Markets Adjust to Unfolding Events

By Ketu Desai

August was the tale of two halves. The first half of the month was driven by fear. Concerns ranged from delta-variant risk, geopolitical risk around Afghanistan, Chinese regulatory and growth risk, Fed tapering, and domestic growth peaking concerns. The sentiment was quite negative. AII sentiment was the lowest since October 2020, the last time we actually had a meaningful correction at the index level. The negative sentiment changed quickly, as it became clear that the Fed was taking delta-variant as a serious risk to growth and was likely to push the taper out to later in the year. Further, Pfizer's vaccine got full approval from the FDA, and the Chinese indicated that they are likely to pursue simulative policy. Despite the change in sentiment, the economic data has been softening.

The Citigroup Economic Surprise Index has turned negative, meaning economic data is below expectations. Consumer sentiment is meaningfully lower, retail sales have slipped, credit card spending has moved lower, travel metrics have moderated, and housing data has weakened. PMIs have weakened across the world. The question for the coming months is if this is a temporary slow-down because of delta-variant and supply issues or we are really entering back into a low growth world.

With yields so low, when investors want to get defensive they pile into large cap tech, certain large cap pharma names, utilities, and staples. US large cap stocks have acted like the global safe haven trade lately. This is an important reason why the S&P has not corrected, and the dips are shallow. For many investors, fixed income is too risky at current levels. Many have felt significant pain this year in fixed income, as long duration fixed income was down 10-15% during the first quarter of the year. US large cap names with their strong balance sheets and earnings growth have filled the void of fixed income as the safety trade.

As the sentiment shifted during the month, the risk-on trades were back. This includes cyclicals like energy, materials, industrials and financials. It includes emerging markets, small caps, and growth areas such as biotech and high growth / high multiple tech. These areas have been really beaten up over the past few months. If risk-on continues, these are the areas that have the most upside in the market. For instance, crude oil (WTI) formed a weekly golden cross (50D moving average moves above 200D moving average). This has happened 6 times since 1987, and the median gain afterwards was 31% and an average gain of 98%. When oil prices were at similar levels in 2018, XLE was more than 40% higher. Short interest in many oil names is the highest since the depths of the pandemic, which could certainly help spark the rally. With limited ability to expand because of ESG, energy companies have significantly cut cap ex, allowing them to generate phenomenal cash flow. Many energy companies are generating 10-15% free cash flow yields, and paying north of 4% dividend yields. Finally, energy could prove to be an important inflation hedge and benefits from the reopening and further fiscal spending.

As we move ahead, the macro is perhaps more important than usual. There are a number of events that could determine where the market is headed. The month gets started with an important jobs number, which is critical in the timing of the taper. The market will also focus on how delta-variant progresses, debt ceiling negotiations, the infrastructure bill and reconciliation package, news out of China, and the September Fed meeting with a dot-plot. The key areas to look for how to position your portfolio during this are yields and the dollar, with perhaps AUD/USD an important currency pair to focus on. If yields start moving up and the dollar weaker, the risk-on trades could be ready to rip meaningfully higher. If it is the opposite, look for safe haven trades to outperform.

----------

Ketu Desai is the Principal of i-squared Wealth Management Inc. ( www.isquaredwealth.com ), an investment management firm based in New Jersey. ketu@isquaredwealth.com