Markets Grappling with Unknowns

By Ketu Desai

The market spent May consolidating. The market is working through two issues. The first is the unwind of significant deflationary bets that have accumulated over the past decade. While a significant portion of the hot inflation readings are due to base effects and are transitory, I think most, including the Fed, would agree that we are reflating. Whether we are in a completely new inflation paradigm is to be determined. It may take a year or longer for the answer. Investors have not, and are not going to wait to rebalance their portfolios. That means, investors continue to take profits in deflationary assets and sectors, such as tech, growth, and parts of the fixed income market. Those flows come to sectors such as energy. Energy is a sector that has been terrible over the last decade. Most investors are underweight energy, it's just 2.7 percent of the S&P. While energy is up 37% this year, it will continue to benefit from reflation, the reopening, weaker dollar, infrastructure spending, and years of low capital investment and tougher environmental standards has the impact of lowering supply in a time where demand is increasing. Energy also benefits from the rotation from growth to value. Energy is expected to have nearly 3x the growth rate this year and next year than technology, and it trades at 18.9x forward earnings compared to tech at 24.3x. Lastly, when WTI was at similar prices in 2019, XLE was more than 20% higher.

The second issue the market is grappling with is understanding where we go from here. In particular, whether or not we are at peak growth and inflation. I think we are likely peaking from a growth rate perspective, purely because we are coming off a base in which there was very little economic activity. That said, with a 27.6% savings rate, more than $6 trillion in household savings, an all-time high in disposable personal income, the lowest household debt service to disposable income ratio in over 40-years, and money supply up 18%, there is plenty of fuel for a strong economy for multiple years. Further, corporations are flush with cash. The corporate cash to asset ratio is the highest on record. 2021 may be the beginning of a new cap-ex cycle. Goldman expects corporate cash spending to grow 19% this year, and another 6% next year. Finally, the government has clearly been in spend mode, with potentially more to come. With all three major segments (consumer, corporate, and government) of the economy in spend mode, growth should be above trend for a while.

Another tailwind for equity markets is the weaker dollar. The dollar hit multi-year lows during the month. It has clearly broken its multi-year uptrend. While domestic markets certainly will benefit from the weaker dollar, foreign markets could be set up to outperform. Foreign markets have underperformed for a while now. Many are beginning to show better COVID and vaccination trends. European banks could be an interesting allocation. US financials have outperformed European banks by an astounding 85% over the last 5-years. European banks with the cleanest balance sheets in a while, could be an interesting catch-up trade. They trade at just 0.83x book, compared to 1.6x for XLF. Further, they benefit from European reopening, the growth to value rotation, and provide a cheap rate hedge. The German 10YR is approaching positive territory for the first time in a couple of years, while the yield curve is steepening, which should improve profitability. European banks are under-owned, and from a technical perspective are in a clear uptrend, making a series of higher highs and higher lows. For the first time in over a decade, it may be the time for European banks.

Looking forward the market will continue to focus on the reopening, economic data, the Fed, and the latest out of Washington.

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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