Interest rates signal we're not 'out of the woods': Strategist

Jefferies Global Equity Strategist Sean Darby joins Yahoo Finance’s On The Move to discuss the economic outlook for the U.S. and the Fed’s response to the coronavirus.

Video Transcript

ADAM SHAPIRO: --the recovery may not be as fast as some are hoping. And to do that and help us understand what happens to your investments, joining us in the stream is Sean Darby. He is Jefferies Global Equity Strategist. He's joining us from Hong Kong. Thank you for being here.

And as we listen to not only our central-bank chair talk about this, you've pointed out that a number of risk indicators are peaking with credit-- only the credit spreads misbehaving. Clearly the Fed is watching those spreads. But are we out of the woods with all of this just yet, Sean?

SEAN DARBY: Well, I feel that at least the credit markets now are beginning to behave in a much more orderly fashion than they were about six to seven weeks ago. So one of the things that we've always said about this potential recovery is that you needed both credit spreads to narrow, companies to go out and refinance, and also see rates remaining extremely low. So in particular, real interest rates being sort of somewhere between minus 1% to minus 2%.

And I guess the question that was asked of Mr. Powell was that with essentially real rates at 0% at the moment, we're still not into the sort of real easing policy that they would like to see. So only really credit spreads are behaving at the moment. Both the dollar, real interest rates, and even inflation expectations really aren't necessarily signaling that we're out of the woods just yet.

JULIE HYMAN: So, Sean, it's Julie here. What then does this imply for US equities? Does that imply that they're not out of the woods yet and we're still going to see some rockiness? And does it also imply that not just with assets but with the real economy that, you know, the market has kind of priced in at this point that the worst has happened?

SEAN DARBY: Well, I think the good news is that we do feel that, all things being equal, that the markets did make a bottom at around about March 19 to March 23 based on what we've seen in previous credit recessions. It's not perfect, but by and large, the balance of probabilities suggests that we're out of the-- we're somewhere out of the bottoming process.

The more difficult news is that we're not really seeing a bottoming in earnings yet. So we had a reasonably OK first-quarter-results season, but earnings have not necessarily yet bottomed out. And I think that really means that we've hit a ceiling on the S&P 500 at the moment, which is really around about 2,900. Unless we start to see a dramatic change in earnings revisions, I think the markets will probably drift from here. But I think we've still got one or two more difficult months of macro data, and probably it's going to be second half before we start to see a much more visible earnings cycle coming through. So unfortunately, I think we're sort of range bound at best at the moment.

ADAM SHAPIRO: Sean, when you talk about the second half, what should we as investors pay most attention to? Because we're going to get some form of additional stimulus in the United States, and won't that helps the markets? Whether it's the $3 trillion that Nancy Pelosi is proposing or far less, it's still going to be a boost, isn't it?

SEAN DARBY: It is. So I guess if you were just looking at the monthly data-- we've done sort of back testing. The three things that really matter to the US equity investor is job openings. We really would need to see that stimulus changing job openings, opportunities.

We certainly do need to see the global trade cycle start to turn around. It's been miserable for 18 to 20 months. So again, global earnings are very important for the S&P 500 given that 40% comes from overseas.

And thirdly-- and I feel quite reasonably confident about it-- is that bank lending standards start to ease. So the credit shock that's happened in the first quarter and certainly was visible in the senior loan officer survey by the Fed doesn't necessarily carry on into the second half. It certainly-- we see lending standards begin to crawl back or ease back, then I think again the earnings recovery will start to be a lot more visible, a lot more confident for equity investors.

BRIAN CHEUNG: Hey, Sean, it's Brian Cheung here. I love it when people reference the Fed's SLO survey. It's a very in-the-weeds report.

But I want to ask about just broad capital flows. I mean, it's tough to look at just any interest-rate differentials right now. But, I mean, it is kind of a salient point that with negative rates in other parts of the world and here in the United States, at least we're just above or near 0%. Is there still capital flow coming into the United States even though we're kind of lagging many other countries in being able to get our recovery just because the timing of all this, or do you think that there's still a lot of money overseas on the sidelines?

SEAN DARBY: That's a really good question. First of all, I'm afraid to say outside of the US there's still quite a heightened sovereign risk for many of the emerging markets. So they still prefer to hold their money in the US, number one. And number two is that looking at money-market funds globally, there's $1.5 trillion, round about that number, that's parked in money-market funds compared to where we were a year ago, which was about $250 billion. So six to seven times the amount of money has been stashed in money-market funds doing nothing. So I can understand why some parts of the equity-- some parts of the money markets are looking for negative interest rates to move or shift that change of behavior.

I think from looking from overseas, most of the central banks now have finished their monetary stimulus, and a bit like the United States at the moment, they're much more looking to the politicians to do the fiscal ammunition. So on the interest-rate side of things, I don't think necessarily that overseas is going to make a big change in terms of the temperature flows or the money going into the US. There's still heightened risk aversion out there given that a lot of other countries are nowhere near coming to an end of the COVID-19.

AKIKO FUJITA: Sean, having said that, how are you weighing your exposure outside of the US? I mean, as we see a lot of these countries start to reopen, do you see opportunities in places, for example, like Europe?

SEAN DARBY: Well, it's a good question. The one thing that I think is important to realize is that the manufacturing sector probably has the better opportunities in terms of a rebound. I know there's some depressing numbers going through the global economy at the moment, whether it's ISM or PMI numbers. But if you look at the sort of second- or third-most-important factor for why the weakness in manufacturing is so dire, it's generally because of supply-chain issues. So companies just can't get components or various other items.

The good news is that we're certainly looking at China with [INAUDIBLE] coming to an end. So the manufacturing sector has some upside surprises potentially.

I think for the services sector, it all comes down to two words, social distancing. And just how that really interacts with the service sector is what we call a known unknown, and that unfortunately is where most people are employed in the developed economies.

So if I had to make a judgment call, some of the European countries have reasonably large exposure to capital goods and the export sector. They'll probably do reasonably well in the first part [AUDIO OUT]. Those countries which have got a very high tourist orientation, places like Italy, Greece, New Zealand, I think they're going to have quite a difficult year. They're going to still be on some form of stimulus going right into 2021.

ADAM SHAPIRO: Sean Darby is Jefferies global equity strategist, and you are joining us from Hong Kong. Thank you for your insight here "On the Move."