Stock-Market Selloff & the Fate of the Euro Zone -- The Capital Note

A trader works on the floor of the New York Stock Exchange shortly before the closing bell, March 17, 2020. (Lucas Jackson/Reuters)

Welcome to the Capital Note, a newsletter about finance and economics. On the menu today: the stock-market selloff, weakness in the euro zone, and a look at Bush v. Gore.

Stock Selloff

Big-tech stocks are selling off today, marking a sharp reversal of the stock-market rally that began in late March. Led by the “FAANG” companies, the Nasdaq is down 5 percent.

Equity valuations have been on a seemingly inexorable rise since the height of the coronavirus panic. Over the past few months, intermittent drops have been punctuated by repeated rallies. Even after today’s decline, stocks remain above their March lows by 80 percent.

That being said, there are obvious signs of worry. The VIX, a measure of expected volatility, stood at 26.6 as of yesterday, despite all-time highs in stock indices and relatively muted realized volatility for the past few months. Coinciding with a record highs in the S&P, recent levels of market “fear” surpass those at any point during a stock-market peak.

VIX on days of new S&P record
Source: Goldman Sachs

Investors are also concerned about the election, as Andrew pointed out in a Capital Note earlier this week. October- and November-dated VIX futures spiked in mid-August amid uncertainty as to how the pandemic would affect elections. Markets are expecting a move of more than 3 percent in the S&P in November, the highest ever in an election year.

It remains to be seen whether today’s decline means anything for stocks in the long run.

— D.T.

Euro Zone: North and South, Yet Again.

The Financial Times:

Eurozone retail sales fell in July for the first time in three months, indicating that the recent rebound in consumer spending in the region has run out of steam.

There were also signs of a widening north-south divide in the pace of economic recovery, with German, French and Dutch retail sales remaining above last year’s levels, while the Spanish, Portuguese and Greek figures stayed in negative territory.

This divergence was confirmed by IHS Markit’s final composite purchasing managers’ index for August, which showed Germany and France remained above the key 50-point level that separates business expansion from contraction, while Spain and Italy dropped below it.

The weakness in Italy (and, to a lesser degree, Spain) is worth noting. Italy’s debt/GDP is on target to exceed 150 percent by year-end, and its GDP is likely to fall by over 9 percent. This matters, at least in theory, as a currency union is only as good as its weakest link, but, with the European Central Bank (ECB) active in the market, there seems little reason to think that Italy won’t be able to finance its debt.

Reuters explained last week:

Investors may struggle to find new southern European government bonds for the next two years, as the European Union’s support programmes could cover much of the new funding needs of countries worst hit by the pandemic.

Together with ongoing European Central Bank bond buying, the net supply of new sovereign Italian bonds to the open market may even shrink.

Grants and loans from the recovery fund and cash from the so-called SURE jobless scheme could cover around 80% of borrowing needs after accounting for redemptions in Italy and Spain across 2021 and 2022 and 70% in Portugal, Morgan Stanley reckons.

“This is effectively about providing levels of financing to these countries that they will not need to go out and do themselves in the primary market,” said Tony Small, the bank’s head of European rates strategy.

That’s true enough, but it doesn’t remove Italy’s underlying problem: It has hard-currency debt (which is not going away), and a “soft” currency economy (which is not going to change) — and the two do not fit together.

And speaking of countries that do not belong in the euro zone, there was this from Bloomberg:

Separate figures Thursday showed that the Greek economy shrank 14% in the second quarter, falling to levels not seen since 1997. The drop was the result of a 32.1% decline in exports and an 11.3% fall in private consumption.

Under the circumstances, it is not surprising that Greece’s negative balance within the euro zone’s Target-2 settlement system has seen sudden, rapid growth. In February that number stood at a negative €25.2bn, about where it had been for the previous year. As of July, the number had risen to a negative €70bn indicating that money is flowing out of the country at a sharp pace.

But back to retail sales.

The Financial Times:

After being hit by the lockdowns imposed to contain coronavirus, retail sales bounced back strongly once those restrictions were lifted in May.

But that rebound seems to have lost momentum after Eurostat said on Thursday that eurozone retail sales fell 1.3 per cent in July from the previous month.

The figures undershot the consensus expectations of economists for eurozone retail sales to continue their positive momentum with monthly growth of 1.5 per cent, according to a poll by Reuters. Compared with the same period last year, eurozone retail sales were still up 0.4 per cent.

Economists at Morgan Stanley said the drop in retail sales “might reflect the payback from strong pent-up demand during initial re-opening”.

That seems fair enough, but the picture does not suggest much strength in the euro zone economy, making it unsurprising that the euro has given up some of its recent gains against the dollar, although, if I had to guess, it’s still quite a bit higher than the ECB would like to see.

The ECB’s next move will be worth watching.

— A.S.

Around the Web

Some common sense from the Competitive Enterprise Institute on the proposed new rules from the Department of Labor governing the use of Environmental, Social and Governance (ESG) criteria in certain pension investments:

One genre of responses that seems to be common is that the department’s rule (assuming it get finalized and published more or less in its current form) would represent some kind of major attack on—of even “death knell” for—ESG investing itself. Those criticisms are overstated.

One business law attorney recently blogged that the proposed rule and subsequent letters to investment firms requesting information about their ESG practices constituted “another nail in the coffin of environmental, social and governance (‘ESG’) disclosures” and made it “more likely that ESG will be consigned to the ash heap of history.” This dire prognosis will no doubt come as a surprise to ESG’s vocal advocates, who routinely declare it to be “an unstoppable force” with “inevitable” consequences.

To clarify, the proposed rule applies only to fund managers who serve as fiduciaries for private pension funds regulated under the Employee Retirement Income Security Act of 1974 (ERISA). It also only applies when a fund manager explicitly prioritizes the advancement of environmental and social issues over providing maximum returns to beneficiaries—a goal that ERISA has always required. As the department’s initial filing pointed out, not only is the current proposal not a departure from the existing statutory interpretation, it’s not even a meaningful departure from previous sub-regulatory guidance issued in previous administrations.

Some optimism for once, via Conor Sen at Bloomberg:

Slow labor-market recoveries in the recent past have occurred because of prolonged job slumps in goods-producing sectors. This time around, there are signs these areas are rebounding much more quickly, which could help buttress the economy and increase labor demand even while the pandemic health threat is still with us…

V-shaped recoveries in manufacturing and construction would be significant because they’ve been at the root of slow labor rebounds in the past. Manufacturing employment never recovered the declines it sustained in the 2001 and 2008 recessions, and it took years for construction employment to recover after the bursting of the housing bubble. To the extent employment during the pandemic is suffering in service-sector industries such as dining and travel, it may only take the end of the public health crisis for those to normalize.

Low levels of inventories, growing demand, and a currency that makes U.S. exports more competitive globally than they’ve been for a while are all tailwinds for manufacturing and construction jobs in the months ahead. While the pandemic may keep in-person services activity subdued for many more months, this recovery in the goods-production sector should support economic growth in the meantime, and perhaps allow us to avoid the kind of years-long labor market recoveries that have become all too normal in recent cycles.


The New York Times:

In simpler times, divinity schools sent their graduates out to lead congregations or conduct academic research. Now there is a more office-bound calling: the spiritual consultant. Those who have chosen this path have founded agencies — some for-profit, some not — with similar-sounding names: Sacred Design Lab, Ritual Design Lab, Ritualist. They blend the obscure language of the sacred with the also obscure language of management consulting to provide clients with a range of spiritually inflected services, from architecture to employee training to ritual design.

Their larger goal is to soften cruel capitalism, making space for the soul, and to encourage employees to ask if what they are doing is good in a higher sense. Having watched social justice get readily absorbed into corporate culture, they want to see if more American businesses are ready for faith.

“We’ve seen brands enter the political space,” said Casper ter Kuile, a co-founder of Sacred Design Lab. Citing a Vice report, he added: “The next white space in advertising and brands is spirituality.”

Random Walk

On the topic of election-day volatility, today’s Random Walk takes us back to the November 2000 election. During the two weeks following that contested election, the Dow Jones index fell by 5 percent. Some market watchers believe November 2020 could see a similar sell-off.

Not everyone fared poorly during that election, though, according to a paper from Fordham University’s John Shon:

Using the full population of publicly traded firms, I find an economically significant positive (negative) relation between pre-election campaign contributions to Bush (Gore) and stock returns during the 37-day election recount period. This relation exists for both the level and partisanship of contributions, and exists incrementally at both the firm and industry levels…

[S]ubject to some caveats, my evidence suggests that the oil and gas industry’s US$1.889 million contributions to the Bush campaign translated to an increase in market value in the industry of approximately US$103 billion.

— D.T.

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