Let’s pick up the ongoing debate over what kind of market cycle this is. Readers will know I have been juggling three narratives to explain the ongoing market boom as it confronts an economic boom:
- Bad news is good news meaning the ongoing deflation (after a brief spike) will ensure asset prices outperform the economy.
- Good news is bad news meaning the stocks boom will go bust as inflation and yields rise.
- Good news is good news meaning expensive stocks can weather higher rates because the profits boom is real but there will be violent rotations under the bonnet.
Goldman is still the outstanding example of the first regime:
Three macro issues have dominated investor discussions about the US equity market since the start of the year: rates, inflation, and taxes. Interest rates have been the most important of these topics. In a rising interest rate environment, short duration outperforms long duration in both fixed income and equities. In fact, of all our thematic baskets, duration has been the best long-short trade, posting a+25%return since the start of 2021 (see page 17). A sector-neutral portfolio of short duration stocks(GSTHSDUR) has climbed by +24%YTD compared with a-1%return for a long duration portfolio (GSTHLDUR). As Exhibit 1 shows, duration has been a major contributor to alpha generation.
There are 1992 words left in this subscriber-only article.
Start your free 14-day trial today!
Looking ahead, a static fed funds rate at the zero lower bound combined with a continued rise in both real rates and breakeven inflation means a steeper yield curve. US GDP growth will peak in the current quarter at 10.5%and nominal rates may rise by another 15bp to 1.8%. Short duration stocks should continue to outperform. However, some clients argue Treasury yields peaked at 1.75% at the end of March, and secular-growth Tech stocks will now outperform once again.
“Don’t fight the Fed” is a quip investors have learned to ignore at their peril.What the central bank wants is usually what it gets, sooner or later. A year ago, the Fed’s forceful intervention to backstop the money market sent both companies and fund managers a clear message about its willingness to provide liquidity. It set a floor beneath equities and sparked the 80% rally that has lifted the S&P 500 to an all-time high. The index has rallied9% YTD and now trades at our mid-year2021 targetof4100. Our year-end and 12-month target implies a gain of 5% (7%with dividends).
I am still of the view there is one more leg higher for yields and the prospects for a spike above 2% are real. That said, I see that as an internal equity rotation play not a shift of asset class.
Representing the second regime is still BofA:
Big flow to know: inflow to stocks past 5 months ($576bn) exceeds inflow in prior 12 years ($452bn–Chart3).
3views: 1. vaccine>virus, reopening>lockdown, boom>bust = asset rotation beats asset price rally in 2021; 2. 3R’s of rising Rates, Redistribution, Regulation = low/volatile bond& equity returns = sell asset overshoots; 3. secular lows is in for inflation & rates = realassets>financial, commodities>credit, RoW>US, small> large, value>growth.
For me, the major flaw in this analysis is the assumption of ongoing higher inflation. I see that as unlikely given so many factors driving it are temporary and China is set to slow soon, dumping commodity prices.
Finally, there is my position, which is that profits growth will put a sizeable dent in the overvaluation as inflation spikes but then falls back, driving violent rotations under the equity hood but no major breakdown in the engine itself. JPM is similar:
Equity and credit markets continue to grind higher, undisturbed by the recent rise in bond yields or negative news about corporate taxation. The majority of investors appear to be focusing instead on the fundamental drivers of risk markets such as the growth and earnings trajectories which appear to remain very supportive for risk assets. Retail investors appear to be at the forefront of this year’s flow impulse into equities but, after a year, their behavior appears to be changing away from buying individual stocks or stock options and towards buying more traditional equity funds as was the case before the pandemic. The record $300bn poured into equity ETFs in only three months has made retail investors even more overweight equities. While we recognize the risk from a potential slowing in retail investors equity fund buying going forward given elevated positioning, we are reluctant to reduce our equity OW in our model portfolio for three reasons. First, the fundamental picture, which appears to be the focus of the majority of equity investors, remains very supportive. Second, we don’t believe that the equity bull market is yet exhausted. Third, for those investors wishing to hedge potential downside risk we would consider using credit or credit vol rather than equities given more limited upside in credit and given low levels of implied volatility in credit vs. equities.
Finally, Morgan Stanley also comes down near my own position:
Over the past few weeks, the S&P500 has continued to make new all time highs. However, underneath the surface, there has been a noticeable shift in leadership which could be telling us something about the reopening that may not be obvious. More specifically, the Russell 2000 small cap index has underperformed the S&P500 by 8% sincepeaking on March 12. While this follows a period of historically strong outperformance, when relative strength like this breaks down, we take notice. Furthermore, some of the cyclical parts of the equity market we have been recommending for over a year are starting to underperform, while defensive are doing a bit better (Exhibit1).If that weren’t enough, indices of IPOs and SPACs have underperformed by 20% and are both down for the year.
…the underperformance in IPOs and SPACs is a signal that the excessive liquidity provided by the Fed is finally being overwhelmed by supply. My experience is that when new issues underperform this much, it’s generally a leading indicator that equity markets will struggle more broadly. When combined with the fact that leverage in the system is very high, it could spell more trouble for riskier, more speculative investments. From an investment standpoint, we have made some changes to our recommendations to avoid these risks while taking advantage of some underloved areas. First, we downgraded small caps four weeks ago. Not only are small caps rich (Russell 2000 at 32.5x NTMEPS) and vulnerable to the move higher in interest rates, but they are also likely to suffer disproportionately from the supply shortages and subsequent higher costs we foresee. Two weeks ago we recommended investors upgrade their portfolios by adding higher-quality stocks that have a better chance of managing through this reopening transition. If there’s one thing we’ve been surprised about over the past year, it’s the speed with which our recovery thesis has played out.
Amen to that! I agree that growth, tech, small cap and lower quality plays are the highest risk plays as inflation rises and, moreover, that there is more of that ahead. We run a value/quality matrix anyway so I’m not perturbed by any shift to mid-cycle dynamics.
But, I maintain that that inflation pulse is going to be brief and, indeed, come under major downwards pressure pushing into H2 and 2022 as supply-side bottlenecks ease and China pulls to rug from under commodity prices as it tightens.
For me, therefore, the base case major rotation ahead is back to growth as inflation turns back to lowflation in relatively short order.