Markets Look to Elections

By Ketu Desai

The market had a record August. After a moderation in high frequency economic data in July, August saw some improvement. JPM Chase consumer card spending hit a post-COVID high, despite expiration of the unemployment benefit. Initial jobless claims improved to a million for the first time since COVID. Similarly, TSA throughput and seated restaurant diners hit a post-COVID high. Housing continues to be the foundation of this recovery, with strong numbers across the board, including earnings from names such as Toll, Home Depot, and Lowe's. Inflation data came in hot during the month, CPI came in double the expectation, and monthly core CPI (ex-food and energy) rose the fastest since 1991. PPI, Core PCE, unit labor costs, and import prices were also hotter than expected. While it may be too early to worry about inflation, many conditions appear to be in place to expect more inflation. To start with, money supply, as measured by M2, is up 23 percent over the last year. We have a record deficit, showing no sign of diminishing, and likely only growing. The dollar continues to weaken. Onshoring driven by tariffs and bringing supply chains closer to prevent the issues during the early stages of COVID, will likely further drive prices to the upside.

Chairman Powell made a very consequential speech during the month. Chairman Powell said that the neutral Fed Funds rate has fallen significantly, and that the Fed will have a more flexible inflation mandate. They will focus on average inflation targeting, in which they will let inflation run hot. This means that the Fed will be slower to raise rates, and let the economy run hot. This has enormous consequences for financial markets. This means that the dollar should continue to weaken. This means that the commodity rally should continue. This should favor emerging markets and multinationals. This penalizes savers looking for yield in the fixed income market. This favors TIPs over Treasuries. This favors floating rate credit over fixed rate. This likely favors risk-on versus risk-off asset classes. This means that the Fed has our back.

On the equity side, the barbell of long growth with long cyclical value continues to get rewarded, at the expense of defensive yield names. Defensive yield are names across utilities, consumer staples, and real estate that are often considered fixed income proxies. This part of the market has significantly underperformed in recent months, a performance gap that should further widen if the recovery remains on track. Long growth is now viewed by the market as both defensive and long-term secular growth winners. While these stocks are well positioned for the long-term, they have run quite a bit, and trimming and taking some profit would be prudent risk management. Especially since most of these are long duration assets and any increase in the discount rate could cause a violent move down. Long cyclical value is the recovery trade, this is where the upside is in the market. S&P high beta trades under 11x earnings, less than 1x sales, and near book value. The earnings yield is over 8 percent that of the 10-year and over 5 percent that of the S&P, with a dividend yield that is more than 3x the 10-year yield. As Fundstrat points out, cyclicals are 24 percent of S&P market cap, but are expected to account for 62 percent of EPS growth in 2021.

The price ratio of sectors such as financials and industrials versus the S&P is the lowest since 2008. These names benefit from a weaker dollar, more inflation, rising rates, steeper yield curve (yield curve control appears to be on hold for now), improving ISM and PMIs, low expectations, and an economic recovery. Lastly, these names are the catch-up trade for the $5 trillion on the sidelines.

Looking forward the market will turn its attention to the election, while continuing to focus on COVID and the economic data.

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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