Morning Commentary: Unintended Consequences

Foreign Exchange - Morning Commentary
Unintended Consequences 
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
One of the clearest illustrations of an unintended consequence from the Fed’s largesse can be seen on the fringes of the stock market; this area is populated by unprofitable small cap companies.  

In the month of March alone, the Fed came through with emergency rate cuts followed by massive bond purchases and a variety of emergency facilities to support the credit markets.  Additionally, the Fed also coordinated with central banks around the world to ease the supply of US dollars.  

As of the end of last year, 38% of Russell 2000 companies were unprofitable with this number continuing to rise.  Since the lows in March, the stock of unprofitable stocks have rallied 79% on average.  Conversely, companies that are profitable have rallied only 47%.  While companies that are viewed as “stay at home” winners make up some of the big winners, stocks for unprofitable companies in the plastic surgery and energy fields are also rising.  

To be sure, outperformance tends to come from companies that are the most beaten down.  Further, the Fed’s moves facilitated easy access to credit, which mitigated the risk of bankruptcy.  The pandemic delivered a massive shock to the economy and authorities needed to act fast, and on balance, the pros from stimulus outweigh the cons.  Still, it is unsettling to see the ranks of unprofitable companies grow while their stock prices continue to rise. 

Even when you pull back to a broader level and compare all equity prices to the real economy, the gap between the two remain historically wide.  After a period of positive economic surprises, partially due to a mechanical re-opening bounce, there are starting to be signs of a pullback.  With massive amounts of stimulus sloshing around the markets, this disconnect can persist for a while.  But ultimately, you have to pay the piper and if traditional recessionary effect are being disguised by stimulus, the worst may not be over. 
  • US initial jobless claims came in at 1.4 million claims, missing expectations for 1.3 million claims.  In addition to missing expectations, initial jobless claims rose for the first time since March.  This provides another data point suggesting that the initial re-opening bounce could be fading and illustrating continued stress in the labor markets.  
  • US stimulus talks continue today.  Treasury Secretary Mnuchin has indicated that the payroll tax holiday will not be in the next package but may be in follow-up legislation.  Discussions are also continuing on what to do with the additional $600/week in jobless aid.  An extension is expected but at a lower amount.  
  • Virus headlines continue to trend negative with worldwide COVID cases exceeding 15 million cases.  Asia was one of the first areas to bend the curve but is seeing a resurgence in cases in Hong Kong, Australia and Japan.  These results illustrate one of the biggest risks to re-opening.  Markets have been taking a “glass half full” mentality.  However, a resurgence in infections should make the re-opening process bumpy and could force markets to reassess price action in risky assets including the US dollar.    
  • UK-EU Brexit talks ended with no progress as expected.  The same issues remain with fishing rights and “level playing field” rules among the key points of contention.  The UK government also admitted that a trade deal with the US is unlikely to be completed this year as hoped.  
  • The Australian government published its economic and fiscal outlook that painted a gloomy picture despite expectations for a large stimulus package next fiscal year.  
  • News reports indicate that China is considering responding to the closure of its Huston consulate with cuts to the US mission in Hong Kong. 
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