BakerAvenue Prudence Indicator Says...
Long-term: Positive | Short-term: Neutral
The Upcoming Policy Push
"Though we see the same world, we see it through different eyes.” – Virginia Woolf
As negotiations over the largest tax increase in fifty years and the largest spending package in a hundred years heat up, there is little doubt we are entering the primetime for policy actions. Toss in a debt ceiling debate and Fed Chairman election, and the headlines coming out of Washington this Fall will be important to monitor. August closed out seven months of positive returns (S&P 500) with several indices reaching all-time highs. What should investors expect as the legislative calendar heats up?
We are entering the peak season of policy actions with many issues (the budget, infrastructure, fiscal cliff, debt ceiling, a $3.5 trillion spending package, tapering, Fed reappointments, etc.) potentially impacting financial markets. We have seen far smaller legislative items impact financial markets in the past, so it will be prudent to monitor the legislative calendar. To us the set-up for September – October 2021 looks like the set-up of 2013. At that time, the Federal Reserve chose to delay tapering until after the fiscal issues were resolved. We suspect last month’s employment report has likely given the Fed similar cover to delay tapering until these fiscal issues are resolved again. This was very different from another volatile legislative zone, 2011, when the Fed ended QE days before the debt ceiling fight erupted in Congress.
The American Taxpayer Relief Act of 2012, signed into law January 2, 2013, raised the top income tax rate and the rate on capital gains and dividends while making permanent the so-called “Bush Tax Cuts” of 2001. This bill was being negotiated at the same time of a “fiscal cliff”, not unlike what some are concerned about today. When the bill was passed, the S&P jumped over 4% the first day, almost 7% the first month and 34% for the year.
Was it all because of the legislation? Probably not. For much of the year, the U.S. economy continued to limp along, building up steam but doing it slowly. One of the real reasons the market did so well was that interest rates stayed low with the commitment of the Federal Reserve’s $85 billion a month bond-buying program and Ben Bernanke’s persuasion to investors that interest rates would stay low for a long time. We feel that interest rates, and more broadly, monetary policy, coupled with steadily improving fundamentals, will have a bigger impact on the stock market than the current fiscal policy discussions.
August was, in the broadest sense, a “more-of-the-same” month with respect to global equity performance trends in 2021. US large caps led the field and widened their YTD performance gap. Emerging markets underperformed the most but were already in last place after a tough first half of 2021. Everything else fell somewhere in between these extremes. 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.
We wrote last month that growth rates would start to decelerate as we lap the early days of the pandemic-induced shutdown, and 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.
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 (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 (view previous market commentaries). 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 in equities. Consolidations and pullbacks, should they occur during the politically charged weeks ahead, should be bought.
The Fundamental Perspective:
Fundamentally, we continue to focus on the trend in corporate profits and credit metrics. Our weekly series for forward revenues, earnings, and margins all rose to record highs last month, suggesting that Q3 will also be another record-setting quarter. Q2 earnings season saw the largest percentage of S&P 500 companies beat revenue expectations (87%) since 2008. We expect more upside surprises this quarter, but pre-announcements suggest a more muted trend. Supply chain constraints, input cost pressures, and labor shortages are issues we are monitoring and may impact the linearity of the upcoming quarter or two, 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 pace in stock prices 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 remains supportive. Both investment-grade and high-yield spreads vs. Treasuries are 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.
The Macro Perspective:
The macro discussion starts with a view on the global economic recovery. While it continues, risks remain elevated and concerns we have passed peak growth, particularly in the US, are increasing. A resurgence in COVID cases and uneven vaccine rollout success are leading to an increasingly desynchronized recovery. China's growth remains strong but appears to be slowing as regulatory risks are rising.
Regarding the new Delta COVID variant, we assume that the currently available vaccines are reasonably effective against it. Therefore, even as caseloads rise again, our base case assumes governments will not reinstitute the sorts of lockdowns we saw in 2020, because total hospitalizations will most likely be lower than last year. We continue to expect GDP growth to be the strongest in forty years.
Interest rates will be the fulcrum by which investors express their economic growth views. We suspect they are somewhat distorted. The world’s central banks (e.g. the Fed, the ECB, etc.) have provided the monetary fuel to help boost the recovery. Some reports estimate they are buying more than two-thirds of all Treasury issuance. 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. We expect rates to move gradually higher over time as the Federal Reserve pulls back QE and the economy continues to grow. Inflation expectations have steadied over the past month, a welcome sign.
The Fed recently acknowledged that aggressive bond purchases are not a policy that fits well with a supply-constrained economy. The 2021 plan seems to be to taper QE soon (to help address inflation) while holding off on any rate hikes for an extended period (to aid growth). We believe it is still early to be concerned about Fed tightening.
The last several months have seen the market challenge the “reflation trade”. Worries have centered on the mix of slowing growth, including the risks from the delta variant, and the beginning of Fed exit. We expect this stagflation scare should pass, as conditions generating price spikes ebb (e.g., bottlenecks ease, labor supply increases) and growth picks up.
The Technical Perspective:
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. There have been eight tests of the 50-day moving average (S&P 500) this year; ,each met with a staunch defense. Longer-term moving averages (e.g. the 200-day moving average) remain in good standing with approximately 75% of stocks trading above this key threshold (a healthy level).
Internal metrics are more mixed. Market breadth has deteriorated slightly over the past several months and can be seen by looking at the performance of small cap stocks (e.g. the Russell 2000, a proxy for small cap stocks, is trading at the same level it did in February). The “average stock” hasn’t kept pace with the largest, predominately technology, issues. Currently, the top 20 firms in the S&P 500 make up 42% of its market cap, and the top 5 a whopping 25%. A bit top-heavy; we expect a broadening market as we move deeper in the Fall.
Rotation within the market continues to be a weekly theme. Leadership has turned less risk-on (e.g., IPO/SPACs are performing poorly, volumes are anemic, growth is outperforming value, etc.), and we suspect that reflects some healthy skepticism. Investor sentiment is mixed with money flows into equities picking up but remaining well below those of bonds and cash. We expect this churning behavior to continue as uncertainty over the pace of the recovery remains. Despite the back-and-forth among asset classes and styles, we were glad to see most major indices continue to hover near all-time highs.
Political headlines and the accompanying volatility are part of investing. The upcoming negotiations over the largest tax increase in fifty years and largest spending package in a hundred years are significant and prudently monitored. We suspect they will keep more than a few investors on edge. If history is a guide, legislation of this magnitude can result in tactical dislocations, and opportunities (ala 2013). We have championed a ‘barbell’ approach by investing with secular winners while simultaneously allocating capital toward assets that will benefit most in a recovery. We see no reason to change that view considering the political backdrop.
While August 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 contact BakerAvenue, we are happy to share our thoughts in greater detail and welcome your questions or comments.
Disclosure: Past performance is not indicative of future performance.