“A week is a long time in politics”. Harold Wilson was referring to the fast-moving UK political environment of the 1960s. Wilson was Prime Minister during the aftermath of the collapse of the Bretton Woods regime, but he would no doubt have looked askance at the volatility in today’s financial markets. Last week, the mood among investors was one of pessimism. Positive economic indicators were being overshadowed by data pointing towards anemic growth.
Risk aversion was on the rise; credit spreads were widening, US Treasury yields were falling, oil prices dipped below $60 a barrel for the first time since mid-May. It didn’t take long for risk appetite to return. There has been a swift reversal in the indicators listed above, with credit
spreads rallying and Treasury yields rising. The impetus did not come from the global economy, where the data continues to be mixed. Corporate profitability, particularly in the US financial sector, was the catalyst for this week’s rally. Goldman Sachs, that perennial overachiever, kick-started the revival on Tuesday with record quarterly profits. JPMorgan followed suit yesterday with better than expected earnings, and today Bank of America and Citigroup surprised on the upside.
In truth, there has been a suspicion that the banks would outperform given the improved conditions in the capital markets. To merely meet expectations might have triggered a sell-off, as has happened in some non-financial credits this week. But the strong performance of the sector reassured the broader markets and signalled that banks – at lease the major ones – should emerge from the current recession in a powerful position. Optimism was not confined to the banking sector. Technology credits put in a strong performance after Intel Corp, Google and IBM posted better than expected results and gave upbeat forecasts for the third-quarter. Other blue-chip names such as Johnson & Johnson posted robust earnings.
But there were some clouds on the horizon. JPM, Citi and BofA all showed that the plight of the US consumer is getting worse. Losses from credit cards and consumer loans continued to rise, a trend that will probably extend through the rest of the year given the expected rise in unemployment. Then there was CIT Group. The lender is on the brink of bankruptcy after it failed to persuade the government to offer financial support. CIT has been shut out from the wholesale markets where it used to rely on funding, and now faces liquidity challenges that could lead to its demise. The government’s decision that CIT poses no systemic risk signals that it will not rescue medium-sized lenders, and the spreads in such companies widened as a result.
Earnings will continue to determine spread direction. Next week sees Morgan Stanley and Wells Fargo report second quarter earnings, and investors will be looking for impressive results. Other names to watch out include Apple and Coca-Cola (Tues), Pfizer (Weds), and McDonalds and Microsoft (Thurs). All our iconic names and regarded as bellwethers of the US economy.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.