting. In my view, we will need a few months’ data before we get clarity on the economy. Moreover, with 45% of S&P500 companies offering no forward guidance, it’s going to be hard to say anything about earnings. Only when the smoke clears from the re-opening, by September and October, are we going to have the kind of clarity we need for shares to move based on fundamentals.

The technicals

Having said that, it’s interesting to see what the technical indicators have been saying about sentiment. This MarketWatch blurb came out just as the major correction was happening on Thursday, for example:

Thursday’s slide could reflect a change in complexion in the bullish outlook for markets, at least for the moment. Many chart watchers use the 200-day moving average to gauge momentum in an asset. The index remains well above its short-term 50-day moving average at 24,268.36, however. It’s important to note that the Dow is remains in a bearish condition, known as a death cross, where the long-term moving average is above the short-term average.

On Friday, Market Watch was saying:

U.S. stocks are firmly higher early Friday, rising in the wake of Thursday’s aggressive broadly-based market downdraft.

Against this backdrop, the S&P 500 has thus far maintained key support, an area matching the 200-day moving average, currently 3,014, and the 3,000 mark.

We’re still higher today. I’m not turning into an equities technical analyst here. But, the point I’m trying to make is that nothing in the market internals says sentiment today has shifted markedly. And, without a fundamental catalyst, there’s zero reason to think this pullback has legs.

It was interesting to see technical analyst Katie Stockton on Real Vision today saying pretty much the same thing. She actually thinks the market will hit new highs before 2020 is over.

Where are we?

So to wrap up, we are still in the uncertain phase where there are a wide dispersion of potential economic and market outcomes. But there is a  phase shift that is upon us. And it has to do with the data flow.

As the re-opening now unfolds, the dispersion of outcomes will narrow with either a bullish or bearish skew. And when that narrowing takes form, only then do I think we could see a fundamental move. What has changed now is that the re-opening data prints have gone from prospective outcomes to actual data. And that means, we are in a period of narrowing optionality. Every data print will narrow range of medium-term economic outlooks. And eventually, the bulls or the bears will be forced to capitulate.

If you look at this from a data print perspective, you have the jobless claims prints showing continued labor market pressure. Meanwhile the manufacturing and PMI prints show a V-shaped resurgence. Eventually these two will fall into line and that will feed through into risk assets. China might be a harbinger.

Global leaders are closely watching China to see how long it takes to get back on its feet as they begin to relax their own stringent anti-virus measures and reboot their economies.


But a collapse in export orders amid global lockdowns has left factories more reliant on domestic demand, which is recovering at a more sluggish pace.

Retail sales fell for a fourth straight month. While the 2.8% drop was smaller than the 7.5% slump in April, it was larger than the 2.0% fall tipped by analysts. Heavy job losses and fears of a second infection wave have kept consumers cautious.

My read on the Chinese data is that output can and will ramp up quickly. The question is end demand, both domestic and foreign. And a lot of that depends on consumer behavior in the wake of the first wave of the pandemic. Initial reads from China show the country ramping up to meet external demand, while internal demand remains weak. That’s more negative for current account surplus countries like China or Germany than deficit countries like the US or the UK. But, it’s still early days.

What else am I watching?

I need to see how the credit cycle is doing. So I am watching an evolving story in the shale oil space. The Wall Street Journal is writing that US banks are reining in reserve-backed loans to shale industry oil companies. And this is causing a liquidity crunch.

Moody’s Corp. and JP Morgan Chase & Co. forecast a total reduction of as much as 30% to the asset-backed loans, or tens of billions of dollars. At current prices, that will be enough to tip some weaker players into bankruptcy as capital for the beleaguered industry dries up, say bankers, lawyers and energy executives.

In the 2015-16 shale oil meltdown, banks rolled over loans. And that helped us through that period. Now, it seems there is less willingness to evergreen these things. That means bankruptcies are coming, especially if oil prices remains under pressure.

The BP write-off today is big news in that context. In essence, BP is saying their reserves are worth less. And so, they have taken an asset impairment charge. The menace for BP is leverage because a weaker oil price environment outlook could cause more impairment, a downgrade into junk and a dividend cut. This bears watching since BP is an oil major.

But, note that oil prices have firmed today, along with the equity market indices, I believe in large part because of the bid from retail investors. I see dollar weakness, equity strength and oil price strength as all part of one trade where the narrative underpinning that matrix is a V-shaped recovery.

I am also looking at the Calpers story in the FT.

Calpers is to move deeper into private equity and private debt by adopting a bold leverage strategy that the $395bn Californian public sector pension fund believes will help it achieve its ambitious 7 per cent rate of return.

The takeaway is that Calpers – faced with the prospect of dwindling returns – is not lowering its return target. It is, instead, taking on more risk. To me, this points to what US pension companies as a whole are looking to do to weather the retirement crisis storm. And, as long as markets go up, this strategy can work. It’s when markets fall, especially over a sustained period that we should expect these pension companies to run into trouble.

To me, this points out a ‘need’ for rising markets rather than just a desire for one.

My View

I fully expect to see people double down on the V-shaped narrative as Morgan Stanley has done. This downdraft is not a fundamental move.

At the same time, over the next several weeks, we will get a lot of economic and viral data. From that, we should get a sense about production, consumption, jobs, and second virus waves. I see the re-opening as the end of the recession. And so, with this data, we will get a sense as to whether we double dip or continue toward the V-shaped outcome markets expect. Policy stimulus is key because it will fill in any gaps should the data trend soft.

I see risk assets as fully priced in that all of the gains in the re-opening rally have been based on multiple expansion, from already rich levels. You need a V-shaped recovery to justify the resurgence in shares irrespective of how much liquidity the Fed pumps in. So, most of the risk is to the downside here. But markets can continue to rally in the face of that risk until and unless it becomes clear that we are falling short of the V-shaped recovery.

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