The U.S. stock market has had a great run this quarter, fully recovering its losses from March, but the S&P 500 is not the best performing primary index in the developed world. That prize goes to the German Dax which is up nearly 23%. 1 1 Close It’s up less than the NASDAQ 100, but I would argue that is not the primary U.S. index. Is it? Return data from Bloomberg as of 6/25/2020. Much of the rest of Europe has performed well too, though it still lags the U.S. on the year. The recovery in European assets has not been talked about much here in the U.S., where analysts have been preoccupied by the strength of domestic markets. It’s a shame, because what’s happened in Europe is in many ways encouraging, despite having some uniquely European risks.
Europe was hit early by COVID. Belgium, Spain, Italy and France experienced some of the highest mortality rates in the world. 2 2 Close Financial Times: “Coronavirus tracked: has the epidemic peaked near you?,” as of 6/25/2020. Investors fled stock and bond markets in affected countries. Economies across the continent contracted because of both mandated and voluntary changes in behavior. Whenever there is any sort of economic or financial crisis, investors worry about the sustainability of highly indebted countries such as Italy, but they worry a little more when the crisis is affecting those countries directly. It is no wonder that forecasters and investors were so pessimistic in February and March.
Since then, many European countries have been able to contain the virus’ spread. The worst hit areas are starting to get some good news on re-opening. Case levels, hospitalizations and deaths have come down steadily. While there have been a few outbreaks which have brought back regional restrictions, authorities have not been forced to reinstitute country-wide lockdowns. 3 3 Close BBC: “Coronavirus: German outbreak sparks fresh local lockdowns,” 6/23/2020. Sports are starting to come back without crowds but with fake crowd noise. 4 4 Close I’ve been so desperate to watch live sports, I’ve been tuning in to Bundesliga matches. “Come on it’s the 80th minute, put the American kid on the bench in!!!”
Europe is known around the world for its culture, which includes art, food, wine, literature and bureaucratic malaise. Its institutions were slow to act in past economic crises, and many had expected the same this time, but monetary and country-level fiscal stimulus have come quickly. The countries which always enjoy spending have used the crisis as an excuse to do just that. France increased healthcare spending and gave grants to small and medium size businesses. 5 5 Close Details of French and German fiscal responses from the IMF: “Policy Responses to COVID-19,” as of 6/25/2020. It added loan guarantees and direct support for certain industries. But more surprising, one of the biggest spending packages came from Europe’s Teutonic budget disciplinarian. Despite its strict rules on budget deficits, Germany put together a very ambitious “emergency” fiscal spending package. It includes a sales tax cut and support for businesses and families. Some estimates put it at five times the size of Germany’s post-financial crisis package.
The ECB provided even more help than the governments. After an initial stumble on its willingness to support peripheral debt, the ECB proved that the Fed isn’t the only central bank with serious acronym game. It added a new €750billion asset purchase program known as the PEPP. It created special new pandemic long-term refinancing operations known as PELTROS. 6 6 Close ECB: “ECB announces new pandemic emergency longer-term refinancing operations,” 4/30/2020. It took existing TLTROS and with a few conditions made them more attractive for banks. 7 7 Close ECB: “ECB recalibrates targeted lending operations to further support real economy,” 4/30/2020. The uptake on the programs has been good so far, and they have helped to narrow bond spreads. While it is difficult to compare the stimulus among different central bank programs, by sheer volume the ECB’s may eventually be the largest.
In addition, European economies did not experience the volume of layoffs that the U.S. did, 8 8 Close Euro Stat data through April has shown no increase in the Eurozone unemployment rate since the start of the year. so they may be better positioned to return to potential growth. 9 9 Close It’s also possible that the U.S. will experience a more efficient allocation of resources because folks will return to jobs that are more needed. But if Europe has done so well, then why do its equity markets, despite the recent recovery, still trail the S&P on the year? Before you answer, “because of small investors irrationally buying U.S. stocks,” be aware that there are some differences in the sectoral composition of the markets. European indexes have fewer technology stocks. The more tech heavy indexes such as the German Dax and the Dutch AEX have been the best performers in Europe.
Politics may also play a role. The crisis has tested European unity and challenged already wavering support for the European Union. Many people in Italy, including some prominent Europhiles, feel that Germany and the EU didn’t do enough to help early in the crisis. 10 10 Close Some take it further to accuse the Germans of outright obstruction. This is tied to an ongoing debate about fiscal integration. Some folks argue that the EU should have a large single budget precisely for times like this. However, wealthier countries are reluctant to commit to a fiscal union which they feel would force them to subsidize their neighbors in perpetuity. Early compromise proposals involved using the ESM, a program which was created during the sovereign crisis. They did not get a good response from Italy and Spain where the ESM is anathema because in the past it required strict monitoring of future spending as precondition for the loans. 11 11 Close Reuters: “Spain plans to side-step EU bailout fund – sources,” 5/15/2020.
This debate has not been resolved, but it looks like the German government is more willing to consider a fiscal union than it has been in the past. 12 12 Close The government anyway. The courts may be telling a different story. The current proposal appears to allow for one-time transfers. However, despite having the approval of both Germany and France, several Northern European countries have expressed doubts, preferring loans instead of transfers. Some Eastern European countries have concerns about the distribution of the funds. We will get a better idea in the next few months as the negotiations play out. A satisfactory agreement could provide a boost for European assets. In its absence, there is the risk that some countries may feel that it is not worth staying in the EU. Future elections may favor Eurosceptic parties, and there may be more legal challenges to ECB programs. Investors do not like instability and uncertainty so this could scare people out of European assets, even if fundamentals look promising and the economies continue to recover.
What We Are Watching
China PMIs (Tuesday/Wednesday)
Chinese PMIs moved into expansionary territory in May as government stimulus supported the economy and as the country appeared to show progress in emerging from the coronavirus pandemic. Despite positive headline numbers, some details in the data pointed to underlying weakness. In particular, the Caixin survey employment component remained in contraction as did the backlog of work category, suggesting lackluster demand and little need to increase capacity utilization. With a new round of infections reported in Beijing in June, Chinese policymakers reinstituted some containment measures. If these developments led to a setback in business sentiment, it may be a negative sign for other countries hoping for a smooth recovery path in the months ahead.
U.S. ISM Manufacturing PMI (Wednesday)
After ticking up for the first time in four months in May, the ISM Manufacturing index will be closely watched next week for signs of a recovery in production in the U.S. Despite last month’s improvement, the survey still pointed to net contraction in industrial output. While reopenings may lend sequential strength to the index, weakness in export markets, high unemployment and uncertainty around the outlook for the coronavirus outbreak in various states could weigh on manufacturing sentiment. Market participants will likely focus on the more forward-looking components of the survey, particularly the new orders component, which also improved modestly in May but remained close to all-time lows.
U.S. Employment Report (Thursday)
Last month’s employment data from the Bureau of Labor Statistics (BLS) delivered a significant positive surprise. Whereas forecasters were expecting continued job losses and increased unemployment in May, the BLS instead reported job growth of around 2.5 million and a decline in the unemployment rate. Nonetheless, the data still show an extremely weak labor market, with total headcount down 19.5 million from pre-pandemic levels and unemployment still elevated at 13.3%. The weeks between the survey period for the May data and the survey period for the June data saw relaxation of lockdown measures in a large number of states and localities, while indicators such as retail sales pointed to a meaningful bounceback in spending activity. As a result, economists are forecasting strong job growth and a further decline in unemployment in this month’s data. However, there remains significant uncertainty around the speed of the labor market recovery, as jobless claims have remained elevated in recent weeks (although this was also true leading up to the strong May report). Statistical uncertainty is also higher than usual, as response rates to BLS surveys have fallen and as the behavior of the labor market departs from historic patterns. 13 13 Close For example, seasonal adjustment algorithms may generate odd results. Education employment fell sharply in March and April, so may decline by less than the seasonal adjustment factors expect around the end of the schoolyear in June/July. This could cause the seasonally adjusted numbers to spuriously show large increases in education payrolls over the summer. A positive surprise might add to perceptions that the economic recovery is proceeding more rapidly than expected, providing a boost to equities and weighing on Treasuries. Conversely, a disappointing report might trigger fears of a more prolonged labor market downturn, providing a blow to risk sentiment.