"The question is not what you look at - but how you look and whether you see."
- Henry David Thoreau
Shifting Narratives
The reflation narrative, born out of reopening economies and historic stimulus, helped power shares of economically sensitive companies higher after nearly a decade of underperformance. However, over the past several weeks, pandemic beneficiaries have outperformed reopening trades. Growth stocks have trounced value stocks, commodities have lagged, and Treasury yields, which peaked this year at the end of the first quarter at 1.8% (10yr), have moved steadily downward toward 1.3%.
The combination of peaking growth (both economic and earnings-related), the Fed’s more hawkish tone, and risks from the COVID variants have coincided with enough force to shift the narrative and give markets a growth scare. These recent activities are driving asset prices in large and somewhat erratic moves, with the dramatic fall in bond yields being the most obvious indicator. Equities have held up relatively well so far, but this belies large risk-off rotation underneath the surface, which has largely washed out the positive returns from reflation trades.
What do we make of the changes in sentiment? We wrote last month that growth rates would start to decelerate as we lap the early days of the pandemic-induced shutdown as the recovery matures. The move from accelerating growth to decelerating growth is a natural progression of any business cycle, but investors will need to get used to the concept. We also noted the market has yet to fully reflect the above consensus growth we expect in the coming quarters. With trillions still parked in money market funds, it is clear many investors remain under-exposed to that attractive growth setup.
While the market narrative oscillates between ‘risk-on’ (e.g. cyclical stock outperformance, bond yields up) and ‘risk-off’ (e.g. secular growth stock outperformance, bond yields down), investors would be well-served to remain focused on the long term. We believe a sustained expansion is the base case, and interest rates will continue to normalize to that outlook. We sense rebalancing, light volumes, and technical factors make the recent asset class moves more volatile than normal.
At BakerAvenue, we maintain analytical independence from pre-written market narratives. We remove preconceived biases from the equation and defer to our analytical output. Ultimately, our views are only as optimistic or pessimistic as our technical, fundamental, and macro analyses indicate. Currently, our short-term metrics are in a neutral position. Long-term trends continue to paint a more optimistic picture (positive).
For those who have been following our weekly market updates (click to view previous market update videos), you will be familiar with several of our key concerns and opportunities. For well over a year, we stated that the retrenchment in economic activity in 2020, while necessary, was self-inflicted, not structural, and prone to snapping back as re-opening resumed or vaccines entered the narrative (click to read previous market commentaries). We are seeing that snapback happening now with the economic recovery in full stride. While we recognize a sustained expansion is quite different than quick normalization, we suspect favorable policy decisions, economic growth, and earnings will continue to support a further grind higher inequities.
The dominant macro narrative remains one of recovery. Powered by fiscal stimulus, vaccination progress, and excess savings built over the past year, economic forecasts have seen a steady stream of positive revisions over the past few months. GDP growth for 2021 is expected to be the strongest in forty years.
The world’s central banks (e.g., the Fed, the ECB, etc.) have provided the monetary fuel to help boost the recovery. Low interest rates, a series of government support packages, and a commitment by the Fed to highly-accommodative fiscal policies have buffeted the pandemic shutdowns and laid the groundwork for the recovery. While the Fed recently signaled they are beginning to discuss removing some accommodation, we don’t think investors should fear the shift. Despite a more seasoned expansion, we believe investors will see little tightening (rate increases) before late-2022. In short, the recent move lower in yields seems premature, if indeed spurred by concerns that growth may not materialize due to tighter policy conditions.
Regarding the new Delta COVID variant, we assume that the currently available vaccines are reasonably effective against it. Therefore, even if caseloads rise again, we don't believe governments will reinstitute the sorts of lockdowns we saw in 2020, because hospitalizations will most likely be far lower than last year.
The current technical backdrop remains in decent shape. Most major indices remain in well-defined price channels, with shallow pullbacks doing little to alter their longer-term trend. The S&P 500 was up each month last quarter and seven of the last eight months. It was the second-best first half of a year since 1998.
There have been six tests of the 50-day moving average (S&P 500) this year; each met with a staunch defense. Leadership has turned less risk-on (e.g., IPO/SPACs are performing poorly, volumes are anemic, small caps are lagging recently, etc.), and we suspect that reflects some healthy skepticism.
Internal metrics are a bit mixed. Market breadth has deteriorated slightly over the past few weeks and can be seen by looking at the Value Line index, a great proxy for the average stock. It had a fantastic run into its mid-March peak, strongly outperforming the S&P 500. The 2nd quarter wasn’t as kind, with a lot of churning in this relationship. How this tight range resolves itself in the months ahead will say a lot about what the back half holds. Investor sentiment is mixed with money flows into equities picking up but remaining well below those of bonds and cash.
Absent a negative catalyst stretched technicals, and bullish positioning alone is unlikely to cause a sharp correction, despite making the market more vulnerable to bad news. We feel pullbacks present opportunities to deploy capital for the long term.
Rotation within the market continues to be a weekly theme. We expect this churning behavior to continue as uncertainty over the pace of the recovery remains. Despite the back-and-forth among asset classes, we were glad to see most major indices continue to hover near all-time highs.
Fundamentally, we are focusing on the trend in corporate profits and credit metrics. Earnings estimates continue to be revised higher, and we suspect 2021 will end with profit levels at record highs. We run earnings revision screens each week, and in 2021 not a week has gone by where profits weren’t revised higher. Supply chain constraints, input cost pressures, and labor shortages may impact the linearity of upcoming quarters, if just temporarily.
Valuations are stretched in some pockets of the market but only slightly above long-term averages in others. The pace of the expansion in corporate profits has exceeded the price in 2021, so multiples are now lower than they were at the start of the year. Valuation dispersion remains at record levels with a sizable gap between the secular growers and the more economically sensitive recovery plays. During the recent rotation, the growth stocks have benefited most, widening the gap. We expect less dispersion going forward as investors embrace a more balanced view.
The credit backdrop has improved with both investment-grade and high-yield spreads vs. Treasuries back to pre-pandemic levels. Because continued tightening here is consistent with a rally in stocks, it has been encouraging to see. Dividend reinstatements (or increases) are now running well ahead of dividend cuts. As corporations’ confidence in their outlook continues to improve, we expect share buybacks and M&A to follow.
In sum, we remain comfortable with our positioning. Shifting narratives are part of investing and often result in tactical dislocations and opportunities. We have championed a ‘barbell’ approach by investing with secular winners while simultaneously allocating capital toward assets that will benefit most in a recovery. While the second quarter rewarded more defensive assets, we feel maintaining some cyclical presence is prudent. Systemic risks that could result in recessionary or bear market conditions remain low given the accompanying growth backdrop. Our forecast for a maturing but sustained economic expansion strengthens our belief that investor focus should be on “how” one is positioned, not “if” they should have exposure at all. That “how” should continue to include both secular growth and cyclical allocations.
Our investment philosophy is based on a dual mandate of growing, and protecting, client assets. With our cash positions now residual in nature, we are focusing on strategy positioning vs. our respective benchmarks to control risk. Should our base case hold, we plan to maintain our steady positioning. Of course, should the backdrop start to destabilize, we will take a more defensive stance.
Given the volatile and ever-changing backdrop, we believe a strategy that combines disciplined fundamental, technical, and macro analyses has the best chance of generating superior risk-adjusted returns. While our forecasts are subject to revision, our commitment to client service is rock solid. Should you have any questions, please reach out to us. Contact BakerAvenue, we are happy to share our thoughts in greater detail and welcome your questions or comments.