For the last few months, I have been tracking three narratives driving all major markets. The first is good is bad news which has been manfully promoted by BofA:
- The Price is Right: lumber, copper, steel, iron ore, tin, corn,soybeans, at or close to all-time highs.
- Trade of ’21: long copper (+27.9%), short 30-year Treasury (-13.8%); note annualized 10-yr return from commodities positive (0.8%) 1st time since Nov’14 (Chart2); comparewith10-yr return from stocks 14.2%, government bonds 6.4%, corporate bonds 5.5%.
- Top of ’21:NY Clockdown Mar 21st 2020 coincided with SPX 2237 low; July 21st2021 =NYC full reopening…we say long inflation>deflation, long quality>risk.
- The taper barbell:long inflation & long quality; long inflation = long commodities, short bonds & long commodity currencies, small cap, EAFE/EM cyclicals; long quality = long low-bet a utilities, staples, and short“long-duration” equities.
- Long inflation: case for inflation causing jump in inflation expectations (seeTIPSbreakevens–Chart6); asset price inflation now mutating into real estate, commodities; next leg of trade…a. acceleration in wages (AHE YoY >3.5% in coming months), b. newhighs in oil price, c. further breakdown in long duration stocks e.g. XBI <$130, TAN<$80, ARKK <$110, KWEB<$70.
- Inflation laggards: neither commodity currencies (e.g. AUD–Chart7), nor EM assets(bonds & stocks–Chart8) reflect strength of commodities (nbEM equities a new index…was 37% resources in’08 now 13% as tech/consumer has surged from 26% to 51%-Chart9); still we think EAFE/EM cyclical offer inflation hedge for equity investors (nb 1533/3042MSCI ACWI constituents still >20% from all-time highs).
I agree with this to the extent that US inflation is going to rise enough for yields to steepen further over the next year. That is going to sink growth stocks further as the rotation to value continues.
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But, I do not see this as running out of control as BofA does. Largely because the commodities bid is going to come apart as China slows and the world passes out of catch-up growth plus spending reorients towards services. This will cap inflation.
The market is already onto this and it is why it is discounting the commodity/EM bid that BofA is overexcited about.
The second narrative is bad news is good news which has been pursued by Goldman:
With 61% of S&P 500 companies having now reported 1Q results, firms continue to easily surpass consensus expectations. 69% of firms have beat consensus EPS estimates by more than one standard deviation, surpassing 3Q 2020as the highest rate since at least 1998. Notably, 57% of companies have also beat on sales, the highest rate on record (see page 11). However, investors continue to look through results with a focus on the outlook. Stocks that beat EPS expectations typically outperform the S&P 500 by 110 bp the day after reporting, compared with just 26 bp this quarter. Several of the largest S&P 500 firms have recently announced substantial cash spending plans. AAPL recently announced an acceleration of its domestic investments; it plans to spend $430 billion across the country during the next five years.AAPL noted this initiative would span direct spend with American suppliers, data center investments, and capital expenditures in the US. AAPL and GOOGL also announced $90 billion and $50 billion buyback authorizations, respectively. 444 S&P500 companies have market caps below the combined $140 billion. The five largest stocks (“FAAMG”) alone accounted for 18% of total cash spending in 2020.
More recently, higher “quality” themes have outperformed, consistent with typical rotations when US economic growth peaks. The clearest change between environments of growth acceleration and deceleration is the performance of “quality” strategies (seeUSMacroscope). Stocks with attributes such as strong balance sheets, high profit margins, and low volatility typically underperform when economic growth is strong and accelerating, but outperform when growth slows. From a cash use perspective, our debt baskets have recently been consistent with this playbook. Debt Reducers have outperformed Debt Issuers by 5 pp (+9% vs. +4%) since early March. Unlike the stretched valuations of most of our quality factors, our DebtReducers trades at forward P/E discount to Debt Issuers (17x vs. 22x)
Goldman views inflation as likely to fall short of expectations and this bad news leads it to surmise good news for equity multiples. I agree in a structural sense but reckon that yields will lift much more quickly than Goldman does so remain skeptical of growth and strong on value stocks.
Finally, there is good is good news which I have touched on above. After we get through the base effects that will first rocket then crash US inflation over the next six months, I expect to see a steady rise in PCE as the labour market tightens towards 4% by year-end.
2022 is a year of 2%+ endogenous inflation for the US catch-up growth hands off to a strong fiscally-led growth cycle. But it will be capped by exogenous deflation as China slows, DXY rises, EMs underperform, and commodities deflate.
This keeps me long value for the time being with a watching brief to shift to growth and longer duration assets if the latter deflation overwhelms.